According to Section 9A and 9B of the Social Security Act 1991, a defined benefit pension is a pension which exchanges a purchase price for a specific defined income stream. A defined benefit pension can be either lifetime or life expectancy complying pension. One of the key features of a defined benefit pension is that the pension payment does not depend on the account balance, but is determined at the beginning of the term and cannot be changed. The pension is also non-commutable and has no residual capital value.

The key benefit of a defined benefit pension is that it is entitled for either 100% or 50% Centrelink Asset Test Exemption (‘ATE’) depending on the commencement date. However, an annual actuarial certificate is required in order to retain the ATE and to comply with the requirements of the Superannuation Industry (Supervision) (SIS) Act 1993. The defined pension liability is calculated based on a high probability valuation which consists of a Best Estimate Valuation, Investment reserve and Mortality reserve. The actuary provides an opinion as to whether there is a high probability that there are sufficient assets in the fund to be able to pay the required benefits in the future. The certificate also notifies the tax exempt percentage of the Fund as a defined benefit pension is not 100% tax exempt.

In case the actuary cannot sufficiently conclude the asset backing for the defined benefit pension, due to a fall in the value of the fund assets, the fund would be required to consider other alternatives. It is imperative to note that a complying defined benefit pension is non-commutable unless it is rolled over into another complying income stream.

The following flowchart provides the alternatives/ implications when a defined benefit pension is restructured:

Commutation of a defined benefit pension

Commuting to an account based pension or lump sum would have an adverse outcome for tax and Centrelink/DVA purposes. Potentially the fund could become non-complying and be subject to top marginal tax rates. Centrelink/DVA benefits could also be clawed back retrospectively.

In May 2016, the draft Federal Budget has introduced the $1.6 million transfer balance cap which limits the total amount that a member can transfer into tax-free pension phase. Once this proposal is legislated, the treatment of defined benefit pensions which are greater than $1.6 million will need to be clarified, considering the commutation of such complying pension to accumulation is not permissible.

For SMSFs that need to restructure their existing defined benefit pensions, the trustees must seek appropriate advice before proceeding with the commutation. Trustees must consult closely with Centrelink/DVA to ensure the waiver-of-debt conditions are satisfied.