Why you should take a reversionary pension

Reversionary pensions became a hot topic a few years ago, when the ATO indicated that the tax-exempt status of pensions ended with the member’s death. Taking a reversionary pension avoided potential capital gains tax issues for the super fund.

The recent government decision – discussed in Binding death benefit nominations (BDBNs) can help avoid these problems and they provide a high degree of certainty as to who will receive the benefits. However, just like a will, these nominations are susceptible to a challenge from, for instance, an ex-spouse or an estranged adult child.

If you’re sure of the beneficiary, a better approach can be to make the pension ‘reversionary’ upon its commencement. This means it automatically passes to a dependent (see below) upon the member’s death, providing certainty and minimising the risk of a legal challenge (on the basis that a transfer to a reversionary pension does not amount to the payment of a death benefit). It's worth noting that SMSFs are not regulated by the Superannuation Complaints Tribunal, adding an additional layer of protection.

Most SMSF funds revolve around a ‘couple’ – who usually want the pension balance to go to the surviving spouse – so in this case you might just make each member’s pension ‘reversionary’ to the other.

Where a reversionary pension has been used, a simple set of trustee minutes noting the death of the member and reversion to a beneficiary is all that is required (avoiding the mass of paperwork). After that, the trustee will continue to pay the pension to the reversionary beneficiary.

Who can be a reversionary beneficiary?

A reversionary beneficiary of a pension can only be one of the following people:

• A spouse (including de facto);
• A child (including step-child) under the age of 18, or between 18-25 and financially dependent on the deceased just prior to death;
• A person who lived in an ‘interdependency relationship’ with the deceased; or
• A person who was financially dependent on the deceased.

If, at a later date, your reversionary nomination ceases to be valid because your circumstances change – for instance, because of a divorce – it is important that you update your reversionary beneficiary nomination so it remains valid or consider switching to a BDBN.

If your reversionary nomination is invalid, it falls back on the trustees to determine who is entitled to your remaining balance and how to divide that balance.

As with a regular superannuation fund, the trustees will generally consider your spouse, your children, a person in an interdependency relationship with you, or any other person that thinks they have a claim to your benefit. But, as this is a SMSF, the trustees have the final say.

Other benefits of a reversionary pension

We’ve said that a reversionary pension makes things simpler, and less open to challenge, upon a member’s death. But it also offers the following benefits:

1. Easier management in the short term. With a ‘normal’ pension someone needs to act as soon as possible to make decisions on behalf of the fund. For instance, the pension payments should be stopped if no direction has been received as to who is entitled to receive future payments. This may sound simple but, with blended families, you may have a current and possibly one or more ex-spouses, children from each relationship and others who may believe they are entitled to support. The trustee and/or executor has the power to act, but also has a legal duty to act properly in making any decisions. This requires, at least, a comprehensive review of the trust deed and trustee powers (chewing up time and legal costs).
    
2. Certainty. Using reversionary pensions allows for more certain tax and estate planning, especially with their ability to handle multiple pensions. Verante Financial Planning (the new name of Liam’s firm) often work with SMSF trustees to set up more than one pension targeted to different beneficiaries to achieve the best financial outcome. Each pension may comprise different taxable and tax free components (see our earlier article Multiple pensions: Why your SMSF needs a ‘sacrificial lamb’ for more on this point).

Nuts and bolts of a reversionary pension

To establish a reversionary pension, you must elect for this option in writing when starting a pension in a SMSF. In the application, the initiating pension member will nominate to whom they would like the pension to revert automatically upon their death. So if this person passes away, the balance and supporting assets will continue as is and the pension will simply be paid to the nominated individual.

If they wish, the reversionary beneficiary can choose to stop (commute) the pension and take a lump sum. There may be tax consequences of doing this, depending on the age of the reversionary beneficiary and how soon after the member’s death this decision is made. They can also just move the funds back to accumulation phase (which might be appropriate for some people relying heavily on government benefits). For these reasons, it’s critical that you seek tax advice if a member of your SMSF dies.

If you want to extend your influence after death by, for instance, protecting a beneficiary who may be a spendthrift or otherwise vulnerable, you have the option of making a reversionary pension non-commutable. This prevents a lump sum being taken, but requires detailed legal advice.

The negatives

The main drawback of a reversionary pension is that your personal circumstances may change. If, for instance, you have named your spouse, but then subsequently divorce or separate, you may want to change your reversionary beneficiary.

To do this, you may have to commute your pension and start a new pension although, if your pension documents and trust deed allow it, you might just be able to amend the pension or add a new beneficiary.

In simple terms, this just means a bunch of paperwork, but it may have other implications in future. For instance, if done after January 2015, the establishment of a new pension would mean it would be subject to the deeming rules rather than the current concessional rules for income streams under the Centrelink Income Test.

Generally, this would mean a lower pension eligibility as you would no longer benefit from the generous ‘Centrelink Deductible Amount’ calculated for income streams. This deductible amount reduces the amount of any income tested for Centrelink purposes by a factor based on your life expectancy at the time you took out the pension.

Final words

If you’re confident you know where you want your assets to go then a reversionary pension makes a lot of sense. Even if the benefits are only minor, they’ll often outweigh the negatives, and, if something unexpected happens, the benefits can be a game saver.