Australian Government, The Treasury -

Review of Pensions in Small Superannuation Funds

4 Key issues with pensions provided by small superannuation funds

4.1 Introduction

The vast majority of small funds are self-managed superannuation funds (SMSFs). SMSFs are small funds with fewer than five members. They are run by the members, that is, each member must be a trustee. SMSFs have been the fastest growing sector in the superannuation industry in recent years, reflecting the desire of many people to have more control and flexibility in using their superannuation fund assets.

SMSFs must be established for the sole purpose of providing benefits to people on their retirement, or to their dependants in the case of a member’s death. These funds are also subject to the same rules that govern other superannuation funds, such as those regarding the preservation of benefits. SMSFs are regulated by the Australian Taxation Office. Funds with five or more members are regulated by the Australian Prudential Regulation Authority.

Nevertheless, there are several issues with SMSFs and other small funds related to their ability to pay defined benefit pensions.

The Government sought to address these issues through the integrity measures it announced in the 2004-05 Budget.

The key issues with pensions provided by small superannuation funds are examined below from the perspectives of choice, complexity, taxation and social security objectives, and risk.

4.2 Choice

Many small superannuation funds are established so that members can have more control over their retirement investments and avoid the ongoing fees and charges of external management. Members are attracted to these funds as they provide choice over the eventual structure of their withdrawal benefits, including the perceived ability to access an income stream that can be aligned with a retiree’s financial needs and personal circumstances.

The restrictions on small funds providing lifetime and guaranteed term pensions introduced in the 2004-05 Budget reduce the range of income stream choices available from small funds.

Initial submissions note that members of small funds purchasing an equivalent annuity through a life company incur extra costs (through external fees, asset realisation costs and capital gains tax) and give up control of their retirement savings and estate benefits (beyond the pension guarantee period). Retirees also perceive lifetime annuities as poor value for money.

Small superannuation funds still can provide allocated pensions and market linked pensions to their members. These are account based pensions, with choice of pension investments and consequential risk remaining with the individual account holder. The market linked pension is also a complying pension, which qualifies for a higher reasonable benefit limit and a 50 per cent asset test exemption under social security rules.

These products provide a range of retirement income options that meet most retirees’ needs. However, initial submissions argue that there will still be demand for defined pensions from individuals wanting a given income level for their lifetime or other term, and that small funds should be able to offer these pensions to their members.

4.3 Complexity

The system for retirement income stream products in Australia is intrinsically complex, reflecting a legislative framework that encourages self provision in retirement through a mixture of taxation and social security incentives. There are also prudential requirements and measures designed to meet other retirement income policy objectives. An example of the complexity arising from these different regulatory dimensions is that actuarial certification provisions for defined benefit pensions provided by small funds apply different assumptions for prudential and taxation purposes. There are also interactions between the tax and social security systems in the treatment of income stream products.

Providing these products may involve a significant compliance or administrative burden for retirees, the superannuation industry and regulators. Many retirees may have to access professional advice to make informed decisions about the best retirement strategy and the ongoing management of income stream products. Retirees may also focus on the tax and social security advantages of competing products rather than their underlying suitability.

4.4 Inappropriate access to tax concessions

A key element of the Government’s retirement income policy is the provision of significant taxation concessions to encourage savings for retirement. These concessions are provided on the basis that these savings will be drawn down as income in retirement. The value of the concessions is estimated at $13.3 billion for the 2004-05 year.

For equity and budgetary reasons, certain limits apply to individuals accessing these concessions. For instance, the system includes age-based taxation deduction limits for contributions and an overall cap on the level of benefits that can receive tax concessions. In addition, the superannuation cashing rules and income stream standards are intended to ensure an individual’s superannuation savings provide genuine retirement income rather than estate planning or wealth accumulation benefits.

Many of these limits and standards can, in practice, be avoided by designing and providing a pension through a small, non-arm’s length fund.

4.4.1 Reasonable Benefit Limit compression

The Reasonable Benefit Limit (RBL) arrangements provide an overall lifetime limit on an individual’s superannuation benefits that can receive tax concessions. Complying pensions (lifetime, life expectancy and market linked pensions) receive a higher reasonable benefit limit as they are non-commutable, do not have a residual capital value and make annual payments for a term which is usually at least as long as the recipient’s life expectancy at the commencement of the pension.

RBL compression refers to the practice of designing a lifetime pension in order to reduce the pension’s value that is reported for RBL purposes. The strategy is used to avoid excess benefits tax (including on death benefit payments) and secure a full rebate (15 per cent) on taxable pension income.

Pension valuation formula

Pensions payable for life are valued according to the formula in section 140ZO of the Income Tax Assessment Act 1936 (ITAA 1936).

[Annual value x Pension Valuation Factor] – Undeducted Purchase Price + Residual Capital Value 6

Manipulating the formula

The goal of RBL compression is to minimise the capital value of the pension (according to the above formula) as far as possible. Several key elements in the formula can be readily manipulated through providing a lifetime pension through a small fund.

Pensions in larger funds

The formula and the pension valuation factor tables in Schedule 1B of the Superannuation Industry (Supervision) Regulations 1994 (SISR), were designed to apply to lifetime pensions provided by traditional public sector and corporate defined benefit funds. The formula and the ‘one size fits all’ approach of the tables reflect the uniform characteristics of these pensions rather than the gender or personal circumstances of their recipients. Nevertheless, the lack of precision and outdated assumptions of these tables makes most valuations of lifetime pensions provided by these funds lower than equivalent purchased annuities.

4.4.2 Estate planning

The tax concessions provided to superannuation can result in superannuation being used for inappropriate estate planning purposes. In particular, small superannuation funds can be used to maintain investments in a low tax or tax free environment, to pass to future generations, rather than being paid out as retirement income. The ability to pay a defined benefit pension, on non-arm’s length terms, may form a key element of these arrangements.

Estate planning arrangements

Estate planning can include specific strategies to preserve key family investments in a small superannuation fund for subsequent generations. These strategies may involve use of non-complying pensions, that can be commuted or have a residual capital value. For example, a term pension, with 100 per cent residual capital value, can set aside a given investment to pass to a nominated family member following a pensioner’s death.

Estate planning benefits also arise through the need for small funds paying lifetime pensions to maintain investment and mortality reserves. According to the Australian Government Actuary, reserving policies for reversionary lifetime pensions, on average, are likely to result in about 25 to 30percent of the residual capital (in real terms) remaining in a small fund after 25years (Appendix D). This is about three to four times more than the expected remaining account balance for a market linked or allocated pension product.

An important difference to note regarding these outcomes is a compulsory minimum drawdown with market linked and allocated pension products. With a lifetime pension there is no minimum compulsory drawdown, thus providing better estate planning opportunities.

Estate planning incentives

Some initial submissions argue estate planning incentives are moderate since reserves eventually are cashed from the superannuation system as beneficiary pensions or lump sum death benefit payments.

These arrangements still provide significant tax advantages over and above those received by beneficiaries of arm’s length pension arrangements or from savings held outside the superannuation system. Reserves reallocated to ‘second or third generation’ fund members may benefit from remaining in a low tax environment for 30or more years. Furthermore, while these amounts are reported for surcharge purposes, they are not subject to contributions tax or deduction limits. Lump sum death benefit payments also receive very favourable tax treatment with tax free payments to financial dependents up to the deceased’s pension Reasonable Benefit Limit.

The tax treatment of superannuation funds paying defined benefit pensions may limit the incentive to build up excessive reserves. The tax exemption for income earned by a small superannuation fund paying a lifetime pension is limited to a ‘best estimate value’ of the pension. Any income generated from surplus assets above this level is taxed at the fund taxation rate of 15 per cent.

However, any fund tax imposed through holding surplus assets will be minimal as it will only apply to a small proportion of the fund’s earnings. The use of franking credits and capital gains tax concessions could reduce the rate of tax on these earnings. There is also some scope for actuarial discretion in estimating surplus assets.

4.5 Inappropriate access to social security concessions

A further element of the Government’s retirement income policy is the use of substantial social security means test concessions to encourage people to maximise their retirement income. Generous concessions are provided under the income and assets tests to those individuals who choose to draw down their savings for retirement in a steady, predictable manner in the form of an income stream. At the same time, the Government is concerned to minimise the scope for relatively wealthy people to use income streams to access the age pension inappropriately.

Access by relatively wealthy people to the age pension is largely addressed by the reduction in the exemption from the assets test from 100 per cent to 50 per cent for complying income streams purchased from 20 September 2004. However, small funds that provide these pensions can still manipulate their reserves to increase access to age pension payments. There are also concerns regarding the capacity of small funds to guarantee the complying pensions that facilitate increased access to the age pension, potentially increasing pressure on age pension outlays.

4.6 Risk

A defined benefit pension is an entitlement to an income stream where the characteristics are established on creation and payment is guaranteed for the term of the pension.

4.6.1 Key issues

There are three key issues about the ability of small funds to guarantee such pension entitlements. First is the lack of an employer sponsor or other guarantor (such as shareholder capital). Second is the absence of risk pooling, and third is the management of investment risks.

Lack of an employer sponsor or other guarantor means no one is obligated to contribute extra money if the fund experiences poor investment returns that jeopardise member entitlements.

A major issue, particularly with lifetime pensions in small funds, is the absence of risk pooling — especially mortality risk. A pension for an individual may be paid for a day, or far beyond their life expectancy. Consequently, the fund is bound to have too much or not enough money. In a larger pooled arrangement deaths occur with greater certainty, consistent with the broader population allowing the spreading of risk. Thus future benefit liabilities are easier to estimate.

More members also provide for more diverse investment choice, to ameliorate the risks of poor returns and investments not being able to be liquidated to meet pension payments. In small funds, investments may be concentrated in a single investment class (such as property or business assets) or even a single investment.

4.6.2 Risk management techniques

Current legislation allows a small fund to manage its risks to some extent through techniques such as reserving, asset and liability matching, and regular actuarial review and control. The legislation also allows a small fund to adjust the pension payment through commuting and repurchasing the pension. However, these provisions are not ideal. For example, reserving may be tantamount to estate planning, and downward adjustment of the pension payment raises the question of whether the pension was viable to begin with.

6 In this formula, the annual value means the sum of the pension payments to be made in the course of the first year of the pension. The pension valuation factors are set out in Schedule1B of the Superannuation Industry (Supervision) Regulations 1994. Regulation 53H of the Income Tax Regulations 1936 provides that the factor mentioned in the definition of the ‘pension valuation factor’ in section 140C of the ITAA 1936 is in accordance with Schedule1B of SISR. The undeducted purchase price is the amount outlaid (after tax) by the individual to purchase the pension, for which no tax deduction has been granted. The residual capital value for a complying lifetime pension must be zero but can be up to the purchase price for a non-complying pension.


Next: Strategies for addressing issues

Previous: Retirement income policy objectives


Commonwealth of Australia 2005
ISBN 0 642 74275 8