How can I qualify for pension cap indexation?

Question: I’m concerned about how a part commutation of a super pension relates to an entitlement to future indexation of the $1.6 million transfer balance cap, a topic you dealt with recently (Weekend AFR April 25-26).

The article made a point I have never read before – that if you reduce the transfer balance cap though a part commutation (by withdrawing a lump sum) the lower cap won’t be entitled to indexation.

It stated the super rules require you to look at a pension’s cap history and the lowest cap space percentage it ever had. This would seem to imply that a transfer balance can't be wound back, which conflicts with my understanding based on what I have read. Is my understanding incorrect? Geoff.

Answer: When the Turnbull government introduced the huge change of a $1.6 million limit on how much super could be converted from taxable superannuation savings to tax free retirement pensions from July 1, 2017 – called a general transfer balance cap – rules were set on how this cap will be indexed in the future.

It was determined that indexation of the limit would be based on increases in the December average Consumer Price Index for Australia’s eight capital cities with effect from December 2016.

While it is reviewed every December and set to apply from the following July 1, the limit won’t increase unless the indexation calculation results in a $100,000 increase.

In the nearly three years since the $1.6 million cap was first set, it hasn’t achieved that level of increase and might not for another two years.

When the relevant CPI at the end of December last year was compared with the December 2016 base CPI, the result showed that the movement of the index was only 5.6 per cent.

And when this was applied to the current $1.6 million cap, the resulting increase to $1,689,600 was less than the $1.7 million necessary to lift the general transfer balance cap from July 1 this year.

CPI estimates

According to Meg Heffron, managing director of self-managed super fund administrator Heffron SMSF Solutions, it might not even make it from July 1 next year. She has estimated the December 2020 CPI figure will need to increase by at least 0.6 per cent for the year (December 2019 to December 2020).

According to AMP Capital chief economist Shane Oliver, the prospects of this occurring are low. His view reflects an expectation of low petrol prices, low rents, price discounting by retailers, airlines and hotels and various cuts in government charges and rebates.

His own forecast for the December CPI is a minus 0.4 per cent change compared with a forecast by the Reserve Bank of Australia of 0.25 per cent.

This suggests a transfer balance cap increase to $1.7 million may not occur until July 2022, and that anyone who starts a pension between now and then must check this against the $1.6 million cap general cap.

However, the question of how a part commutation of a pension will relate to this, or any future indexation increase, adds an extra layer of complexity to the issue.

Whenever you start a super pension, says Heffron, it will initially be checked against the general transfer balance cap that happened to apply at that time: currently $1.6 million.

When it comes to any future indexation, (for example, the $100,000 increase to $1.7 million that might apply from either July 1, 2021 or July 1, 2022), the full $100,000 increase will not be passed on to those who have already started a pension that was counted towards their $1.6 million transfer balance cap.

If you ever had a pension balance equal to your transfer balance cap by starting, for example, a pension in December 2018 with $1.6 million of your super, you will get no indexation at all.

The amount of the $100,000 increase you get depends on what is described as your “unused cap percentage”. This is the amount of unused transfer balance cap.

Even if over the next few years you withdraw one or more lump sum payments from your super – known as partial commutations – that reduce your transfer balance cap to, say, $1.2 million, you will have no entitlement to indexation.

Unused cap

This is because at some point you used all of your transfer balance cap – so your unused cap percentage is zero. You’ll find this information in section 294-40 of the Income Tax Assessment Act 1997, says Heffron.

The only circumstance where you might receive a portion of a future $100,000 indexation increase is where you have not used all of your transfer balance cap when starting a pension.

As an example of a partial entitlement to indexation, says Heffron, where someone starts a pension with $1.2 million in July 2019, for example, while their personal transfer balance cap was $1.6 million.

At the time they started the pension, they used up 75 per cent of their transfer balance cap ($1.2 million divided by $1.6 million), this will leave them with an unused cap percentage of 25 per cent.

If, over subsequent years, you take no further retirement phase pensions but then your partner dies and leaves you with a $1 million-plus superannuation death benefit pension, the initial entitlement to this as a tax exempt pension will be determined by how much of your personal transfer balance cap remains.

Where your unused cap percentage is 25 per cent and the general cap has increased at least once, your personal cap will be $1.625 million ($1.6 million plus 25 per cent of a $100,000 indexation increase). This will allow you to convert $425,000 of your partner’s super to a pension.

If the transfer balance cap has increased twice over the period, your cap will increase to $1.65 million: the original $1.6 million plus two entitlements of 25 per cent of $100,000 indexation increases.