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A financial advisor reading a pension plan member’s termination statement might see language stating that the purchase of an annuity could result in adverse tax consequences.

The Income Tax Act requires that the rights under the annuity contract cannot be “materially different” from the rights under a client’s registered pension plan (RPP). If they are, the plan member will have an income inclusion equal to the purchase price of the annuity contract.

In July, the Canada Revenue Agency (CRA) released a newsletter that mitigates the risk of purchasing a buy-out annuity — also known as a copycat annuity — that’s “offside.”

Financial advisors, annuity providers, and plan administrators and members should be pleased that Newsletter 20-1, Registered Pension Plan Annuity Contracts, has been issued in final form following a draft and consultations that began in December 2018.

An increasing number of defined-benefit RPPs are being wound up or converted to defined-contribution plans. Plan members may also be terminating their employment and, therefore, their plan membership. A copycat annuity could be a tax-effective strategy for clients in those situations.

A member of an RPP who is able to commute their pension may be able to acquire a life annuity with the commuted value. This would allow them to avoid the tax liability typically associated with transferring the assets to a (locked-in) retirement savings arrangement, and at the same time avoid longevity and market and/or investment risk. But the rights under the copycat annuity contract can’t be “materially different” from the rights under the pension plan.

CRA has added language to the newsletter to make it clear that the terms of the plan “as registered” includes the current plan text as well as amendments the CRA has accepted. It also includes amendments that have been submitted and that it’s reasonable to expect the CRA will accept.

The newsletter also makes clear that guarantee periods cannot be extended beyond what was available under the RPP, and that the purchase can be made either before or after lifetime benefits have begun to be paid.

Here are other notable clarifications in the newsletter.

Indexed annuities

While many RPPs have indexing, the Canadian market for annuities indexed to CPI has vanished, making it challenging to find a true copycat. The CRA confirmed the option of two proxies in lieu of a full CPI indexing adjustment.

If an annuity had been purchased in July 2020, for example, the draft newsletter allowed for fixed indexing equal to either the midpoint of the Bank of Canada inflation control target (2%), or the spread between the yield of Government of Canada long term bonds and real return bonds in the month or the month preceding the date of purchase (1.03 for June 2020 bond rates).

The newsletter says it’s acceptable to use a fixed rate between the two proxy rates. An annuity may have the appropriate adjustments made where there is less-than-CPI indexing or indexing for specific periods. The CRA indicated it will accept written requests to review the various methods an insurer might use.

Scaling back annuity payments

There may be situations where the commuted value (CV) won’t provide the benefits that would have been provided under the RPP. The CRA accepted that scaling back the amounts will not cause the annuity to be offside. The annuity can provide for reduced lifetime or ancillary benefits, or a combination thereof.

The agency specified that no element of the benefits can exceed the amount of that element, as paid from the plan. Take the example of a plan member who would have been entitled to a lifetime retirement benefit of $2,500 per month and a special allowance of $700 per month to age 65. If the CV is not sufficient to provide for both, one or both can be reduced. However, it would not be permissible to scale back the special allowance of $700 but increase the lifetime benefit to more than $2,500 per month.

Annuities that cost less than the CV

If an annuity costs less than the CV, the newsletter makes it clear that the excess of the CV over the purchase price is taxable to the plan member. The payments from the annuity cannot be increased from what the plan would have paid.

Annuities purchased from IPPs

Annuities bought with IPP assets must account for the provisions of the plan as registered. The newsletter accepts that an employer may have to make additional contributions to the plan, or that it may be necessary to reduce the benefits paid should the assets be insufficient. The newsletter also permits a plan with excess assets to allow for additional lifetime retirement benefits and/or ancillary benefits, to the extent that the benefits are not already at the maximum.