Damian Hearn
Technical

Negative investment returns can cause trouble or create opportunities for super strategies

By Damian Hearn

Even though the market meltdown might seem a long way behind us, your clients may still be rethinking whether their current superannuation product is appropriate.

Careful consideration should be given to avoiding the detrimental impact on your client’s super components and retirement plans when rolling from one fund to another. On the other hand, your client could benefit from commencing a pension as part of their retirement planning strategy (such as transition to retirement).

Personal member contributions1 made into superannuation are included within the tax-free component of a member’s account whilst investment returns will accrue in the taxable component. The tax-free component is basically fixed and does not change unless:

  • further personal member contributions are made; or
  • a benefit is paid (such as a lump sum benefit or rollover).

Rolling over superannuation accounts can be detrimental

After a period of negative investment returns and before account balances have been restored due to negative investment returns, rolling over your client’s superannuation account can have a detrimental effect on your client’s super components and retirement plans.

When completing a rollover, the components must be drawn proportionally from the taxable and tax-free components. However, if the account balance is less than the fixed tax-free component due to negative market movements, the rollover will only include a tax-free component. This means any future investment earnings within the new fund will be allocated to the taxable component.

Clients like John, in the below case study, who have made large personal member contributions over the past few financial years can be impacted when rolling over.

Case study

John made a $400,000 personal member contribution in December 2008 into his existing account of $50,000 (as shown in Table 1) before the significant decline in the investment markets during the first few months of 2009. Due to the negative returns, his account balance has reduced to $290,000 by 30 June 2009.

Table 1 – Account balance and component breakdown at rollover to new fund

Date Item Tax-free component Taxable component Account balance
December 2008 Contribution $400,000 $50,000 $450,000
June 2009 Reporting date $290,000 - $290,000

Since John’s reduced account balance of $290,000 is less than the fixed tax-free component of $400,000, any transaction such as a rollover into the new fund (as shown in Table 2) will only include a tax-free component.

In April 2010, John’s account balance has increased in value with the improved performance of the investment markets. However, his account balance remains at $362,000 and no further contributions have been made into his account to date.

John eventually decides to open a Self Managed Super Fund (SMSF) and rolls over his existing superannuation account. His reduced account balance of $362,000 is less than the fixed tax-free component of $400,000 (as shown in Table 1) which means the rollover into the new fund will only include a tax-free component. Consequently, the rollover results in a $38,000 reduction in John’s tax-free component (ie $400,000 - $362,000).

Table 2 – Account balance and component breakdown at rollover into new fund

Date Transaction Tax-free component Taxable component Account balance
April 2010 Rollover - in $362,000 - $362,000
June 2010 Reporting date $362,000 $48,000 $410,000

When the rollover is received by his SMSF, the new fixed tax-free component of $362,000 will be recorded in his account and any future investment earnings in the new fund will be allocated to the taxable component.

When the member accounts are created for John’s SMSF as at 30 June 2010 (as shown in Table 2), his improved superannuation account balance will include a taxable component of $48,000. The loss of the tax-free component of $38,000 could eventually impact John if he is planning to retire between age 55 to 59 due to increased tax on lump sum withdrawals or pension payments from an income stream.

Commencing a pension can be beneficial

The same principals outlined above about the impact of negative investment returns on components apply when commencing a pension. Most importantly, if the account balance is less than the fixed tax-free component due to negative market movements, the rollover will only include a tax-free component.

In contrast to rolling over a superannuation account, commencing a pension can be beneficial to your client. At the commencement of the pension, the tax-free component will be 100 per cent and this is significant for three reasons as follows:

  • all future investment earnings will be allocated to the tax-free component for the lifetime of the pension (ie no taxable component will exist);
  • clients aged 55 to 59 can commence a tax-free income stream; and
  • clients over age 60 can avoid death benefit tax when paid to a non-death benefits dependant (such as an adult independent child of the deceased member) upon their eventual death.

Case study - revisited

If we revisit the case study of John who is now aged 56, when rolling over into his SMSF he could commence a tax-free pension as part of a transition to retirement strategy before any investment returns are allocated to the taxable component. This is a significant benefit to John until he turns 60. In addition, any future investment earnings will be allocated to the tax-free component within the pension.

Conclusion

Care should be taken in the current market environment to avoid detrimental effect on your client’s super components and retirement plans. In contrast, it can be an opportunity to commence a tax effective pension as demonstrated within the above example. Once more, the value and benefits of seeking financial advice can be demonstrated to your clients.

1Amounts not claimed as a deduction using an s290.170 notice of intent to claim a deduction or other contributions such as the proceeds from a personal injury or compensation payments.