An Individual Pension Plan is the only retirement savings vehicle allowing for higher tax deductions when investments don’t perform as expected.
When IPPs perform poorly, investors can contribute funds to make up for shortfalls, which translates into additional corporate tax savings.
Business owners aged 40 and up who earn T4 income can contribute more annually to IPPs than RRSPs. And, in most cases, they can make IPP contributions for past service.
IPPs promise a certain amount of retirement income based on the client’s past and projected T4 earnings, as well as number of years of service. Plan contributions are calculated by an actuary using assumptions provided by the Income Tax Act.
The most notorious of these assumptions is IPP funds will earn an average of 7.5% per year. But in today’s economic environment, that’s challenging.
Assuming other assumptions are realized, when actual fund performance is compared to the benefit promised, a discrepancy will often exist.
But there’s a silver lining: the company sponsoring the plan can make additional tax-deductible contributions to balance out the discrepancy. An IPP is the only tax-sheltered retirement vehicle allowing investors to shore up low returns.
The table below illustrates the projected accumulation of assets at age 65 and 71 for an IPP established on January 1, 2012 for a 50-year-old participant. His employment history dates back to 1991 and he has sufficient T4 earnings to accrue the maximum pension.
If we assume any deficits in the IPP were entirely funded and that both the IPP and RRSP earn a 7.5% rate of return, the IPP will allow the business owner to accumulate close to 50% more than someone with only an RRSP. This is because the corporation is allowed to make larger, interest-earning contributions to the IPP.
In today’s market, though, your clients likely aren’t earning 7.5% on their RRSPs. Assuming a more realistic annualized return of 5%, the IPP generates close to 100% more tax-sheltered savings than an RRSP.
That means clients’ tax-sheltered retirement savings multiply faster, and businesses have opportunities to make important tax-deductible contributions.
IPPs are also effective in prosperous markets. If the IPP returns more than 7.5%, the company can continue to make regular annual IPP contributions as long as the surplus is less than 25% of the value of the pension, as per the Income Tax Act.
Companies can choose to ignore any surplus below this threshold when determining future payments, which would be indicated and validated in the client’s actuarial valuation report.
Impact of other legislated assumptions
The maximum pension per year of service increases as the average industrial wage index rises.
Legislation prescribes that actuaries must assume this index will increase at 5.5% in each future year when determining IPP contributions.
In slow economies, though, 5.5% is often too high. If this is the case, it would create a gain to the plan which could offset all or a part of any investment shortfall. Other assumptions may also affect the final deficit or surplus amount, as well as the contributions that can be made.
IPPs can be a suitable option for all types of business owners. The majority of plans make contributions optional, so owners don’t have to worry that their companies won’t have enough cash to fund the plans.
And in provinces requiring mandatory funding, clients can work with actuaries to design plans that make funding as flexible as possible.
Normand Frenette is a consulting actuary and retirement practice leader in the Ottawa offices of Buck Consultants, A Xerox Company.