If you are a small business owner or a senior executive you may have some vague understanding of what an Individual Pension Plan (IPP) is and how it works. If you are an accountant or financial advisor you might have seen a few clients benefit and a few clients suffer from an IPP. Being in the pension industry for over 30 years, I have seen the good, the bad and the ugly when it comes to IPPs.
Most IPPs are ‘sold’ as a ‘Super RRSP’ rather than being ‘bought’ as a registered pension plan. Buyers are told by the expert selling them that the RRSP rules are unfair and grossly limit what a business owner can save for retirement compared to government workers in gold-plated defined benefit pension plans. This is true.
To solve the problem of inadequate tax-sheltered retirement savings the well-paid non-government workers are advised by the experts to get an IPP. This Super RRSP comes with higher contribution limits and, if you can build in ‘past service’ back to when you started working for your employer you can really load up on assets that are protected from the immediate grasp of CRA.
Unfortunately, what goes wrong for many IPP sponsors is that they are completely unaware that they are registering a defined benefit pension plan and all of rules set out in the provincial and federal legislation that come with that one decision. Most critical, few understand the work of actuaries that are central to the contribution requirements and find themselves waking up somewhere along the road to financial circumstances they never understood were possible.
Who Are We Helping?
IPPs come in two flavours: one for the ‘connected member’ and one for the ‘non-connected member’. Some sponsors add to the complexity by having more than one member covered in one plan to save on administrative expenses – this approach changes the IPP into an Executive Pension Plan (EPP) if one cares about labelling. There are rules about how you decide whether a member is connected or not, but for simplicity, think of connected members as business owners and non-connected members as executive employees.
When an IPP is setup for a connected member, the Income Tax Act limits the benefits that can be earned, fundamentally to make sure that the business owner doesn’t work to minimize his T4 income over his working lifetime and then in the last few years boost that income to generate a generous ‘final average earnings’ defined benefit pension. There are other nuances, but I won’t get into them here.
The challenge with a connected-member IPP is getting the business owner to pay attention to the administrative duties (filing forms, monitoring investment policy, etc.) and to take the time to understand the tax rules and funding requirements of the plan. What is often lost in the conversation is that the liability that can arise under the plan’s promise can be substantially different than the assets held in the fund when a member dies or retires. If a business has multiple owners, the unexpected liabilities that can arise on death or retirement of one owner may need to be funded by the remaining owners depending on what the shareholder agreement requires.
The challenges with a non-connected member IPP are the same as above, but to some extent their magnitude is greater. Trying to get a business owner to understand and care for their own IPP is challenging – asking them to understand and care when the IPP doesn’t involve their own retirement can be tougher than quitting smoking or staying on a healthy diet.
The IPP for the non-connected member is to be chosen with great caution. Some businesses think the IPP offers an improved retirement benefit for the executive employee, the cost of which can be reasonably budgeted over the executive’s remaining career with the organization. Quite often when the Board of Directors get a handle on the true costs, the commitment cannot be undone and hard feelings can arise. This is especially painful if those true costs are not revealed until the executive is retiring.
Getting it Right
If you are setting up an IPP you need three advisors. You need a good actuary to put the numbers together, you need a good investment advisor to help you manage the money, and you need a good pension consultant to help you stay on top of the promises being made and the risks that might be hidden in the fine print. If someone is selling you an IPP make sure to ask which of these roles they play, what the costs of their services will be, and how much time they will be spending with you in each role. Too often sponsors hire only one of these three advisors and never interact with either of the other two – a recipe for unexpected outcomes.
Stay tuned for Part II: Getting Control and Part III: Getting Out