With tax time upon us, advisors are looking to squeeze every last drop of tax-advantaged savings and investment for their clients. Understanding the number in box 52 of your clients’ T4 slips will help you do just that.
Nuts and bolts
If your client participates in a company-sponsored registered pension plan (RPP) or deferred profit-sharing plan (DPSP), he or she will have a pension adjustment (PA) entered in box 52 of the T4 slip. The PA represents a mandatory deduction applied to the taxpayer’s RRSP contribution room for the next calendar year.
The purpose of PAs is “to equalize the tax advantages available to all of us for retirement savings,” says Ashley Crozier, an independent actuary based in Toronto.
Take, for example, the case of two taxpayers who both earn $65,000 a year, but only one is a member of an RPP through his employer. Without the PA system, both would have the same RRSP contribution room for the following year, but the taxpayer with the employer-sponsored RPP would have a significantly higher level of tax-deferred savings than the taxpayer with no plan.
For those enrolled in a defined-contribution or deferred profit-sharing plan, the PA is simply the total amount contributed for the year. Coming up with the PA for those with a defined-benefit plan is more complicated (see illustration below, “PA calculations”).
The defined-benefit PA calculation
Assume a case where two employees, one aged 20 and one 50, make the same salary and are enrolled in the same defined-benefit plan with the same employer. They both contribute the same amount and have a PA of, say, $6,000.
Ian Genno, senior consultant in Towers Watson’s retirement practice in Toronto, explains that an employee’s age makes a difference when it comes to the true value of the pension in any given year. Yet the factor of nine used to calculate the PA for defined-benefit plans does not reflect this.
“If I have a 20-year-old employee and a 50-year-old employee, and if they’re the same in all other respects, the value of the pension this year for the 20-year-old is going to be a lot less than it is for the 50-year-old,” he says.
That’s because the 50-year-old is only 10-to-15 years away from wanting that pension. A 20-year-old, by contrast, is decades away from ever seeing it. So the economic value of a defined-benefit plan is greater for someone who’s closer to actually receiving the benefits.
“As an actuary I would say this factor-of-nine theory should differentiate between people based on their age,” Genno says. “Theoretically, it should be a factor that goes up with time or age.”
Now, the federal government doesn’t want to set up something that appears age-discriminatory. Imagine the furor if 50-year-olds had less RRSP contribution room than 20-year-olds, purely because they’re 50. “The government has to make a simplifying approximation,” notes Genno. “But in pure actuarial or economic terms, there should be a distinction based on age.”
Crozier explains another way the PA calculation is less of an equalizer than its billing might suggest. Let’s say a friend of his has exactly the same salary, and they’re the same age. The only difference is the friend has a much more generous pension plan. Crozier’s pension plan has no death benefit after retirement, no indexing, no bridge benefit, and no ability to retire with an unreduced early retirement pension. The friend, by contrast, is a teacher with an indexed pension, can retire early with an unreduced pension (provided he has enough service), and has wonderful bridge and death benefits post-retirement.
“The value of his pension may be twice as much as mine,” he says, “and yet both of us have exactly the same pension adjustment.” Crozier observes the factor of nine was devised with a view to defined-benefit plans that have all the bells and whistles, like a government or teacher’s pension.
Genno makes the same point, noting the federal government built in a lot of provisions that are present in some public sector pensions, but aren’t as prominent in the private sector.
“If you’re in a defined-benefit pension plan that doesn’t provide all those great ancillary benefits, then the factor of nine overestimates the underlying value,” says Crozier. “That person is going to end up getting less retirement savings, ultimately, or lower value than what the person who is in a pension with all of those benefits gets.”
Genno notes the $600 deduction worked into the pension adjustment calculation was intended to compensate for the slimmer private sector pensions. But since everyone with a defined-benefit plan gets the deduction, it still yields a pension adjustment that gives those with loaded plans more value than those with less generous ones.
Crozier says there really isn’t much people can do to make up the RRSP room lost from PAs that overvalue their plans — apart from lobbying their employers to make changes.
Employers can improve the tax efficiency of retirement savings for their employees by cutting the benefit while adding indexing. This would reduce the annual PA by about 30%, he explains. If an employee quits and decides to roll out the cumulative value of the plan, he’ll get the same amount he would have gotten otherwise. But with the lower PAs, in the years leading up to the end of employment, he has significantly more RRSP contribution room.
“You can do the same type of thing by adding early retirement benefits, or joint survivor pensions,” says Crozier. “But it’s the employer who ultimately has to decide to do that, or if there’s a unionized group it has to be negotiated with the employer and employee and the union.”
But is it in the employer’s interest to make these changes?
“Imagine I’m an employer telling an employee, ‘I’ve cut your pension by 30%, but don’t worry. I’m not changing the value of your pension.’ The reality is, very few are contributing the maximum even with the higher PAs, so giving people a lower PA and higher RRSP contribution room is not going to help many,” says Crozier. “An employer looks at it and says, ‘What you’re saying makes sense, but why should I go through the cost of trying to do this when I’m going to get people upset?’ ”
In some industries employers have been willing to tinker with plans to improve employees’ retirement savings opportunities, notably the oil-and-gas and high-tech industries, where Crozier notes employees are higher paid on average. In these cases the direction often taken by employers is to allow employees to make additional contributions, which will be used to purchase indexing, a bridge benefit, a better death benefit, or an unreduced early retirement.
The federal government has discussed the idea of assigning different factors to different plans, with the aim of having PAs better reflect each plan’s true value. Under this scenario, many public sector plans would keep the factor of nine, “but a plan that doesn’t have indexing or reduced early retirement, or a joint pension, may have a factor of only six, as an example,” says Crozier.
“The different factors — recognizing the different ancillary benefits that exist in the plans — give closer reflections of the true underlying value of each
Unfortunately, Crozier says, little has come out of these discussions.
Implications for advisors
Blair Corkum of Corkum & Arsenault Chartered Accountants and Financial Advisors in Charlottetown, PEI, says understanding the PA is critical from a planning perspective. “Once I know the PA, I know what the client is going to be allowed to put into an RRSP next year,” he says. “And then I try to convince the individual to put that money away as soon as possible.”
But, since most people don’t have enough money to make their full contribution in one shot, Corkum suggests coming up with a monthly or per-payday plan. That way, clients avoid “scrounging around in the month of February — as so many do — trying to find money to put into their RRSPs so they can reduce their taxes.”
Corkum emphasizes every year, this monthly or per-payday figure needs to be checked against the PA and, if necessary, recalculated. One of the problems with setting up a monthly plan is that the PA number may change in the coming year. So if people do a monthly plan based on the prior year, they might have over-contributed.
“The paperwork for withdrawal of an over-contribution and the tax return that’s required for an over-contribution are painful to do,” Corkum adds.
Genno says there are two key times when advisors must pay close attention to PAs. The first is when a client takes on new employment and needs to decide whether to join the company pension plan.
Some company pension plans are mandatory, “but certainly there are situations where advisors will say — mostly to clients in senior management roles — ‘We think you should go back to your employer and negotiate an exemption from the requirement to participate in the company pension plan. You’re better off doing it on your own.’”
Determining whether to make this call requires careful examination of the alternatives, with the mandatory pension adjustment taking centre stage in the cost-benefit analysis. “The advisors will look at the pension adjustments for a defined-benefit plan and say, ‘If you belong to the plan, here’s what the pension adjustments come out to, and here’s by how much that reduces your personal RRSP limits. Now let’s figure out if you’re better or worse off,’” Genno explains.
Advisors must look at what happens if the person plans to stay with the company a few years and then leave, versus working there for a long time or even retire from the company.
If the client doesn’t plan to stay long, he likely won’t be getting much value from the company plan, and certainly not as much value as the factor of nine calculation assumes. Conversely, says Genno, “If I’m already mid- or late-career and I might retire from that company, the factor of nine might potentially understate the value of the pension coverage,” making it a good decision to join. In any case, an advisor has to balance the plan’s benefits with the reduced personal contribution room.
The other important time to pay close attention to PAs is on termination of employment. In such situations, clients may have “a choice between leaving their benefits in the pension plan at the company or rolling it out and investing it on their own,” Genno says.
“In that context, the PA system comes into play again because of PARs. [See sidebar, “Pension adjustment reversals.”] The advisor will now say, ‘Here’s the lump sum available to you. Let’s estimate what your PAR is going to be, and figure out how much additional RRSP contribution room becomes available. That would be part of a cost-benefit analysis,” Genno adds.
Genno notes advisors need to avoid any appearance of a conflict of interest.
“If the advisor is being paid on an hourly basis, then arguably there’s no conflict of interest. If the advisor is paid on the basis of percentage of assets under management, it creates a potential conflict of interest. If the advisor says, ‘Roll your money out into our firm’s private arrangements,’ he’s going to generate more fees out of that than if he advised the client to leave the benefits in the company pension plan.”
Part of any good advisor’s meeting with clients includes a transparent discussion about fees. And it’s important to be open to the fact that value can build up within a company-sponsored pension plan.
Genno explains that advisors are familiar with the products they’re offering to their clients, but may not be as familiar with the ins and outs of a company-sponsored plan.
“So often there’s an inclination for advisors to think they can best serve their clients using the tools they work with daily,” he says. “It’s important to examine what the trade-off is between the PAR versus the value the individual will ultimately get from the company-sponsored pension plan.”
Pension adjustment reversals
Pension adjustment reversals (PARs) come into play on termination of employment. In the case of defined-contribution plans, assume the employee contributes $1,000, the employer matches this amount, but the employee quits after one year. For that year, the employee has a pension adjustment of $2,000 and his RRSP contribution room is reduced accordingly.
Since the employee isn’t yet vested in the employer’s contribution, he only gets $1,000 back on termination. “His personal RRSP contribution room was reduced by $2,000, but at the end of the day he’s only realizing a benefit of $1,000,” says Ashley Crozier, an independent actuary.
A PAR arises when the employee stops being a plan member. And since the employee isn’t vested in the employer’s contribution, he would get a $1,000 PAR and regain $1,000 of RRSP contribution room. Had he remained in the plan long enough to become vested and then quit, he wouldn’t get the PAR, because he’d get his contributions plus the employer’s contributions.
For DB plans, assume the employee is in the plan five years, and has PAs of $9,000 a year. His cumulative PAs amount to $45,000 and after five years he decides to quit. Losing out on due to not being vested is not an issue. “But I’m given a choice to either leave my pension in the plan, or to transfer the cumulative value into my individual RRSP,” Crozier notes.
If the client chooses the latter, and the amount of the cumulative value is only $30,000, the RRSP contribution room has been reduced by $45,000—yet in reality, the client is only getting $30,000. Therefore, he gets a PAR of $15,000 in order to equalize the retirement savings opportunity.
The $15,000 disparity between the cumulative PAs of $45,000 and the $30,000 payout—the true value of the pension — is a consequence of the factor of nine overvaluing this particular plan.
Crozier goes on to say the PAR “is a reasonable attempt to equalize, after the fact, the retirement savings opportunity. The downside is I’m only able to put that $15,000 in after five years’ time when I quit, as opposed to putting it in over the last five years when I may have earned extra investment return.”
Another negative, Crozier explains, is “I only get it if I transfer the commuted value from the pension plan. So if I leave my pension in the plan, I do not get the PAR even though the true underlying value of my pension benefit may be less than my cumulative PAs. I don’t get any relief from that.”