In a recent article, we looked at how individual pension plans (IPPs) can help more clients than you’d expect thanks to the importance of wages and ages.
This article examines what an IPP could pay in the way of retirement benefits and terminal funding for 2018. The funding is especially large when we are looking at older members who choose to start drawing a pension.
The following cases, which deal with baby boomers on the cusp of retirement, illustrate an IPP’s attractiveness where a corporation is seeking to maximize its tax-deductible contributions and minimize its taxable income.
How much is the annual pension accrual?
Contributions to an IPP are tax-deductible to the employer, so tax rules cap the annual pension accrual. This amount is referred to as the defined benefit limit (DBL). There is also a 2% cap on the accrual rate.
In theory (though not in practice), members of defined benefit (DB) and defined contribution (DC) plans are meant to have equal access to tax assistance. Due to the factor of nine that underpins the rules for tax assistance to retirement savings, the maximum annual accrual for a DB plan is one-ninth of what could be contributed to a DC plan. For 2018, the DBL thus becomes: $26,500 x 1/9, or $2,944.44. The cap on what can be contributed to a DC plan is indexed; so too, then, is the DBL.
IPPs generally use the maximum benefit accrual rate of 2%. Since the DBL for 2018 is $2,944.44, once a person has covered earnings (a.k.a. compensation) of $147,222, he or she has maximized the accrual under the IPP for 2018 (since 2% of $147,222 equals $2,944.44).
Table 1 illustrates two case studies. In both cases, an IPP was established on Jan. 1, 2018 for someone who plans to retire in 2018. The first person is 64 years old and the second is 60. Both people’s compensation has been such that their pension accruals are at the maximum for 1991 through 2017. With 27 years of service, their lifetime pensions would each be 27 x $2,944.44, or $79,500. The amount would be indexed each Jan. 1. (The retirement pension is calculated using 2% of indexed average earnings, subject to a cap of $2,944.44 for each year of service. Someone with fewer years of service, or wages that are not at the maximum, would receive a lesser amount.)
When the members file their tax returns, both the lifetime benefit and bridge benefit qualify for pension splitting and the $2,000 pension credit, irrespective of their age. (For Quebec provincial tax purposes, the member must be 65 to pension split.)
What else could the IPP pay?
Neither person in our case studies is 65. Thus, the plan could pay a bridging benefit up to that age. If the plan were to provide maximum bridging benefits for both CPP and OAS, the maximum would be $20,400.
There are very specific tax rules that outline how to calculate this benefit. For example, in both case studies we assumed maximum earnings; the maximum bridging benefits will be limited to $13,400 (the CPP benefit—the people in our case studies did not qualify for the OAS bridge).
Actuaries are required to complete valuations every three years. Where the IPP has a surplus, and the plan provides that the surplus belongs to the member, the member would also be entitled to make surplus withdrawals. (There is a specific process for doing so.)
|Case Study 1 – Age 64 on Jan. 1, 2018||Case Study 2 – Age 60 on Jan. 1, 2018|
|Years of service (1991 to 2017)||27||27|
|Lifetime benefit (unreduced)||$79,500||$79,500|
|Additional bridge benefit to age 65||$13,400||$13,400|
|Total payment until age 65||$92,900||$92,900|
|Past service contribution by employer||$497,000||$415,800|
|Qualifying transfer from RRSP||$635,900||$635,900|
|Total value of IPP on Jan. 1||$2,194,400||$2,551,700|
What could be contributed to the IPP?
For DB plans, all contributions must be made pursuant to the recommendation of an actuary. Routine funding and solvency valuations are required every three years. The corporation can deduct contributions made in the fiscal period or within 120 days of its end.
What is the maximum funding valuation?
The Department of Finance amended the tax rules to allow business owners operating through corporations to again establish IPPs in 1991. At the time, there was concern about the assumptions that actuaries might use to calculate the required contributions. Hence, it introduced the maximum funding valuation, which essentially places an artificial cap on what an employer may contribute to pension plans that are considered designated plans under the tax rules.
Major assumptions that the actuary must use include in the maximum funding valuation:
- post-retirement increases not exceeding CPI less 1%,
- retirement no earlier than 65, interest rate of 7.5% per annum,
- salary and wage increases of 5.5% per annum,
- CPI of 4% per annum, and
- mortality rates equal to 80% of the average male and female rates of the 1983 Group Annuity Mortality Table.
In the above case studies, the sum of the “past service contribution by employer” and “qualifying transfer from RRSP” have been calculated for the pension accrued by the plan member as of Jan. 1, 2018 ($1,132,900 for the 64-year-old and $1,051,700 for the 60-year-old). Part of the past service liability is funded by a transfer of RRSP assets. However, the corporation still has the opportunity to make a sizeable contribution and therefore receive a sizeable tax deduction.
What is terminal funding?
Terminal funding is the opportunity to make additional contributions once all the members of the plan have retired and started to receive their pensions. On retirement, the actuary has latitude to determine individual assumptions that are appropriate for each member. Additional contribution room arises because the actuary can reflect retirement age and other assumptions that are more realistic and hence more conservative than the maximum funding assumptions.
The two case studies show there is an opportunity for significant terminal funding, which is elective.
From an administrative perspective, modifying the key economic and mortality assumptions of the maximum funding valuation requires the actuary to remove the designated status of the IPP (which CRA will allow once all the members of the IPP are retired and there is no expectation for further accrual of pension benefits).
Terminal funding for the 64-year-old
In preparing the maximum funding valuation, the actuary must assume post-retirement indexation of CPI minus 1%. In the case of terminal funding, full CPI indexing can be assumed.
Under the maximum funding valuation, the actuary had to assume the plan member would not retire until age 65. But the plan member is retiring 12 months earlier and will start drawing her full retirement pension of $79,500. The member will also be drawing a bridge pension of $13,400 in respect of CPP benefits otherwise receivable at age 65. (This member qualifies for unreduced early retirement and a partial bridge—effectively only CPP. Specific tax rules specify whether a discount for early retirement or other reductions to a full bridge would apply. Not all plan members will qualify.) The largest portion of the terminal funding relates to the economic assumptions (discount rate, inflation rate) and mortality assumption used in preparing the valuation. The 7.5% rate on the list of prescribed assumptions is clearly not appropriate. The actuary can now choose an appropriate rate. Similarly, a more current mortality table allowing for projections of future mortality improvements is also appropriate. The terminal funding opportunity of $1,060,000 for this case uses economic and mortality assumptions consistent with purchasing an annuity from an insurer.
Terminal funding for the 60-year-old
The terminal funding valuation prepared for the 60-year-old produces significantly higher terminal funding. Why is this? The unreduced pension and bridge benefits are being provided for five years, rather than for one year as is the case with the 64-year-old.
The cost of funding the full indexing is also higher, since this younger member can be expected to draw the pension for a longer period.
IPPs are powerful tools for providing retirement income for the incorporated business owner. All administrative costs—including investment management fees—and contributions to an IPP are tax-deductible. This is an area in which specialist advice should be sought. Business owners who have thus far not engaged in retirement planning should do so.
Lea Koiv, CPA, CMA, CA, CFP, TEP, is a tax, pension and retirement expert with Lea Koiv Associates. Mark A. Lesniewski, FSA, FSA, is consulting pension actuary with LMC Group Inc.