By: Jean-Pierre Laporte
The last few years have seen a flurry of activity in the realm of pension reform. Aside from the federal pooled registered pension plan, Quebec’s voluntary supplemental pension plan, and the changes to the Saskatchewan Pension Plan and Canada Pension Plan, provincial legislatures are wrestling with new forms of plan designs such as target benefit pension and jointly sponsored pension plans. The stated goal of governments is to increase pension coverage, mainly in the private sector where millions of Canadians have nothing better than an RRSP to count on in terms of tax-assisted retirement plans. Some have argued that the pension coverage crisis extends to more than 3.5 million Canadians.
Ironically, if the goal of reformists is to ensure the provision of an adequate tax-assisted solution for individuals not covered by broadly-based employer-sponsored pension plans, it would seem that the media and many commentators have simply overlooked a solution that has been available since 1991 – the individual pension plan. This article will review some of the often forgotten characteristics of the individual pension plan, its strengths and weaknesses, and how, if properly structured, this particular vehicle could provide a partial solution to the pension coverage problem.
Growth In Check
Owner-operators have been allowed to save through an individual pension plan or IPP since the last major round of pension tax reform in 1990/91. While statistics on the numbers of plans in operation aren’t always up-to-date, it would appear that at least 15,000 currently exist in Canada. While all of the major banks and insurers offer IPPs as part of their comprehensive market offerings, the complexity of the product, and the popularity (and simplicity) of its cousin – the registered retirement savings plan (RRSP) – appears to have kept its growth in check.
Advocates of the RRSP point out that the IPP is more costly to administer, that funds in an IPP are locked-in by pension rules, and that the investment rules are more restrictive. All of these criticisms are valid. That said, as this article will demonstrate, the true potential of a well-designed IPP has not yet been truly realized on a large scale in the Canadian marketplace.
The IPP is now defined under federal tax rules as a Defined Benefit plan for less than four individuals. Being a registered pension plan, it must also be registered by the applicable pension authorities – for example, in Ontario by FSCO (the Financial Services Commission of Ontario.) Because it offers a defined benefit, the services of an actuary are required to determine the appropriate level of contributions. A DB plan, like an IPP, can also allow for the purchase of past service with an employer. Individuals who have owned and operated a corporation for a number of years can, if they can point to a history of employment income, have their corporation make a sometimes substantial tax-deductible contribution to fund the purchase of past service. While recent amendments to the income tax regulations have made this deduction somewhat less substantial in certain circumstances, the ‘past service buy back’ is still alive and well. Many IPPs were marketed with that single feature in mind – to fund a generous pension with corporate income that would have otherwise been taxed inside of the corporation. In reality, the past service buy back is only one of many advantages that only an IPP can offer.
Perhaps the greatest feature of any IPP is the fact that the pension it promises can be delivered in retirement so long as the corporate sponsor has the financial wherewithal to make the necessary contributions. While risk cannot be pooled over a group of individuals with different life expectancies and ages as is the case with traditional registered pension plans, there is a measure of risk sharing between the employee and the IPP’s sponsor. As such, monies in non-registered accounts can be lent to the IPP sponsor who can then turn around and make the necessary contributions to ensure a fully-funded pension benefit. In effect, the IPP allows the ‘registration’ of additional funds above and beyond existing tax limits found in RRSPs. Most RRSPs and Defined Contribution plans are not designed to ensure that the contributor will have a fixed amount of pension in retirement.
The other key advantage of the IPP over the RRSP is the ability to tax shelter a greater amount of corporate wealth without incurring additional market risk.
In 2012, a 55-year-old business owner could put approximately $30,770 from his corporate employer into an IPP as a normal cost contribution. If a deficit exists in the IPP because of investment returns below the prescribed 7.5 per cent, additional special payments could augment this base contribution to approximately $33,000. Given that the RRSP limit for 2012 was capped at $22,970, this amounts to an additional $10,000 of income that is contributed in a tax effective manner. If we assume a corporate tax rate of 15.5 per cent, the owner-operator will now have both a tax refund of $1,550 and an extra $10,000 in his pension fund.
All pension plan and pension fund administrative and investment fees are also tax-deductible within the context of an IPP, something that few, if any RRSPs can do. The payment of fees by the corporate sponsor, instead of out of the pension assets, has two impacts. It allows for true compounding of invested assets since no fees are withdrawn and it means that the fees are paid with pre-tax income. Over time, this fiscal advantage can be considerable. By way of illustration, imagine an RRSP with $100,000 invested in a variety of investment options where the average management expense ratio is one per cent. Each year, in the best case scenario, a minimum of $1,000 is removed from the account. If we assume a conservative investment in GICs yielding two per cent per annum simple interest, the net growth of the account after a year will be of $980 ($2,000 interest minus $1,020 in fees).
By way of comparison, in the IPP, the fees ($1,020) are paid by the corporate sponsor and deducted from the sponsor’s corporate income. At the same corporate tax rate of 15.5 per cent, the true cost of the fees amounts to $861.90. But more importantly, the account will now have $102,000 at the start of the second year, instead of $98,980 ($100,000 minus $1,020). Thus, the IPP member has increased his net worth by $3,178.10 (due to higher account balance and lower effective fees).
Seen another way, this client has generated an internal risk-free rate of return of 9.6 per cent ($3,178.10/$33,000), above and beyond what he might have tax sheltered in his RRSP. The rate of return is risk-free because market risk does not form part of the value creation process, in this case, since it is assumed that the underlying investments in both the base case RRSP account and IPP accounts are identical. Where the investment manager of the IPP generates an alpha, the alpha would be added to the 9.6 per cent, in the above illustration, to create the total gross returns available to the plan.
While the fiscal advantages of the IPP are undeniable, there are some drawbacks.
Some of the core drawbacks are that the product is complex and highly regulated since both the Canada Revenue Agency and the Financial Services Commission of Ontario have an interest in ensuring that all legal requirements are being followed. Ultimately, it is the plan’s sponsor that typically undertakes to administer the IPP and it is that entity that is held to account in the final analysis. While service providers and consultants will prepare regulatory forms and reports, issues of compliance end up on the door step of the plan administrator/employer.
Another drawback is the fact that, unlike in RRSPs, IPP mandatory contributions are typically locked-in by pension legislation and cannot be withdrawn prior to retirement age (with some minor exceptions). Entrepreneurs with uncertain cash flows may not wish to adopt a strategy that works well when business is vibrant, but imposes an unbearable drain on scarce cash flows when it dries up.
Some also take issue with the fact that IPP monies must be invested in accordance with a statement of investment policies and procedures subject to the federal investment rules set out in Schedule III to the Pension Benefits Standards Regulations, 1985. One particular rule, colloquially known as the ’10 per cent rule,’ prevents a plan administrator from using more than 10 per cent of the book value of the pension fund to purchase any one security. RRSPs are not constrained by these quantitative restrictions and are thus better suited for sophisticated investors who are willing to take large speculative market positions.
Where a business owner derives salary income from an active business, he or she would be well-advised to consider setting up an IPP instead of continuing to save for retirement through an RRSP.
The ability to create a risk-free rate of return through the superior tax-sheltering rules available to all registered pension plans is an important competitive advantage, especially in times of market uncertainty. The ability to make up for bad investment choices through tax deductible special payments also offers a way of ensuring that sufficient funds will be available for retirement.
is the CEO of INTEGRIS Pension Management Corp. (email@example.com).