The Individual Pension Plan – Part II: Getting Control
If you missed Part I: Getting Started you can find it here. I will jump right in on this stage of the story and I am assuming that you are up to speed.
Once an organization sets up an Individual Pension Plan (IPP), someone must be responsible for its ongoing operation. The people responsible for an IPP often fall into one of three categories:
- The business owner directly benefiting from the plan but too busy and uninterested to properly supervise the program;
- A junior staff member responsible for the paperwork but with no explanation of what the program is or how it works; or
- A senior staff member sufficiently engaged to take the time to understand how the IPP works and how things can reasonably be expected to unfold.
In either of the first two cases you have a recipe for disaster. Uninterested and uniformed are not adjectives describing the road to success.
If you are still reading at this point, hopefully you are in the third category or hopefully you have confessed that you are in one of the first two but want to do something about it.
What you need to know
The IPP is a pension plan registered under the Income Tax Act and often the provincial Pension Benefits Act applicable to the member’s province of employment (some provinces sensibly exempt IPPs from registration). That means that there is annual reporting to both Canada Revenue Agency and usually a provincial agency like the Financial Services Commission of Ontario (formerly the PCO and soon to be FSRA). The names may change but the song remains the same.
The most important outcome of registering a pension plan is that an entity then becomes the Plan Administrator. We could write at length about the duties and responsibilities that come with this super-cool title, but for now just know that someone has taken on a fiduciary duty and that there are fines associated with not taking that duty seriously.
What would regulation be without regulatory forms? Regulators want to know that everything is going according to plan, and when it comes to defined benefit plans, every year you likely get a Form 7, a financial statement and Form 8, a member statement, and an Annual Information Return. If this hadn’t been my life for the last 30 years I would certainly want to rebel against the stupidity of all this for what most think is an RRSP.
Actuarial Mystery Novel
In addition to all the paperwork described above, every three years you will be getting an actuarial valuation. This is a document that contains pages and pages of what looks like boiler plate reporting and unless you are an actuary (or an accountant or lawyer that finds this stuff interesting) you likely don’t want to read the report and feel uncomfortable that it might be too hard to understand.
This is the moment of truth. To get control of an IPP, you must fight through the actuarial jargon, incredibly complex reporting standards prescribed by the regulators and the actuarial profession, and the math that may be completely unfamiliar to you. When the fight is over you will learn three things:
- Actuarial science is not that hard to understand;
- The government system for funding an IPP makes little sense; and
- What the actuary reports as the ‘financial position’ of the plan may not be the amount of money needed to pay the benefits that one day need to be paid.
On the first point – I am not offering false humility. The math behind DB actuarial science and the computer programming required are both reasonably complex. But the overall scheme of what we are calculating and what the numbers mean are not. One of the big challenges in understanding an actuarial report is wading through the details – the important details and the inconsequential details – to see the big picture. A good actuary is going to help you with that.
On the second point – I used to hope that I would understand the reasons for the rules the government makes. Now I just accept that sometimes the reasons are not fully understandable and there are political forces that drive some rules. The IPP rules are their own special section under the Income Tax Act. Essentially, the government does not want to give an IPP member the chance to fully fund their pension promise the way every government worker expects their employer to do so. We can debate the fairness of this forever, but for now just accept that life is not fair – something I have told the kids on more than a few occasions and something my father endlessly told me and my sisters when we were kids.
On the third point – and this is the big point – the numbers in an actuarial valuation for an IPP don’t tell the full story. First of all, some of the assumptions like mortality tables and discount rates that an actuary would normally set are prescribed in law – and lately those assumptions don’t make a lot of sense. Second, to be useful, valuations rely on ‘the law of large numbers’ and when you have only one member in the plan – then you get only one life where the outcomes can range from ‘die tomorrow’ to ‘live to 120’. It is hard to put one number on that range of outcomes.
What is important to understand is what that range of outcomes might be and what events drive those outcomes. We have seen clients defer retirement resulting in overfunded plans and we have seen clients die or retire young which then require significant increases in funding. No one wants to postpone retirement past the day they are ready and no one wants to call a widow to try and back out of a contractual promise to pay a death benefit – even when no one had any idea how big that death benefit could be. To some degree, some of the hard thinking about what benefits should be promised on death, termination, and retirement should be considered when the plan is setup. Chasing the maximum permitted contribution often comes with the widest range of possible outcomes.
Once you get your head around the range of outcomes, you are now in the driver’s seat to manage the risks and form a plan for cashflow management.
Stay tuned for Part III: Getting Out.