For the majority of Australians, and particularly those in the earlier stages of their working lives, their superannuation is most likely invested in an accumulation-style fund.
Accumulation-style funds may also be known as a defined contribution (DC) fund, with contributions to be made generally reflected as a defined percentage such as the current 9.5 per cent superannuation guarantee (SG).
In a DC fund the client’s returns will be based on a number of factors such as the amount of their employer contributions, any additional contributions they may choose to make themselves, and the performance of the underlying investment options, less fees and expenses.
Importantly, in an accumulation-style or DC fund the member carries the whole investment risk, so their end benefit (how much they retire with) will be directly affected by factors such as those outlined above.
Defined benefit (DB) schemes operate a bit differently. In DB schemes the defined component refers to a fixed or defined outcome, rather than just the contributions made overtime.
Unlike DC schemes, DB schemes carry all the investment risk on behalf of the member.
For DB funds, the outcome is based on a formula which takes into account the member and their employer’s contributions, the length of tenure held at the employer and their final average salary at retirement.
DB schemes have generally been offered as corporate or public sector schemes, which are commonly legacy funds, with many now closed to new members.
Although there are often limits to taking lump sum benefits from a DB scheme, the funds are generally at least partially reversionary, allowing the pension to be payable to an eligible dependant such as a spouse in the event the spouse outlives the member.
The DB pension may also be indexed each year to such factors as the consumer price index (CPI).
Of the range of superannuation changes coming into effect from 1 July 2017, more factors will affect DB members beyond the well discussed interaction with the $1.6 million transfer balance cap and defined benefit income cap.
Given the features of DB funds, it’s important for advisers to work with their existing DB clients to help them maximise the benefits from their plan. This is all the more important when you consider that it needs to complement any additional retirement savings strategies such as including an accumulation fund.
It’s also important for advisers to communicate these changes with their affected clients, and identify how it may impact the existing or future retirement strategy advice they provide.
Concessional contributions and DB funds
Currently special rules are used to determine the amount of concessional contributions made to a DB fund. This is because the members’ employer usually makes the required contributions, rather than the member themselves.
These contributions are known as notional taxed contributions.
Notional taxed contributions are calculated using a legislative formula broadly designed to represent the equivalent employer contributions that would have otherwise been made if the member was in a DC or accumulation fund.
Given the difficulty in adjusting your notional taxed contributions in relation to the concessional contribution cap, special rules apply to individuals who were members of defined benefit funds on 5 September 2006 or 12 May 2009. These rules ensure the client’s notional taxed contributions which exceed the concessional contribution cap will be reported (for excess concessional contribution purposes) as being equal to the concessional contribution cap.
Importantly, contributions to constitutionally protected funds (CPF) are currently excluded from the concessional contribution cap.
From 1 July 2017, contributions to CPFs will count against the member’s concessional contribution cap but will not, in isolation, result in an excess concessional contribution if the cap is exceeded.
In addition, contributions to a member’s accumulation interest in a DB fund, notional taxed contributions in respect of a members defined benefit interest (including those under 5 September 2006 and 12 May 2009 arrangements mentioned above) and the amount of any defined benefit contribution exceeding the member’s notional taxed contributions will count toward a member’s concessional contributions for the year.
Example 1
Megan is a member of a CPF and in the 2017-18 financial year she receives $10,000 in employer contributions to this fund.
She is also a member of a defined benefit fund and in the 2017-18 financial year receives $25,000 in defined benefit contributions, of which $20,000 are notional taxed contributions and $5,000 are unfunded.
Megan’s capped amount for the financial year total $35,000, worked out as $10,000 + $20,000 + ($25,000 – $20,000).
As the total capped amount exceeds the concessional contributions cap, her total concessional contributions will be reported as $25,000, equal to the concessional contribution cap.
Megan is therefore unable to make any additional concessional contributions to an accumulation fund in the 2017-18 financial year without creating an excess concessional contribution issue.
Personal deductible contributions
A new opportunity to come out of the super reforms is the ability for any eligible individual to claim a deduction for a personal super contribution without needing to meet the 10 per cent income test.
While previously restricted to those individuals either substantially self-employed or not employed at all, from 1 July 2017 any individual who satisfies the income, age and work test requirements is able to make a personal super contribution and claim a deduction in their income tax return.
This may allow individuals who otherwise are unable to salary sacrifice via their employer to benefit by making a personal deductible contribution to super themselves.
As part of this measure, members of DB Commonwealth public sector super schemes and CPFs will not be able to claim deductions for personal super contributions made to these funds. They will however be able to make personal deductible contributions to an accumulation fund.
Example 2
Gerard is a member of a defined benefit fund that is a CPF. He also has an accumulation account in a retail super fund.
Gerard sells some direct shares in the 2017-18 financial year which results in an assessable capital gain of $15,000. In his own hands, Gerard would be assessed at an effective marginal rate of 32.5 per cent on this capital gain, so as a result he wishes to make a personal deductible contribution to super to reduce the tax he pays.
He cannot make a personal deductible contribution to the defined benefit fund, however he can make the personal deductible contribution to the retail super fund. The contribution to the retail fund will count against his concessional contributions cap.
Starting a defined benefit income stream
From 1 July 2017, a transfer balance cap (TBC) will apply to limit the total amount of superannuation an individual can hold in retirement phase to $1.6 million.
Valuing a DB income stream is a little different as the member of the plan is generally only entitled to an ongoing income stream or benefit over their lifetime and not a fixed, capital amount.
DB income streams for this purpose are only non-commutable income streams, this means they cannot be converted to a lump sum. This includes lifetime pensions and annuities, life expectancy pensions and annuities and market linked pensions and annuities. Defined benefit pensions which can be commuted are not included in these rules.
A formula will be used to determine the special value of DB income streams outlined in the table below.
For existing pensions, the annualised entitlement is taken to be the first payment from 1 July 2017, divided by the period the payment represents (i.e. 14 days if a fortnightly payment) and then multiplied by 365 days.
Example 3
A lifetime defined benefit pension being paid from an untaxed fund which pays $1,000 per fortnight.
The special value will be determined as:
An annualised payment of $1,000 / 14 x 365 days = $26,071
$26,071 x 16 = $417,143
Example 4
A life expectancy annuity being paid from a taxed fund with payments of $40,000 per annum has a remaining term of 13 years.
The special value will be determined as $40,000 x 13 = $520,000
Where the value of an individual’s defined benefit income stream exceeds their TBC, the excess income will be impacted by the DB income cap discussed below.
In addition, where the individual also has an account based pension they may need to commute some or all of their pension back to accumulation phase or withdraw an amount as a lump sum benefit payment to get back below the cap.
Example 5
Victoria, aged 68, has the following superannuation interests as at 30 June 2017:
- Lifetime capped defined benefit pension (taxed fund) paying $48,000 per annum with a special value of $768,000; and
- An account based pension valued at $900,000.
The combined benefit amounts of $1,668,000 exceed Victoria’s TBC of $1.6 million by $68,000.
As a result, Victoria will need to commute $68,000 from her account based pension back to accumulation or take the amount as a lump sum commutation in order to stay within transfer balance limit.
As the amount in excess is less than $100,000, she has six months from 1 July 2017 to make this change without occurring any penalty.
Defined benefit income cap
Where an individual exceeds their TBC as a result of the income from their DB income stream, there is no requirement to commute the excess amount from their defined benefit plan. In fact, most plans won’t allow you to commute an amount anyway.
Instead, the income tax concessions for the income stream will be limited to the amount of the income stream up to the defined benefit income cap. This cap amount is calculated as 1/16 of the general transfer balance cap for the year and will therefore be $100,000 from 1 July 2017.
Income above the defined benefit income cap will be subject to changed tax treatment as the table below shows, regardless of the tax components the payment represents.
When applying DB income against this cap, taxed and tax-free components of any income payment are considered first before any untaxed components, as illustrated below.
Example 6
Warwick, aged 64, received the following defined benefit income streams:
- $70,000 per annum from a taxed defined benefit income stream; and
- $40,000 per annum from an untaxed defined benefit income stream.
The $70,000 Warwick receives from his taxed defined benefit income stream is considered first against his defined benefit income cap, and will remain tax-free as Warwick is over age 60.
The $40,000 from his untaxed defined benefit income stream is considered next, with $10,000 exceeding his cap. As Warwick is over 60 he is entitled to the 10 per cent tax offset on the first $30,000 from the untaxed fund, with the remaining $10,000 taxed at his marginal tax rate with no tax offset.
Advisers with clients who are members of defined benefit schemes will now need to consider the changed treatment of certain contributions to these plans as well as determining how their client’s defined benefit income streams may be affected by the super changes from 1 July 2017.
As always, these changes are an opportunity to engage with your clients and review their existing strategies to ensure their super and retirement plans remain on track. Given the level of complexity involved, communicating how the changes will impact your clients and what action they should take, will help to demonstrate the clear value of your advice.
Tim Howard is a technical consultant at BT Financial Group.
