Retirement Compensation Arrangements (RCAs) can address pension shortfall concerns for high earners resulting from capped contribution and benefit limits in RRSPs and RPPs.
Towards the mid-2000s, some inappropriate RCA strategies caught the ire of CRA. Letters to CRA auditors and legislative changes chilled the RCA market, even for arrangements that met CRA guidelines. Further, decreasing corporate and dividend tax rates made RCAs less attractive for business owners not on salary. But, although volume declined for individual RCAs, they continued to grow for arm’s-length employees and to secure supplemental pension liabilities at public corporations.
Fast forward to today
Higher tax rates are taking a bite out of owners’ and key employees’ incomes. Against that backdrop, it’s more important for companies to fund pension shortfalls for these folks. Chart 1, this page, shows that beyond $220,000 of income in Ontario, the marginal tax rate is now 53.53%, with non-eligible dividends taxed at 45.30%. Chart 1 also provides the values for other provinces.
Click on the image to enlarge it.
Jim, 50 years old, is president of a business in Toronto that has earnings well above the small business limit. His taxable income is just over $230,000 a year, which covers his living costs and allows for savings. His RRSPs are fully maxed out, and his non-registered portfolio is well managed. His concern is that, at retirement, these two pools will still not generate the income he needs.
As an owner, he has flexibility relative to profits but, because of increasing marginal tax rates for high earners, it does not make sense for him to pay himself more than he needs to live.
Jim owns HoldCo and his accountant will continue to transfer annual dividends from his OpCo. Jim likes this strategy and understands the value of the HoldCo for long-term estate planning. But, Jim takes enough risk with his OpCo; he wants to secure his retirement and, at the same time, to leave a solid base for his family. Jim’s wife is 44 and he hopes that at least one of his sons will join his business.
Jim needs two essential-spending retirement pots so that he can safely use his non-registered asset pool as his discretionary spending pot at retirement. He already has one pot (his RRSPs). The second retirement pot can come from HoldCo dividends, but what portion is required for Jim and his wife, and what can be passed on?
The RCA provisions in the Income Tax Act can provide Jim with his second retirement pot. An RCA is conceptually like a corporate RRSP. Contributions are tax-deductible for OpCo; if OpCo doesn’t make contributions one year, the room can be carried forward. The RCA is not taxable in Jim’s hands until he starts to take benefits. Most importantly, there is no salary cap and contributions are based on Jim’s employment (T4) income.
The RCA can supplement his RRSP pot and provide Jim up to a 70% pension (2% x years of service to a maximum of 35 years) and a 2/3rd retirement benefit to his wife. RCA withdrawals are also more tax-efficient than dividends because the RCA carves out profits before they dividend up to his HoldCo. Those profits are held in a creditor-protected trust. Jim no longer has to worry over what part of the HoldCo’s pool of assets he needs. RCA entitlement and funding calculations must be made by an experienced third-party specialist following CRA guidelines. For Jim, his company receives an unfunded past service deduction and future contributions of approximately $98,000 a year until age 65.
This second retirement pot will give Jim additional income over his RRSP of approximately $72,000 (indexed at 2%) annually, with a two-thirds survivor benefit.
Other benefits of an RCA for Jim
An RCA has both an Investment Account (RCAIA) and Refundable Tax Account (RTA); the latter earns no interest. Investments where underlying earnings can accrue, like under an exempt insurance policy, can therefore be advantageous because of the RTA. But be careful, says Roy W. Craik, founder of Retirement Compensation Funding Inc. (who designed the first insurance policy to be used in an RCA in 1988). A December 2015 letter CRA wrote to CALU regarding RCA tax rules leads him to believe that “the face amount of the policy must not be excessive, particularly for connected employees, so as not to trigger an advantage under CRA guidelines.” The sum insured should remain within the range required to meet exempt testing by the insurer and what is required to provide survivor benefits on the death of the primary member.
Jim’s financial advisor suggests he fund the RCA using a universal life policy. The sheltering of investment returns enhances values in the RCA Investment Account, and an exempt insurance policy also provides the security of pre- and post-retirement protection to the survivor on the plan member’s death.
As a pension plan, the investment selected should include low volatility options, such as guaranteed market indexed accounts. These kinds of investments provide participation in part of the upside of an equity index (e.g., S&P/TSX 60 or S&P 500) but returns will never be negative, even if the underlying index is. Annual resets of gains ensure a new cash value watermark each year.
If past service is being funded in a lump-sum, single deposit universal life policy, there’s an advantage to doing so before new exempt rules on life insurance policies take effect in 2017 (see AER May 2015, New law will impact insurance tax benefits).
Since an RCA can run for a long time from establishment to the death of the surviving spouse (in Jim’s case, it could last 50 years or more), consider a corporate trustee. Bob Mathew, director, Trust Services of BMO Trust Company, says the 21-year rule does not apply to an RCA trust. This allows the trustee to manage the RCA and pay required benefits for a long period.
Pierre Ghorbanian, MBA, CFP, FLMI, the Advanced Markets Business Development Director at BMO Insurance.