Most sponsors of Individual Pension Plans (IPPs) are sold a product intended to achieve one or more goals, such as targeting a certain retirement income, rewarding long and loyal service, or creating ‘golden handcuffs’ to retain key employees. Embedded in the many possible goals is almost always the desire to tax-shelter more dollars for an employee than is possible under an RRSP.
Until retirement is upon the sponsor/member, little thought is given to what happens to the IPP and its assets at that point in time. For IPPs ‘sold’ in the 1990s or even 2000s, plan members most often expect that the IPP will be ‘collapsed’ and the money will be transferred to a personal RRSP so that the member can retain control of their investments in retirement and have the flexibility to draw and defer income as part of an overall financial plan. Unfortunately, the end to an IPP is not always this simple. When the sponsor and the member are ‘non-connected’ things can get even more difficult.
The Connected & Non-Connected Members
Connected members of IPPs are individuals that own at least 10% of the sponsor corporation. Often the member owns or controls 100% of the business and the IPP is just a convenient location to store unspent profits. These plans are almost always seen as a Super RRSP and when it comes time for retirement it isn’t surprising that the business owner wants to keep his or her money in the pot to keep growing. In the old days, at the time of plan wind-up (retirement or the sale of the business) owners simply transferred the funds to a personal locked-in RRSP.
Non-connected members are typically the executives that work for a business that is owned by others. Whether owned by a wealthy individual or owned by thousands of stockholders, these businesses have made a calculated decision to provide the executive with a generous pension at retirement to achieve the dual goals of retaining talent and deferring income to reduce taxes.
It is disappointing to me the number of times I am contacted because the sponsor of an IPP is in shock at the amount of additional contributions that must be made to an IPP (Surprise #1). The IPP industry for the most part is designed to deliver a sponsor with a defined benefit registered pension plan including all its regulatory complexity for a very low price. To achieve this end, there is little room for a sponsor to get to know their actuary and discuss the nuances of pension funding and investment, and the inherent risk-reward tradeoffs that come with every defined benefit pension plan. We don’t offer IPPs in bulk at low prices and only handle a handful where sponsors want a high level of engagement and line of sight to future costs.
In the most recent case, a sponsor approached us to verify the fact that the $1.5 million IPP that they had funded was in fact $300k short of the amount needed. Upon review it was clear that the shortfall was real which left us helping the sponsor understand what had happened.
In a nutshell, the amount a sponsor can contribute to an IPP is limited by special provisions of the Income Tax Act. These special provisions don’t apply to ‘regular’ defined benefit pension plans where typically the actuary will have great latitude to advise on the amount that the actuary thinks should be funded. In the case of IPPs, the limits to contributions are much lower than what an actuary would recommend in today’s low interest rate environment.
Lump-sums and annuities
As mentioned, many IPPs were designed around the idea that the member would ‘cash out’ at termination or retirement. Unfortunately, what was once a simple proposition has become more complicated. With the ‘maximum transfer value’ of a defined benefit pension promise permitted under the Income Tax Act lagging far behind the commuted value that actuaries place on the same promise for older workers, an IPP plan member can find themselves needing to take a significant portion of their nest egg in cash when they collapse the plan. Depending on their age, it is not uncommon to see a third of a member’s commuted value exceed the maximum transfer value which means a plan with $1.8 million will see $1.2 million transferred to a locked-in RRSP and $600k paid in cash. Of course, the cash is taxed in the year it is received and so this transfer option is much less appealing than it once was when commuted values were less likely to exceed the maximum transfer value by much if at all. As a result of the imbalance between the value of these pensions and the amount that can be sheltered in an RRSP, more and more plan members are looking at the ‘monthly pension’ option.
Many sponsors will immediately empathize with a plan member not wanting to take the tax hit and will be fully supportive of the member electing the monthly pension. However, things get greasy when the sponsor starts thinking about the ongoing administration of an IPP for another 30 years. It doesn’t take long for the sponsor to warm up to the idea of buying an annuity and winding-up the plan.
Surprise #2! The price of annuity is never exactly equal to the ‘commuted value’ previously offered to the member. The premium for non-indexed annuities will often be close to the corresponding commuted value but a difference of 10% either way never surprises the actuaries but often surprises the sponsor.
Surprise #3! If the IPP promises a pension indexed to the Consumer Price Index, then the annuity prices are significantly more than the ‘commuted value’. Why does this happen? The commuted value standard, created by the actuarial profession, determines the ‘fair value’ of the pension promise. In contrast, an insurance company will set an annuity price based upon available capital, risk tolerance, investment opportunities, profit objectives, and intangibles such as their relationship with the broker buying the annuity. In recent experience, the difference between the commuted value and the annuity premium for an indexed pension is about 30% with the latter being the higher amount. If you have a $1.8 million dollar commuted value, that is a $500k uptick in the cost of the program.
As noted earlier, business owners often think of an IPP as a tax-deferral mechanism and where there is enough wealth there is not much fuss about making the extra contributions described above. As a safety valve, connected members can agree to reduce their benefits from the plan to lower the costs, essentially giving the business owner some freedom to decide in which pot to keep the money. Unfortunately this flexibility is not available to non-connected members and beneficiaries of a connected member and there are now questions whether a connected member can agree to a benefit reduction after they have retired.
Forms, Forms, Forms
In the eyes of CRA and FSCO, winding-up an IPP is the same process as winding up a full scale defined benefit pension plan. I suspect that FSCO spends a little less time making sure an owner gets the pension that they were promised, and I suspect that CRA spends a little more time making sure that an owner gets no more than is permitted under the ITA – but otherwise there are forms to complete and a process to follow.
Key in this process is making sure that the plan is ‘fully funded’ and getting FSCO approval, usually before an annuity is purchased.
Plan the Work – Work the Plan
In the end, our best advice to sponsors considering an IPP – buyer beware, make sure you understand what you are buying. This is not to say IPPs are bad, they are an excellent compensation tool in the right circumstances and just yesterday I told a friend who is a non-connected employee he should tell the owners of his business that he needs an IPP (I also told him he should tell the owner that he needs the company to pay for a private golf club membership for him – we will see how far he gets with that second one).
For sponsors that already have an IPP, I refer you back to Part II – Getting Control. Getting a handle on the costs of an IPP while an executive is still employed gives time to adjust other forms of compensation and budget effectively over time which is something that is in everyone’s interest.