What if account-based pensions are deemed?

The rules for assessing account-based pensions are set to become less favourable with a move to deeming proposed from January 1, 2015. Louise Biti explores whether this creates a negative impact for clients.

The favourable Centrelink and Veterans’ Affairs (DVA) income test assessment of account-based pensions means that often very little (if any) assessable income is calculated when determining pension eligibility.

The concession may provide an incentive for clients to move from accumulation to pension phase; but plans are afoot to create a more level playing field across all investments. If legislation currently before parliament is passed, deeming will apply to account-based pensions from January 1, 2015. But how much of a negative impact will this have on clients?

Determining the dominant test

When applying for a Centrelink/DVA pension, a client’s entitlement is calculated under both an assets and an income test. In the majority of cases, the assets test has the greatest impact.

Tip The assets test causes a greater reduction in pension entitlements (dominant test) than deeming under the income test if assets are (approximately) more than: ■ Single homeowner – $247,000 ■ Couple homeowner (combined) – $312,000 This is based on the deeming rates and thresholds as at January 1, 2014. If deeming rates increase, the cross-over asset level will also increase. Given the average balance of member accounts in self-managed super funds (SMSFs), it is likely that most of these clients will find the assets test to be dominant.

A recap of the current income test

The current income test rules are based on the assumption that capital invested in an account-based pension will be expended over the client’s life expectancy.

A formula is used to determine how much of the income drawn from an account-based pension is deemed to be capital (which is non-assessable) and how much is deemed to be assessable income.

The non-assessable component (deductible amount) is calculated as:

Purchase price – commutations
———————————————-
Life expectancy

Clients who draw around the minimum income required often have little or no assessable income created, particularly in the early stages of retirement. Higher income payments drawn may reduce Centrelink/DVA benefits.

Commutations are not assessed as income but reduce the deductible amount going forward.

An outline of proposed deeming rules

Legislation is currently before the Senate to change the income test assessment rules for account-based pensions and similar annuities.

If passed, the balance of an account-based pension will be added to other financial investments and deeming will be applied to determine total income.

However, clients may be grandfathered under existing rules if:
■ they receive Centrelink/DVA income support as at December 31, 2014 and continue to receive payments;
■ the account-based pension was in place as at that date.

This may lock clients into existing income streams if they want to remain assessed under the deductible rules. If the pension is commuted and rolled to a new income stream, deeming rules will apply.

Pensions that start to be paid to a reversionary from January 1, 2015 will continue to be assessed under deductible rules if:
■ these rules applied to the original owner at the date of death;
■ the beneficiary received income support when the reversion occurred;
■ the reversion was an automatic reversion.

Opportunity To retain deductible amount rules, determine whether clients can become eligible for an income support payment (pension or allowance) before January 1, 2015. If yes, then before that date: ■ review income streams to ensure they are likely to remain appropriate over the long term; ■ determine whether the pension should be restarted with an automatic reversionary nominated. This also applies to transition-to-retirement pensions. The preservation restriction can be removed, but switches to a new product or in/out of an SMSF will trigger a shift to deeming rules.

Impact of deeming

Deeming the income from an account-based pension is likely to create a higher income assessment.

But this will really only matter to clients for whom the income test is the dominant test. No real impact will be felt if the assets test is dominant.

Advice impacts

In practice, the application of deeming to account-based pensions may not be as negative as it seems, except for clients with lower levels of assets or high levels
of other assessable income.

However, it may still be beneficial for clients to retain assessment under the deductible rules:
■ in case their circumstances change in the future;
■ to hedge against increases in deeming rates;
■ to reduce assessable income for means-tested, aged-care fees.

As clients with an SMSF get older (and/or lose mental capacity), they may start to find it difficult to fulfil trustee responsibilities. Closing the SMSF and switching to a public offer account-based pension would trigger the switch to deeming. An assessment of circumstances before January 1, 2015 will be important to determine whether
a switch is required before that date, or to put in place provisions to either replace the trustee with an enduring power of attorney or convert to a small APRA fund when required.

The new rules do not impact a self-funded retiree’s eligibility for the Commonwealth Seniors Health Card, as this is still based on taxable income. But account-based pensions are likely to have a greater impact on the means-tested part of daily care fees under the deeming regime.

If passed, these changes open a window of opportunity to review circumstances for all clients with an existing account-based pension before the window closes on January 1, 2015.

Case study Hilda is age 65 and widowed. She started an account-based pension in her SMSF with $700,000 and draws the minimum income of $35,000. Assume no other assets or income except her home. If Hilda applies for the age pension, her annual assessable income under the income test is: ■ Current rules – $2623 (non-assessable income is $32,377), which qualifies her for the full age pension of $21,505 per year. ■ Deeming rules – $23,801, which qualifies her for approximately half the age pension of $11,632 per year. Regardless of which set of rules applies, the assets test would result in only a small age pension of $1878 per year. So even though Hilda is significantly worse off under the new deeming rules, it has no real current impact on her age pension due to the dominance of the assets test. Over time, as Hilda uses up her account balance, the income test may have a greater impact than the assets test and the negative aspect of deeming rules may then be felt. Let’s assume that at age 80, Hilda has only $150,000 remaining in her account-based pension. If she still draws just the minimum (now $13,500), the age pension she would qualify for (using today’s payment rates) is: ■ Current income test – $21,505 ■ Deeming income test – $21,257 ■ Assets test – $21,505 At this point, deeming is having a negative albeit small impact on Hilda compared to deductible amount rules and the assets test.