Looking at the old with the new – TAPs and transfer balance cap
Josh Rundmann looks at myth busting term allocation pension treatment misconceptions.
Now the New Year has well and truly been rung in with the usual bout of fanfare, the financial services profession is turning its mind towards the practical implications falling out of the recent ‘fair and sustainable’ amendments to the super system.
The most confusing change in this space appears to be the transfer balance cap, particularly how this works with retirement phase income streams outside simple account based pensions (ABPs).
Whilst prima facie many people can understand that the transfer value (that is, the amount an income stream counts towards a client’s transfer cap) of a defined benefit income stream or an annuity already in place needs a calculation based on annual entitlement – these products do not have an account balance after all – one common misconception is how term allocated pensions (TAPs) are treated.
Many people believe that since TAPs have a market value, and their annual payments are calculated based on this value, their transfer balance value should be equal to the assets backing the income stream, and as such be treated the same as ABPs.
However, an important difference between the two is that TAPs are restricted from making commutations in all bar a few circumstances, such as on divorce or to pay certain superannuation charges. ABPs on the other hand can be commuted at any stage, either in part or in full.
It appears the Government has used this distinction to calculate the transfer value of TAPs in place at 1 July 2017 by using the ‘annual entitlement’ multiplied by the remaining term of the TAP. The annual entitlement generally refers to the gross annual pension payment.
For TAPs, the annual pension is calculated by taking the account balance at the start of the year and dividing this by the ‘payment factor’ which is based on the remaining term of the TAP.
The longer the remaining term, the greater the ratio between remaining term and payment factor, as the payment factors are designed to balance longevity (making sure enough capital sits within the TAP to pay a relatively consistent pension each year over the selected term) and cashflow (making sure the amount of capital accumulated in the TAP does not grow significantly over time when this could be better served by being paid out).
For example, a TAP with 10 years remaining on its term has a payment factor of 8.32 – meaning the TAP has to pay roughly 12 per cent (1/8.32) of its capital at 1 July as a pension. After four years, there are six years remaining on the TAP’s initial term, and the payment factor has reduced to 5.33, so 18 per cent of the remaining balance at this point must be paid out.
Over time the difference between the remaining term and the payment factor reduces until in the final year of the TAP, the payment factor is one – resulting in the entire balance being paid as a pension, and any residual balance is paid out at the end of the year.
However, before the final year, the payment factor is always less than the remaining term, as there is an expectation the TAP will benefit from market returns and thus can afford to make a payment greater than simply dividing the balance by the remaining term.
To understand why this is a potential concern for the transfer balance cap, we will need to do some maths. So far we know that, for TAPs:
- The payment factor is smaller than the remaining term, except in the last year where the remaining term equals the payment factor;
- The annual entitlement is calculated as the account balance divided by the payment factor; and
- The transfer value is calculated as the annual entitlement multiplied by the remaining term.
We can express this as the equation in Box 1 below.
To see the problem more clearly, we can re-arrange the same equation like in Box 2 below.
Given our statement above that the payment factor is always smaller than the remaining term in all bar the final year, the ratio at the front of the above equation will be greater than one in every year before the last year.
This will result in the TAP having a transfer value greater than the account balance in all cases, aside from those TAPs in their final year on 1 July 2017 where the transfer value will be equal to the account balance.
Using the 10-year remaining term with its 8.32 payment factor, the transfer value of the TAP will be roughly 1.2 times the account balance. The longer the remaining term, the higher the transfer value becomes relative to the account balance.
As a consequence, clients with TAPs will not be able to hold as much capital in the tax-free retirement phase as an investor with only ABPs since their TAP transfer value is greater than the actual capital in the TAP.
What can we do?
Setting aside whether this is an appropriate approach to have taken – which is mostly a moot discussion at this stage, since the transfer balance system has been passed into law – what options are available to persons who may be impacted by this change?
We have identified two potential strategies that may be able to help impacted clients:
- Before 1 July 2017, elect to draw the minimum from the TAP for the 2017/18 FY; and
- After 1 July 2017, rollover and recommence the TAP.
The first option is easier to implement, however it will only provide a minor reduction in the transfer value. When calculating the annual pension amount for TAPs, it is possible to vary the pension payments by 10 per cent from the amount calculated by dividing the account balance by the payment factor.
For example, if the pension calculation resulted in an annual payment of $10,000, this could be increased to a maximum of $11,000 or reduced to a minimum of $9,000. This could result in a 10 per cent lower transfer value for the TAP compared to the standard pension.
The reason this election must be made before the start of the following financial year is how the transfer balance calculation will work come 1 July 2017. To be technically accurate, the annual entitlement is calculated by taking the first payment you are entitled to receive in the new financial year, dividing it by the number of days to which the payment relates and multiplying said result by 365.
As such the pension is based on the TAP entitlement at 1 July 2017, an election to reduce the pension to the minimum made after 1 July 2017 will not be effective in reducing the transfer balance value of the TAP. Conversely however, increasing the TAP payment after 1 July 2017 will have no bearing on the transfer value of the income stream.
The second option involves a consideration of a wider number of factors, but may produce a more beneficial outcome particularly where the remaining term is quite high.
Similar to how existing TAPs have a special value for their transfer balance credit, a commutation of one of these income streams is calculated based on a similar calculation. Effectively the same calculation as to the value of the credit is used to determine the value of transfer debit when a full commutation is made. On top of this, this special value of calculating the transfer value of TAPs only applies for TAPs in place at 1 July 2017 – any TAP which is commenced after this date uses the capital value of the TAP at commencement as its transfer value.
Using this interaction, it is therefore possible to fully commute the TAP after 1 July 2017 to effectively undo the initial transfer value calculation (on the basis the annual entitlement and remaining term are the same at the time of the commutation) and use the TAP capital value for the recommenced income stream.
This does come with more potential downsides, such as rolling over the TAP will require selecting a new term, which may impact the pension amount or increase the duration of the TAP.
Some TAPs may currently be held with providers who no longer have an open TAP offering, so implementing this would require a change in product provider, also likely necessitating the sale of the underlying assets.
However, for TAPs with a longer remaining term, and where the person has concerns over managing their transfer balance account, this approach may provide a better outcome than simply reducing the annual payment to the minimum.
Importantly, this does not impact the partial assets test exemption of the TAP, so long as all the capital backing the original TAP is transferred to the new TAP.
Overall the new transfer balance world introduces some interesting challenges, particularly for those who have legacy income stream products – however these same rules have opportunities for advisers to further enhance their value to their clients as the impacts of these super changes starts to become felt.
Josh Rundmann is the technical services manager at IOOF Holdings.
AUTHOR
Industry Expert
Recommended for you
When entering paid employment, it’s not long before we are told that we’ll need to lodge a tax return but there are times when a person will be excepted.
Anna Mirzoyan examines how grandfathering affects income support payments and how factors such as paying for aged care can impact them.
There are specific requirements that only apply to trustees of self-managed superannuation funds, writes Tim Howard, including the allocation in their investment strategy.
Investments bonds offer a number of flexible, tax-advantaged benefits, writes Emma Sakellaris, but these are often overlooked as old fashioned when it comes to portfolio allocations.
