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Self Managed Super Fund (SMSF) Article
Runnning a pension in a SMSF

By Tony Negline.

This article may be out of date.

16th April 2008

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From July '07 Self Managed Super Funds can only commence to pay what is called an “account based pension”.  This is the pension’s official name but in the market-place you will see it called an “allocated pension”.

The use of the word “commence” is deliberate and in superannuation administration terms it’s extremely important.  A pension commences when the super fund’s trustee and the member agree that a pension will be paid from that date.

On this day a trustee transfers the assets used to pay the pension (you will often see this referred to as the pension’s purchase price) from the accumulation part of the fund to the pension part of the fund.  The income and capital gains earned on these assets go from being taxed at 15% to being taxed at 0%.

This is much more than bookkeeping and administration record keeping activities.

For example trustees might decide that they have to issue their member with a Product Disclosure Statement under the Corporations Act.  The PDS will detail all the features and benefits of the pension product.  For many years there has been much debate as to whether a small super fund trustee has to do this and it would be good to receive definitive clarity from the government.

Trustees will also want to think carefully about the asset allocation of the fund.  Whilst saving for retirement the asset allocation of the fund might be targeted more at capital growth than at income generation.  However as a pension requires income payments the trustee might have to change the way a super fund's assets are invested to target investments more focused on earning revenue.

If a super fund is not generating sufficient cash flow via the fund’s investment to pay the pension income payments then the trustee might be forced to sell fund assets.

DIY Super has seen a number of instances where small funds have had to effectively fire sale assets that were also not paying a good level of income in order to make pension payments.

In one case a super fund had 90% of its assets invested in residential properties which were then yielding less than 4% after allowing for all ongoing costs.  The remainder of the fund was invested in at call bank accounts.  The whole fund was being used to pay pensions to Mum and Dad and needed to pay them an income equivalent to 6% of their account balances.

A common solution proffered is to make the pension payments via transfer of fund assets into the members name.  This is sometimes referred to as an ‘in specie’ transfer.  You can’t do this with large assets held directly by a super fund because it will create partial ownership complexities.  In any case the super regulators have said on numerous occasions that a trustee cannot meet pension payments by transferring assets of equivalent value into the member’s name.

The only way a trustee can pay a pension is via a debit transfer from the fund's bank account into the pensioner’s bank account either via cheque or direct debit.  (Some SMSF trust deeds are flexible enough to allow a pensioner to direct the trustee to pay the income payments to another party and there is nothing in the super laws which disallows this.)

Another common solution put forward is to argue that the trustee should ignore their obligations to pay the pension until such time as the fund’s assets have generated sufficient cash flow.  In our above example, the trustee who followed this advice would have delayed making the pension payments for more than 12 months.

Unfortunately a trustee cannot ignore its pension payment obligations.  At law a cornerstone of pensions is that income payments are made at least annually.

It is also common to hear the argument that the account based pension does not create any income payment obligations.  This is incorrect.

If any pension’s income payments are not made at least annually, in cash, then the fund is not paying a pension and arguably has never paid a pension.  The end result?  The fund's assets move from the pension or nil tax part to the accumulation part of the fund and are again taxed at 15%.

The only viable solution is to begin selling assets.  At this point great practical difficulties arise.  What happens if the trustee can’t sell an asset or worse is emotionally attached to the asset?  A SMSF is no place for anyone with emotional attachments to its assets.  A trustee would want to show that they have been making absolute best endeavours and not a timid attempt to sell the asset.

Many pension paying super funds accidentally fail to make the required pension payments each year.  What should these funds do?  The best approach is to fix the problem quickly by making the income payments as soon as possible.  The best long-term solution is not to let this error become habit.

In reality all these difficulties arise often occur when a trustee invests in any asset which might have good chance of capital return but little income earning potential.  Speculative mining stocks, vacant land, artwork and collectables are all good examples of this problem.

It also occurs because trustees and their advisers are not doing what they are meant to be doing which is carefully considering their fund’s cash flow requirements and potential liabilities.

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