In recent articles we talked about what a registered pension plan (RPP) member needs to consider when deciding whether to commute their pension.
The member’s termination statement may indicate that he or she can transfer the commuted value (CV) to another RPP, if that plan will accept the transfer. In the appropriate circumstances, transferring the CV to an individual pension plan (IPP), which is an RPP, offers many advantages.
While the IPP strategy might be appealing, it’s also complex: the transfer must meet requirements of the Income Tax Act (ITA) and the appropriate pension standards legislation. Otherwise, the member will face adverse tax consequences.
Read: Are you entitled to a commuted value?
What is the IPP strategy?
For this strategy to work, the plan member will have to secure new employment elsewhere. The new employer will sponsor the IPP, and the full CV amount will be transferred directly to the IPP. While the IPP will recognize the past service at the previous employer, the formula for the pension is based on T4 earnings from the new employer (or plan sponsor). Future earnings at the new employer will allow the person to accrue additional years of service.
Consider the fictional case of Albert, whose employment at a large financial institution was terminated. Albert was able to commute his pension and put part of his severance package into an equity stake in an existing small business, where he assumed a new senior role paying a commensurate salary. An IPP was implemented at his new employer and the entire CV was transferred directly to the IPP.
While the IPP strategy may sound simple, there are many factors.
Why to consider a transfer
At first glance, the transfer is attractive. An advisor might cite the following advantages:
- Being able to transfer the entire CV to the IPP. (The maximum transfer value, or MTV, rule typically limits the amount that can be transferred directly to a locked-in RRSP without using RRSP room. For younger members of generous plans in this low-interest environment, a direct transfer could be limited to 30% of the CV, with the remaining 70% having to be taken into income and taxed.)
- The potential to leave an estate. (The guarantees for the retirement income paid from the old RPP may result in there being little or no estate value upon the death of the plan member and spouse).
- Control over the asset.
Read: Understanding maximum transfer value rules
What are CRA’s concerns?
CRA will only register a pension plan that meets all the ITA’s requirements, including the “primary purpose” test. Subsection 8502(a) of the act’s regulations requires that “the primary purpose of the plan is to provide periodic payments to individuals after retirement and until death in respect of their service as employees.”
The “service as employees” requirement relates to the legitimacy of service at the new employer. CRA wants to be sure the IPP isn’t being established to avoid the MTV rule.
Even where this requirement is met, the agency becomes concerned if the new employer is only paying nominal earnings. This is because the T4 earnings at the new employer are used to calculate the pension payable to the plan member. (CRA is generally not concerned when the wages at the new employer are comparable to those at the previous employer.)
Lower T4 earnings (which lead to a lower retirement pension) increase the IPP’s surplus. Where the retirement income from the IPP is less than the retirement income from the original RPP, the plan member is able to defer income. Thus, the IPP surplus could be larger than would otherwise be the case.
While the actuary will recalculate the liability every third year, the employer will only be able to make additional contributions to the IPP provided that the IPP does not have an “excess surplus.” The excess surplus arises when the IPP’s assets exceed the liabilities (calculated using the maximum funding valuation, or MFV, method) by 25%.
Employer contributions to an IPP are suspended until excess surplus is used up.
CRA also becomes concerned if the plan member accesses the IPP surplus, particularly if the member does so before the retirement income would have been paid from the original RPP. (The federal Department of Finance introduced rules in 2011 meant to partially address concerns relating to surplus. More on this in the case study below.)
CRA will not register a plan that won’t meet the “primary purpose” test, and will deregister a plan if it later becomes apparent the test wasn’t met. Advisors must review the relevant compliance bulletins and other relevant CRA materials, as well as those of any pension supervisory authority.
What you need to know about ongoing IPP contributions
The actuary will prepare the initial valuation, which will be updated every third year. For IPPs, CRA matches wages used in preparing the valuation to its database. Thus, CRA will become aware of situations in which new employers are paying no wages or low wages.
Where the IPP plan member is a “connected” person (in general terms, someone who either has a 10% or greater ownership interest—voting and/or non-voting—in the employer, or who is related to the employer) the plan will be a “designated plan.” The ITA prescribes the assumptions that have to be used in preparing the valuation for designated plans, referred to as the MFV.
The MFV assumptions produce a very interesting result. We’ll use the fictional case of John, a 55-year-old who was a member of a very generous RPP for 27 years, to demonstrate CRA’s concerns. In this scenario, the retirement benefit was indexed to CPI and the plan provided CPP bridge benefits. John also qualified for an unreduced pension.
John’s commuted value is approximately $2.4 million, of which only $900,000 (or 38%) can be transferred to a locked-in retirement account (LIRA). The remaining $1.5 million would be taxed if John decided on the LIRA route.
When the actuary prepares the MFV to recognize the liability for 27 years of service, assuming maximum wages, the liability is approximately $1 million. Thus, this IPP has a $1.4-million surplus from the outset. The excess surplus is $1.15 million (calculated as $1.4 million less 25% of $1 million). It would be even larger if the wages were less than the maximum.
From a practical perspective, it is unlikely that John’s employer will ever be permitted to make additional contributions to the IPP.
What this means for John
John will accrue additional years of service in respect of his ongoing employment at his new employer. A pension adjustment (PA) will have to be calculated each year, even though his employer is not making additional contributions to the IPP. The PA for any given year will reduce what might otherwise be contributed to his RRSP in the following year.
When he retires, John will receive a pension covering all his years of service (the IPP recognizes the service under the RPP), with the amount calculated using his wages from his new employer. This retirement benefit (plus any bridge benefit paid to age 65) can be split with his spouse or common-law partner under the pension-splitting rules, regardless of his age.
Surplus withdrawals, however, cannot be split under the pension-splitting rules, as these amounts are not considered “life annuity income.”
As already noted, CRA is concerned about undue deferral. Thus, the 2011 federal budget introduced an “IPP minimum amount” rule, which comes into effect in the year John turns 71. Essentially, the minimum payment that John must receive from the IPP would be equal to the RRIF minimum. At age 71, this would represent 5.28% of the Jan. 1 balance of his IPP. While the difference between the IPP minimum amount and the retirement income otherwise payable is a permitted distribution from the IPP, the view is that it does not qualify for pension splitting.
Additional risks to consider
The plan member will need to assess whether the IPP will have sufficient funds to ensure that he or she has lifelong income. As discussed, the MFV has a bearing on what can be contributed. Even if the MFV requirement were not in place, the employer would need to have the available funds with which to make a contribution. This could occur when the corporation is no longer carrying on an active business.
More importantly, John is not avoiding the market and investment risk that defined benefit plan employers typically assume for their members. Where John owns the corporation that employs him, he is indirectly taking on this risk. The IPP is taking on the mortality risk. There will only be an “estate value” to the extent that funds remain in the plan upon John’s (or his spouse’s or common law partner’s) deaths.
Another option that may be available to plan members commuting their pensions is the “copycat” annuity. This is especially attractive where the RPP is poorly funded. It also allows the plan member to avoid the application of the MTV, provided that the rights under the life annuity contract that is purchased from a life insurer are not “materially different” from the rights under the RPP.
Read: Should your client consider a copycat annuity?
Commutation decisions are complex and the advisor will need to assess all the options available to the plan member. If the IPP strategy appears to have merit, it’s essential that this be discussed with an experienced tax consultant and plan actuary. It is an attractive strategy in the appropriate circumstances.
Lea Koiv, CPA, CMA, CA, CFP, TEP, is a tax, pension and retirement expert with Lea Koiv & Associates Inc. (email@example.com). William C. Kennedy, FSA, FCIA, is senior vice-president at Lesniewski Moore Consulting Group.