Super pensions not set-and-forget

PORTFOLIO POINT: Don’t just think that switching to pension is flicking a switch. You need strategy to back it up. Here are some more areas to consider when starting a super pension.

The pension phase of a super fund can be a long one. Even if someone were to delay taking a pension until they were 60, the likelihood is that the pension will need to run for around 20-25 years, if there are sufficient assets to back it.

And for the reasons we discussed last week (click here to see last week’s first part in this series, 15/6/11), the taxation differences alone mean SMSF trustees should evolve their investment strategy for retirement.

Why? Because super funds in pension phase are not taxed. When the fund moves into pension phase, it stops being taxed on income (interest, dividends, rent, coupons, etc) and capital gains.

For funds in accumulation phase, the tax on income is normally 15%, while the tax on capital gains is 10%.

If a fund is earning $50,000 in income from all sources, then the tax saved by being in pension phase is $7500 a year. If a further $50,000 is made in capital gains, there’s another $5000 in tax that won’t be paid by a pension fund. That’s 1.25% of the value of your fund, year after year.

The reason pension funds aren’t taxed is because the pension income becomes taxable in the hands of the recipient. Well, sometimes it does.

If you are between 55 and 59, pension income is paid to you with a 15% tax rebate attached. It is paid to you and added to your normal assessable income, with a rebate on that income itself. So, in most cases, you are likely to pay 15% less tax on pension fund income than you would pay on any other income (except if the pension income pushes you into a higher tax bracket, which potentially opens up salary sacrifice opportunities).

However, if you are over 60, pension fund income is tax free, care of changes made to super in 2007.

Advantages for a “typical” fund of pensions

Just a quick recap from last week. The average SMSF has nearly $1 million in it with two members. Let’s assume the members have $500,000 each and that they jointly own half each of the assets.

They’ve got $600,000 of shares and $400,000 in cash investments. (That’s lacking a bit of diversification, but will do us for now.) The shares are paying dividends of 3.5% (we’ll assume all fully franked, which grossed up is 5%) and the $400,000 cash is earning 6% interest.

Income from shares is $30,000 (the grossed up amount), which the income from cash is $24,000.

Currently, if in accumulation, the fund would be paying $8100 in tax. Switching this whole amount from accumulation to pension would mean that the $8100 would not be paid by the super fund.

Running pensions alongside an accumulation fund

Usually at the start of a pension, members will often be continuing to work and having superannuation contributions put into the account.

This means that members will actually have two accounts running – a pension fund and an accumulation fund. Your employer, or yourself, will continue to contribute into the SMSF while you work, with Superannuation Guarantee contributions, salary sacrifice, or deductible contributions.

If there are two members still working and both on pensions, there are literally four accounts operating within the super fund. Your accountant or financial adviser will usually keep track of these for you.

It might only seem like one pot of money, but it isn’t. There are four accounts (potentially more, if you’re running more than one pension account) for two members. Depending on the size of the four pots, you might not run four actual different investment strategies. But if each of the pots is big enough, then consideration should be given to doing exactly that.

Given that the accumulation fund will be paying tax on income (both earned from investments and from contributions), you should be planning what assets are held where. Do you want to have four fairly separate accounts? Do you want the pension fund holding the assets that would have paid the most tax (but because they’re in pension, they won’t pay any)?

The downside – you have to draw on it

If there’s a downside of having a pension fund that puts some people off, it’s probably that you have to take a pension. Often people don’t want to take the income. Many SMSF trustee-members don’t necessarily need the money and would rather not have it. And I’ve seen people refuse to take a pension because it would mean they had to draw an income.

If you are on a transition to retirement pension, you must take between 4% and 10% of your pension fund as income.

The 4% was reduced by half to 2% following the GFC for FY09, FY10 and FY11. Similarly, all pension drawdown factors have been reduced by 25% for FY2011-12. See table below.

If you have retired, then there are just minimums.

Table 1: Drawdowns for FY2012

However, depending on your age, there are various strategies that can work there also. For a start, if you’re over 60 and the income is coming to you tax free, the income could be re-contributed back into super as non-concessional contributions, thereby increasing the amount of your fund that will be tax-free to pass to your dependants.

But not necessarily the whole fund

Countering this is that you don’t have to turn the whole of your super funds into a pension when you decide to take one. If you have a $1,000,000 fund, you could elect to switch on a pension for anything up to the full amount.

If you only want the minimum income from half the fund, then switch half of your super to pension.

Further strategies could be employed here to ensure that the assets that are transferred to the pension are assets that it would make sense to hold. That is, if you are sitting on some big capital gains in particular stocks, then transferring those assets to pension phase, so they can be sold with no CGT implications would make sense.

If you have big income-producing assets that you’re sick of paying tax on, then they could be shifted to super.

It’s important to point out that there is no one size fits all advice here. It is important to take a critical look at your portfolio – perhaps with help from a professional financial adviser and/or accountant – and consider the relative advantages and disadvantages of shifting assets to the pension fund, or keeping them in accumulation, if you’re only going to switch a portion of your assets to pension.

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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.