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Self Managed Super Fund (SMSF) Article
Defined benefit pensions in SMSFs
By Tony Negline.
This article may be out of date.
22nd June 2005
Super funds established in Australia are allowed to give retirees two different types of benefits – lump sums or pensions.
Traditionally for private sector employees, the pensions have been ‘defined’. This means that the trustee has promised to pay the retiree an income – often a percentage of pre-retirement earnings – until the retiree’s spouse died at which point payments stopped. This type of benefit today is much less common.
Actuaries have played a pivotal role in running these defined benefit funds. They use their mathematical skills to ensure a fund is always able to meet current and future liabilities. If the super fund became short of money then the employer-sponsor was duty bound to step in and make up the deficit.
Life insurance companies also provided a similar type of benefit through lifetime annuities.
With these income stream products, the longer you and your dependants live, the bigger the benefit you will receive. Once you’re dead, you can’t pass on any of your remaining investments in the product to your estate because those assets are pooled with all other investors. These products have not been very popular as a result.
As part of the retirement income reforms introduced by successive Commonwealth Governments over the last 20 years, Allocated Pensions and Term Allocated Pensions have been allowed, called. Both of these pensions do not provide a defined income payment and there is no guarantee that income will be paid for life. If the pension runs out of money, then income payments stop. However any money left in a pension account on death can be passed on to the deceased’s estate.
Since they were introduced allocated pensions have been remarkably popular products principally because of their inbuilt flexibility.
However it has taken time for the underlying problems in this product to be identified. One of the biggest problems is the potential inability to cope with investors living longer than average life expectancies.
Another problem is the direct exposure investors have to movements in investment markets. The amount of income paid from Allocated Pensions is directly related to market performance. If markets are going backwards then the income payment might also fall to the point where the investor is eating into capital merely to meet income payments.
Some investors wanted to find ways to solve all the negatives in the above product types and they have taken a long look at defined benefit (db) pensions in small super funds.
For many years the super industry debated whether a Self Managed Super Fund could provide a lifetime db pension. Such a fund would probably not have an employer sponsor so if the assets backing the pension ran out before the member died who would make up the shortfall? Before 1998 the Institute of Actuaries of Australia (IAA) did not allow its members to approve a small fund paying a db pension.
However in 1998 the IAA changed its mind because it decided that actuaries have the necessary skills to successfully manage the risks. Also in the same year the Government introduced changes to the Social Security assessment rules which made lifetime pensions exempt from the assets test as long as the pension had certain characteristics. At the same time the industry noticed that the value used to assess these pensions against a person’s Reasonable Benefit Limit was often a lot lower than the amount of money used to buy the pension. Additionally it was also realised that if the investor and their dependants died, any assets left in the fund could be distributed to the estate.
Assets test exemption, significant RBL concessions, better planning for living longer, estate planning and the ability to retain control are an impressive list of benefits especially for investors with significant amounts of money to invest. By the beginning of 2004 the popularity of these products had rapidly increased. The super industry was waiting for the government to act and most expected the RBL concession would be removed.
The government had other ideas and as part of the 2004 Federal Budget it announced that that db pensions in small funds were inappropriate and no new small fund pensions could be started after 12 May 2004.
The super industry was shocked and the outcry was sufficient to cause the government to reconsider its original announcement. In June 2004 the government announced that it would ask its Treasury Department to conduct an inquiry into small fund db pensions. An interim report was to be issued together with industry consultation both before and after the interim report was released. The final report was to be handed to government by April 2005. At the same time the government said it would allow new small fund db pensions to begin until 30 June 2005 for people who had retired.
Earlier this month the Assistant Treasurer and Minister for Revenue, Mal Brough, announced that Treasury has passed on its final report to government. He also said that the government was still considering its response to the report now that it had finalised consulting with industry.
Mr Brough also said that he would extend the 30 June 2005 dead-line until 31 December 2005. This means that new small fund db pensions can be started before January 2006. High net worth investors considering retiring in 2006 and 2007 might want to reconsider their options and retire early. In most cases advice will be essential.
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