Introduction to Income Streams
I started my legal professional life as a tax consultant with KPMG and was thrown in the deep end into a world of annuities and income streams – all thanks to my clients at the time, Citicorp Life, a company that created and sold five year annuities with and without a residual capital value. In the space of two years they had sold more than $1billion of annuity products and KPMG’s consulting fees were $200,000 for the period. A great way for me to learn the ins and outs of annuities and superannuation (as many were funded by members from rollover money).
Annuities v Pensions: At the end of the day an annuity and a pension are just income streams which have the same characteristics. However, an annuity is only offered under law by insurance companies and registered organisations. The same income stream if offered by the Trustee of a Super Fund would be a pension.
An income stream, whether an annuity or pension may be for a term, for life or reversionary – which means it passes onto the next person who has been nominated as a “reversionary beneficiary”. It may be multi-reversionary so that it passes from one pension member to the next, then to the next and so on. Generally, if there is a chain of reversionary beneficiaries there is no ability to commute the pension, as this would destroy the ability to keep on passing the income stream down a lineage or bloodline.
Importantly, there is a HUGE body of law around income streams with the first legal definition given by Sir Edward Coke (born 1552; died 1633). During his incumbency as Lord Chief Justice of the King’s Bench, 1613-1620, he defined an annuity as “a yearly payment of a certain sum of money granted to another in fee, for life or years, charging the person of the grantor only.”
Apart from English law, which is very close to Australian common law, the first ever income streams were seen in Egypt in 2500BC. Income streams have a long history and still going strong in Australia, particularly with the mutated account based pension. But, in my experience, they can be things of beauty or absolute beasts. And the determining factor as to which side of the ledger they fall on is the skill of the adviser building and maintaining them.
The Accounts Based Pension – Beauty in it’s Legal Form
Prior to 1994 there were no laws tying a pension to a member’s account. Simply put, a member gave up their superannuation capital to be paid an income for a term certain, life or reversionary. Once acquired there was no going back, the member’s capital had been converted to income and was guaranteed by the Trustee of the super fund.
The demand for pensions and income streams to be tied to underlying investments chosen by the pension member came into vogue in 1994 with the introduction of the allocated pension. An allocated pension was an investment product where the pension member invested their superannuation monies or rollovers with a pension payment requirement to take a minimum and no more than a maximum pension payment based on pension tables. The pension was commutable, which is a legal term for converting the pension to a lump sum, which was an easy task as it was the value of the pension’s underlying investments. Unlike the traditional pension or annuity where the sum invested is gone, with the allocated pension the capital was not lost but plainly visible. It was the first account based pension.
For SMSFs the allocated pension was funded by the Trustee of the Fund from direct investments such as shares or commercial property.
In 2007, a “new” style of pension was introduced with the name “account based pension”. The pension was a simplified version of the allocated pension and had the following rules:
- The pension once commenced could not be added to by way of capital. Any addition of capital would have to be a commutation of the pension back to the member’s accumulation account with a new pension commenced. This is often referred to as a rollback and commencement of a new ABP.
- A minimum pension must be taken each year.
- The capital of the pension cannot be used as security on a borrowing.
The beauty of the account based pension is that the member is in control (particularly in a SMSF…) of the underlying investments (as trustee) and, subject to the minimum pension payment requirement, the amount and timing of payments coming from the pension each year.
The benefit for the pension member over age 60 is that payments are tax free in their hands and importantly the underlying investment earnings are tax free.
However, the REAL BEAUTY is in the estate planning side of the equation….
Section 302-65 of the ITAA 97 provides that any income a person receives as a result of a reversionary pension that is payable to the member on the death of a prior member who was age 60 or more is tax free.
Example One – Spouse: John Smith is age 62 and has an account based pension with a reversionary to his second wife Susie, aged 48. John dies and the pension immediately becomes payable to Susie. Any pension payments to her are tax free even though she is under age 60.
Example Two – Grandson: John Smith above has been paying his 17 year old grandson James a living allowance of $600 per month to help with his schooling and living expenses. John has made James his reversionary beneficiary. On John’s death, if the trustee of the fund is satisfied that James is a dependant for tax and super purposes the pension can be paid to James and the on-going pension payments are tax free pursuant to section 302-65.
As noted in our earlier discussions of income streams, a reversionary beneficiary may have a reversionary. For example, the pension payable to Susie could continue onto a further reversionary beneficiary, say the grandson James Smith, if there was an account balance on her death. Likewise, the pension would continue tax free as John was over age 60 when the pension originally commenced.
When these pensions are commuted, section 302-60 provides that the lump sum will be tax free. For TBAR purposes, on the death of a member and a passing of the pension to a reversionary beneficiary, the reversionary beneficiaries TBAR is credited 12 months from the date the pension became payable. The amount credited is the amount in the pension account on that date 12 months post pension commencement. If the death benefit reversionary is a child there are further rules, however SIS Regulation 6.21(2) provides a limitation on child pensions for those under age 18 or 25 if they were financially dependant on the member. For most, ABPs which start once the member is age 60, the child TBAR rules are limited to a very small group of beneficiaries and may be found at section 294-170 of the ITAA 97.
In summary, the ABP really is an income stream of beauty…
The account based pension is an income stream of beauty thanks to its payment flexibility (apart from minimum pension payments) and wide investment choice in a SMSF. Compare this to an annuity offered by a life insurance company where a fixed capital investment of $500,000 for a 65 year old will purchase an annuity with a set annual payment for life that could be as little as $15,000 per annum if a reversionary pension.
BUT…there is an ABP Beast…
- The Basic ABP
Most SMSF pension members have a simple account based pension. This is a damnable beast as it means when the pension member dies the pension ceases and all the pension benefits go back to the deceased member’s accumulation account. Naturally this can be used to provide a new pension to a dependent such as a spouse provided there is an adequate binding death benefit nomination or favourable trustee in place (otherwise expect a fight).
The problem is that where the pension has been created with tax free component (such that all income and gains earned on the pension account are also tax free component), the instant it rolls back to the deceased member’s accumulation account, any gains will be taxable component. In addition, if the deceased member was running an accumulation account at the time with varying taxable and tax free components, the pension get blended and the strategy of quarantining tax free component for non-dependant tax beneficiaries (meaning a lump sum commutation is tax free) will disappear or be curtailed.
To put it bluntly – the basic ABP is a real beast and one for the DIY super fund NOT for a SMSF put together by a well-trained SMSF adviser.
- The Reversionary ABP
The reversionary ABP can be simple but not without its drama’s. I have seen (on so many occasions!) an ABP put in place where the pension reverts to the spouse only and everyone thinks they are in world of the strategy. Simple and effective if the spouse is alive at the time of the death of the pension member.
But if they are not, the pension ceases and all the problems above apply. And if this is the last member of the fund, who gets what?
BIG BEASTLY TRAP: Most SMSFs these days have corporate trustees, particularly if there is only one member. The problem with the corporate trustee is when the last member dies, succession becomes a beastly issue. To that end, the majority of constitutions provide that the directors can appoint a new director, but what happens if there are no directors left?
The alternative is the shareholders can appoint a director, but this is where the problem lies. The shares will form part of the deceased’s estate and if the Executor is in control, they could appoint themselves as director – if they knew what to do. The alternative is the shares are passed to a beneficiary of the estate who would instantly control the fund. The ghosts of Katz v Grosman and Donovan v Donovan would see a potentially nasty situation evolve.
I have recently advised on a case (seemingly too late) where it cost $120k legal fees to resolve because there was no one left in the fund other than two fighting parties – children from a first marriage and a second spouse.
How to make a reversionary pension beautiful
The reversionary pension CAN be beautiful in its underlying estate planning strategies – but we need to cover the following:
- Who is going to be the reversionary beneficiary?
- Who is going to be the reversionary beneficiary if they are not alive at the time of the pension member’s death?
- Will there be a second or third reversionary and will the intermediate reversionary beneficiaries take income only with any commutation prohibited in order to stretch the pension as long as possible?
- Would the pension member like a clause where any bloodline dependant at the time of the member’s death shares jointly in the on-going reversionary pension?
- What happens if there is no-one left? Will the commutation lump sum go to the estate or should it go into a fixed trust for the benefit of the pension member’s lineage only?
It is only once you get the answers to these questions that you are ready to start building some beautiful estate planning ABPs and also transition to retirement income streams (TRIS).
And guess what?
This “beauty” is the core of the LightYear Docs platform – and you can start right away.
And here’s my advice…
- If you missed the webinar, access a recording from the LightYear Docs Support page, or I Love SMSF TV page.
- Register for a LightYear Docs account at lightyeardocs.com.au and get started today. Our ABP and TRIS documents have these beautiful estate planning strategies completely built-in.
- Need more help with the LightYear Docs platform? Contact firstname.lastname@example.org for a free demo and access to our foundation member pricing
- Need more strategy help? Contact me direct email@example.com or have a look at our SMSF dedicated CPD and ongoing training platform ilovesmsf.com
– Stay Strategic!