How can I address a pension shortfall in my SMSF?

If a pension payment does not meet the minimum requirement, the SMSF pension ceases for tax purposes. This is an important distinction. Pensions are governed by the SIS rules and regulations, while the tax implications of the pension are governed by the Tax legislation.

What happens when a pension is set up?

When a pension is first established, a contract is entered into between the member and the SMSF trustee, in which the member gives up some or all of their super balance in exchange for the right to receive a regular stream of payments. The right to receive the pension payments remains in place until formally ceased.

An account-based pension (ABP) is the most common form of pension taken by a member of an SMSF. The SIS regulations require that an ABP must meet the following minimum pension standards:

• the capital of the pension cannot be added to by way of contributions or rollover
• the pension payment must be made at least annually
• a pension minimum payment is required annually (excludes commutations)
• a pro-rata pension payment must be made where the pension is fully commuted
• the pension can be transferred to an eligible beneficiary on the death of the member
• the pension capital or income cannot be used as security to borrow

There are certain tax concessions granted under the Tax Act, such as the income arising from the pension capital is tax-free at the fund level, and pension payments made to the recipient are tax-free if they are over 60 years old or inherit a death benefit pension where the beneficiary is over 60 or the deceased member was over 60 at the time of death.

Under the Tax Act, the pension is described as a superannuation income stream, with a pension payment being a superannuation income stream benefit. To obtain the tax concessions, the pension must meet the SIS requirements for an ABP.

When does a pension fail?

The ATO’s view is that it fails when a pension standard is not met. When a fund fails to pay the minimum pension,  the pension therefore ceases at the beginning of that financial year.

From a SIS perspective, the pension does not stop until it is formally ceased.

This discrepancy between the tax and SIS legislation results in different timing for the pension’s cessation. For tax purposes, the pension ceases at the beginning of the year in which the pension shortfall occurred. For SIS purposes, it ceases when a formal document is signed to commute or cease the pension, which can be many months after the end of the financial year.

How do you fix a pension shortfall?

It is a common misconception that a partial commutation of the pension can be made to prorate the pension payment, reducing the required payment so the pension does not cease. However, the minimum pension payment is based on a percentage (based on the member’s age) of the member’s pension balance at 1 July, or the pension start date if started during the year. Only a full commutation can result in a prorated pension payment.

For tax purposes, a failed pension is permanently tainted and must be fully commuted; a new pension can be started if the member has a condition of release. Because pension documentation must be prepared in advance and cannot be backdated, a new pension can start only after the pension shortfall is discovered, which may be many months after the end of the financial year. However, if the pension shortfall is minor, the trustee may exercise its discretion to allow the fund to meet the pension standards.