How to start a pension in your SMSF

Q: I have an SMSF fully in pension phase. I am aged 70. I need to withdraw a minimum of 5%. I would have preferred to take this as a lump sum towards the end of each financial year, but my new accountant says I should take it as a regular payment spread out over the financial year. She said the ATO prefers this. I had been under the understanding that for the withdrawal you had a choice, either a lump sum or a regular pension payment. Is there a choice in my situation and if so, what are the pros and cons between each option?

A: In order for a pension to exist, in other words, in order for us to get all the tax benefits to go with a pension, not only do we need to establish it correctly, we need to also make sure that the ongoing pension standards or the ongoing pension rules are met each and every year. These pension standards are contained within the legislation, so they’re hardwired in there, and they must be met, each and every year.

There are five key standards and one of them is that there’s a minimum annual pension payment. We have to make sure that they’re met. Now, those standards, don’t have any or required pension frequency. They just require us to pay the annual minimum amount each year. There’s an annual amount, and it’s going to be paid each year.

There’s nothing that says we monthly, fortnightly, monthly, etc. If we go one step further and look at what the ATO says on this particular issue, they say that a superannuation stream or income stream of pension exists when all of the following apply, – that you’re entitled to a series of payments with each payment relating to each other, the payments are periodic (whether paid annually or more frequently), they’re made over an identical period of time and they meet the standards.

So, you’ll see here, the ATO is quite clear, in fact, that an annual pension payment is allowed. However, be careful here because the caveat is that the requirement or the liability to pay a single payment for one year isn’t a series of payments. So, if I decided to start a pension this year, I make an annual payment and that’s it, and I don’t make any more next year, the year after, it’d be very difficult to say that there was a series of payments. So just be careful. But to answer the question specifically, nothing at all in the legislation or by the regulator requires a frequency of more than one payment per year.

So, if we look at the pros and cons of doing it each way, and you’ll see there that I don’t have a cons column, a negative column for regular pension payments because it’s tied up in all the other boxes anyway.

If we look at annual pension payments, what are the benefits or what could be perceived as the benefits for an annual pension payment? If we only make one payment at the end of the year, we’re maintaining a higher pension balance throughout the year. We’ve got all our pension balance in the fund for the whole period, and then we just take out that larger amount in June. By doing that, we’ve got a higher pension balance. We get higher pension earnings, which we know are exempt. We know they can form part of a taxable or tax-free component. There can be some benefits by allowing higher earnings on a higher balance, something to consider. It could also reduce the need to have larger cash reserves on hand to make the weekly or fortnightly or monthly payments. If you’re only paying an annual amount, you may not need to hold such high levels of cash reserves. But is that in line with your fund’s investment strategy? Consider that, of course, as well.

It could allow certain investments in the fund to be held longer. It could be that if you have term deposits in your SMSF, you might be able to get a longer term with your SMSF term deposit. You don’t need to get access to the interest to make those pension payments. So, they’re just a few of the pros that I came up with.

Some of the negatives, though, it can create a liquidity issue if at the end of the year, you need to take out a large lump sum. Now, it could be $40,000 or $50,000, $100,000 or $200,000 you need to take out as a lump sum at the end of the year, which means you need to have that liquidity on hand at that time. Of course, you could plan for it, but it’s a big chunk of liquid cash to come out.

The second con is around market timing, and this is really an important one and will differ for every SMSF. And what I’m getting at here is what if there’s a downturn in the market at the time you need to make that large withdrawal. So, let’s just say that I have my money in shares, and I plan on selling shares in June to fund my pension payment, but there’s a massive drop in the ASX just at that time. So, I’m selling assets at the worst possible time to make those pension payments. So again, market timing can be an issue for large payments. If it’s a cash asset, that may not necessarily be the case, but then you’ve got to think about tying up cash for that period of time.

The last negative here, which is one I don’t want you to overlook, is what if you forget to make that June payment, that annual pension payment? If you forget it, you’ve missed out. Like, come July, it’s a new financial year. You haven’t met the minimum, and all of a sudden, you’ve now got a massive tax issue because the fund is no longer deemed to have been in pension phase, and you have to pay tax on the earnings. If you are making regular payments monthly or buy them every two months or every six months, if you miss a payment, you still got that ability to make a catch-up payment in the current financial year. If you’re paying annual and you miss that one annual payment, you’ve lost that, and it can have some pretty significant outcome. So some pros and cons there.

Look, why people like regular pension payments and maybe why your accountant and your advisor, your administrator suggests or recommends that is for better management of cash flow for both the fund and the individual. You know that each time, each week, each month, each fortnight, a set amount comes out. It’s literally going from paycheck to pension. It’s that whole better management of cash flow. Market movements have less of an effect on drawdowns. It’s not a large, chunky drawdown. If the markets come backwards, you’re only storing out a smaller amount to meet that required pension payment. And also what I like about it is it’s a systematic approach. It’s regular payments. It reduces the risk of not meeting those standards. It makes us more actively involved, and it means It means that we can see what’s happening, and we’re reducing the risk of not paying our minimum because we’re looking at it constantly.

Look, to answer that question in a shorter way, your accountant or the advisor that’s mentioned this to you is doing a good thing to mention it and say, “Hey, it could be worth considering these regular payments”. But no, it is not at all required, as long as you meet that annual minimum.