What to watch with minimum pension reductions

The reduction in the minimum pension percentage for the 2019/20 and 2020/21 financial years because of the COVID-19 pandemic have been a ‘white knight’ of sorts for anyone experiencing a large drop in the value of a fund’s investments, especially listed shares. But there are some tips and traps to know about when the percentage reduction takes place during the year.

What is the minimum pension reduction?

Not all pensions have the minimum amount reduced because of the economic impact of COVID-19. The reduction applies only to pensions which have the annual pension calculated on the pension account balance at the time the it commences during the year and at each subsequent 1 July. This applies to account-based pensions, including all transition to retirement pensions, market-linked income streams and allocated pensions. The reduction does not apply to complying lifetime and life expectancy pension as the pension amount is calculated by an actuary and take market volatility into account.

The reduction applies to the standard minimum percentage that applies to your qualifying pension and not to the amount that has been calculated by using the percentage. The reason is that the minimum pension amount is rounded up or down to the nearest $10. For example, if you were between 65 and 70 years old your standard minimum pension percentage is 5% and after the 50% reduction for the 2019/20 and 2020/21 financial year it will be 2.5%. If your pension balance on 1 July 2019 was $539,080, then your minimum pension would have been $26,954. As this is rounded to the nearest $10 your minimum pension would be rounded down to $26,950. After the 50% reduction in the minimum amount to 2.5% of your opening balance it would then be $13,477 which is rounded up to $13,480. So make sure you are using the minimum percentage so that you can calculate the minimum exactly.

What if I’ve already taken the minimum?

At the beginning of the financial year or if your pension commenced during the year you may have nominated the amount that you wished to withdraw from the fund during the year. If the amount nominated is greater than the minimum then your nomination may have included an instruction on how any excess was to be treated as a pension, lump sum commutation of the pension or as a lump sum from your accumulation account.

There can be a number of benefits of making such nominations for tax and transfer balance cap purposes, depending on which option you decide. Of course, if the excess is to be treated as a pension there will be no change for tax or transfer balance cap purposes. However, if you decide that the excess will require a commutation of your pension balance, the amount of the excess will reduce your transfer balance account and may come in handy if you wish to commence or top up a pension in future. The third option is to have the excess taken from any balance you may have in an accumulation account. The benefit here is that your pension account balance will be reduced by just your minimum pension and the excess will come from your accumulation account. This will maximise the amount of the fund’s investment income that will qualify for tax exemption.

One tip is that it is not possible to re-classify any amounts that you have nominated as a pension to be lump sums prior to a reduction in the standard pension percentage which has happened because of the COVID-19 pandemic. The ATO have indicated this in answer to a Q&A on its website:

Question: I am retired and receive an account-based pension from my SMSF. My account-based pension has already paid me more than the reduced minimum annual payment required for the 2019–20 financial year. Is the amount over the minimum considered superannuation lump sum amounts?

Answer: Pension payments that you have already received cannot be re-categorised. Accordingly, payments made from your account-based pension in excess of the new reduced minimum annual payment required for the 2019–20 financial year are pension payments (that is, superannuation income stream benefits) for the year and not superannuation lump sums.

So, it’s just bad luck if you have taken more than the reduced minimum amount as a pension before the change became law on 24 March 2020 for the 2019/20 financial year. However, if you had provided an instruction to the fund trustee prior to the change that prior to making a withdrawal that it was to be paid as a lump sum from the commutation of the pension or your accumulation account, then it would be okay. After 24 March it is possible to have any payments treated as pension payments or lump sums as you have instructed prior to their payment to you. A lesson that could be learnt from the current situation is that the later you draw your pension in the year the more likely you are to take advantage of any reduction in the minimum pension percentage.

Is it the right time to start a pension?

The decision to commence a pension from your SMSF always depends on your personal situation and whether you wish to draw amounts from your fund for living expenses. In the current situation if you think the investment markets are at an exceptionally low point then from an investment point it may be the right time.

For example, if the value of your accumulation account in February this year was $1.4 million and you saw it drop to $1 million in mid-March, it may have been worthwhile to commence a pension if you expected that the value of the fund’s investments would increase significantly in a relatively short time. If your pension commenced with $1 million, then it would be counted against your transfer balance cap, which is limited to $1.6 million. Any income earned on investments supporting the pension would be tax exempt. If the investments underlying your pension then grew to $1.8 million in the next year or two the income earned on the pension balance would continue to be tax exempt.

Is it the right time to commute and restart a pension?

If you have a pension that is already in place, is it worthwhile to stop the pension and transfer it to accumulation phase so that you can preserve the current value in the fund? The answer depends on what you are trying to do, however, before you commute the pension and maybe restart it in future, you’ll need to consider the impacts of the transfer balance cap.

For example, if the value of your pension was $1.3 million and because of the COVID-19 pandemic the value of the underlying investments went to $800,000, what would happen to your transfer balance cap account? If you commenced your pension with $1.3 million, then your transfer balance cap account would have a credit of that amount. Then, if you commuted the reduced value and transferred it to your accumulation account there would be a debit to your transfer balance cap account of $800,000 which would result in a credit remaining in the account of $500,000 even though you had no pension in place. So if you were to try and maximise your pension in future, any new pensions would be limited to the difference between your transfer balance cap, currently $1.6 million and the credit left in your account of $500,000. In this situation it may have proved better to not commute the pension and ride out the storm until investment market improved.

Tips and traps

The current situation is difficult in view of the pace at which it occurred and knowing how to react to it. Three lessons that can be learnt from the current situation are:

• paying pensions towards the end of a financial year can take advantage of any reductions in the standard pension percentage where it occurs during a year.
• stopping and starting a pension due to drops in market values need to be considered on their merits.
• from an investment point of view, a diversified portfolio can provide flexibility where there are significant drops in value. Those who maintain a cash reserve in their fund to pay their pension for a reasonable period are in a good position.