Weighing up the benefits and risks of defined benefit pensions
Colonial First State's Deborah Wixted outlines the benefits and traps associated with defined benefit pensions.
Despite defined benefit superannuation funds being on the decline, a number of clients still receive defined benefit pensions.
These pensions differ markedly from account-based pensions, which can give rise to potential traps, but also lead to opportunities, particularly for clients who have not yet retired.
Greater access to benefits
Most true defined benefit pensions (ie, those not purchased with a known capital amount) are paid as non-commutable, reversionary, indexed lifetime income streams with no residual capital value.
As a result, depending on the rules of the particular fund or scheme, clients may be able to access benefits earlier, as summarised in Table 1.
Under both conditions, the client could continue working, commence a defined benefit pension, and implement the equivalent of a transition-to-retirement plus salary-sacrifice strategy.
Postponing benefits is not always a good thing
A feature of some defined benefit schemes is the postponement of benefits that become payable after ceasing employment.
When postponing a benefit, the amount of pension paid at a later date may be increased.
However, it is also important to consider the pension payments lost during this period. Analysis is needed to determine whether the client would benefit from taking a pension immediately – and using any excess income for a range of other wealth accumulation purposes – or continuing to defer it.
The 54/11 rule
Preservation and deferral of a benefit within the Commonwealth Government Super Scheme (CSS) can be beneficial for certain clients who intend to retire from employment at age 55.
Alternatively, if an individual retired before the retirement age of 55 they may become entitled to a resignation benefit, which can be taken as a pension after age 55. Doing so can result in a higher amount of pension payable.
This is due to different methods used to calculate each benefit.
Centrelink assessment of defined benefit pensions
Most clients who receive a (non-purchased) defined benefit pension will be assessed under the Centrelink income test.
These pensions are generally lifetime, non-commutable, nil-RCV pensions that meet legislative requirements and are attributable to a defined benefit interest.
This means that they are 100 per cent assets test-exempt but often there is little, or no, deductible amount with which to reduce assessable income.
The deductible amount of a defined benefit pension which commenced on or after 1 July 2007 is the same as the tax-free component of the pension for taxation purposes (see Table 2).
The deductible amount of a defined benefit pension that commenced before 1 July 2007 was originally the same as the tax-deductible amount rules that existed at the time of commencement.
This deductible amount is retained until the client experiences a ‘trigger day’.
In many cases the deductible amount will be nil if no contributions were made to ‘purchase’ the defined benefit pension.
Once a pre-July 2007 pension passes a ‘trigger day’ – reaching age 60 after 1 July 2007 – other factors, such as the type of Centrelink payment, determine the deductible amount.
Taxation of defined benefit pensions
There are two key issues for the taxation of defined benefit pensions: the amount of any tax-free component; and any untaxed element in the taxable component.
While most defined benefits pensions are not eligible for a tax-free component, in order to confirm if there is any such amount, it’s necessary to look closely at all aspects of a defined benefit pension and the client’s circumstances (see Tables 2 and 3).
There is a greater taxation liability on a defined benefit pension with an untaxed element, such as one paid from an untaxed or unfunded scheme, as it remains assessable after age 60 with a reduced or nil tax offset.
Deborah Wixted is head of technical services at Colonial First State.
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