Daniel Butler from DBA Lawyers lists pros and cons of auto-reversionary pensions.
Recent pension changes upon death have largely removed the need to ensure that pensions are automatically reversionary. Indeed, there is now a choice as to which method is best, yet this depends on a number of factors.
Firstly, the new income tax regulations and the recent release of TR 2013/5 confirm that the benefits of a member who was receiving a pension immediately before their death (assuming there is no automatic reversion of the pension) can be paid in kind and that the pension exemption will continue such that a payment will not give rise to a tax liability at the SMSF level.
However, TR 2013/5 confirms that a non-auto reversionary pension ceases upon death. Particularly, the new tax regulations provide that (ITAR 1997 Reg. 995-1.01):
"… the amount paid as the superannuation lump sum, … is taken to be the amount of a payment from a [pension] …" [Emphasis added]
This allows a lump sum payment to be made following the death of a pensioner without the pension exemption ceasing and, therefore, without giving rise to a CGT-related liability to a superannuation fund.
On the other hand, there are still valid reasons to ensure that a pension is automatically reversionary. The main reason favouring a reversionary pension is insurance.
Insurance increases
Where the SMSF member is likely to receive a significant insurance payout upon their death and the associated insurance premiums were paid from the member's pension interest, an auto-reversionary pension is likely to be worthwhile.
This will especially be the case where the member's interest has a high tax free component.
The reason for this is that, under the new income tax regulations (ITAR 307-125.02), insurance is not included when the tax-free and taxable components of the death benefit are being calculated.
Earnings generated within an SMSF generally form part of the taxable component unless the SMSF is in pension mode. In this case, upon the payment of a benefit, the earnings will take on the proportions of the tax-free and taxable components of the interest.
It follows that any insurance proceeds received upon the death of the member will form part of the taxable component.
This is contrary to the case where the member's pension automatically reverts to a beneficiary — and therefore does not cease upon death — in which case the insurance proceeds will take on the proportions of the pension interest as at the date of its commencement (eg, when the deceased first started the pension).
Thus, if the SMSF has insurance, an automatically reversionary pension is typically ideal.
Can you make in kind 'pension' payments?
The SIS Regulations broadly provide that when a super benefit is cashed, it must be paid in the form of a pension or lump sum (see Division 6.3). 'Lump sum' is defined in SIS Regualtion 6.01 to include an asset.
There is no corresponding definition in respect of pensions. Based on this, the ATO has taken the view that a lump sum, but not a pension, may be paid in kind (ie, in specie).
In particular, see SMSFR 2008/2 where the ATO stated that "… the benefits are to be provided in the form of one or more lump sums (which may be paid either in money or in-specie) or pensions (which cannot be paid in-specie)". [Emphasis added]
However, as discussed above, since a non auto-reversionary pension results in a lump sum payment after the death of the member and after the pension ceases, the payout does not contravene the ATO's position stated in SMSFR 2008/2 above.
Indeed, the new tax regulation treats the lump sum payment as a pension merely for the purposes of the fund claiming the pension exemption up to the time of that lump sum payment.
It is therefore recommended that people with pensions in SMSFs need to carefully consider what is best for their future strategy — an auto or non-auto-reversionary pension?
TR 2013/5 provides that an auto-reversionary pension cannot be left to any discretion of a trustee and must be 'locked in'.
Most reversionary pension nominations would not satisfy the ATO's strict view on this point as most nominations are mere wishes.
To deal with this, specially designed SMSF deed and related pension documents are required that achieve an auto-reversionary nomination as required under the new legislation and satisfy the ATO's view in TR 2013/5.
At present, not many SMSF document suppliers have caught up with these changes and SMSF members should therefore carefully consider whether they are appropriately covered.
Daniel Butler is director of DBA Lawyers.
