Flexible Pension Plans and IPPs

Not an Answer but another question in same area.

As Principals in an Incorprated Company is there a Pension planning Process that allows the owners to put together a Pension Plan that is outside of an RRSP???

Two friends of mine, Trades People, are being told by their accountant No, but my instinct is otherwhise???

Couple of Good OL boys, don't like nuffin too suffisticated.

First, to New Hand,

I'm not familiar with the particular pension plan you're talking about - but here's some basic pension rules:

Any pension contributions put into the pension plan by the employer are not taxable to you, and are deductible by the company.

However, pension contributions give rise to the "pension adjustement" - this is a calculation that will reduce the amount of RRSP contribution room available to you.

It sounds kind of like this pension is just a "self-directed" pension plan. With more information I could tell you more specifically.

Howard,

Yes - kind of. They could use an Individual Pension Plan - there are lots of rules governing it, but if they're over the age of 45 it may be in their best interests to use an IPP. However, this is NOT in addition to an RRSP, it's one or the other. (Because of maximums allowed - that's the reason the over age 45 rule kicks in.) If you want more details, you can email me at rob@keystonefinancial.net

Howard, your instinct is correct.

It is called an individual pension plan (IPP). Generally, an IPP is only suitable if your buddies are over 40 years of age and earn a base salary of $100K+. Higher annual contributions to the IPP can be made than under the RRSP route, it is generally creditor-proof and there might be a possibility for making past service pension contributions.

The rules are very complex, it is "sophisticated", costly (have to hire an actuary) and professional tax advice should be sought.

NewHand:

Flexible pensions have been around for several years but it was only last year that Revenue Canada issued a formal policy on them. I'm not familiar with Canada Life's plan, but the flexible pension concept basically gives private sector workers an opportunity to to build the same high-quality pensions that government employees get -- if they're willing to contribute the high amounts that government employees put in. That can be as much as 9% of pay.

The pension adjustment calculation for defined-benefit plans ignores such valuable features as inflation-indexing and unreduced early retirement that are common in public service plans but not private sector ones. A flexible pension plan allows you to buy any or all of those features. Well-designed ones let you put in the money now but not make your choice until just before retirement.

One big difference between defined-benefit pension plans and defined-contribution plans like RRSPs is the way the govt controls its revenue loss for the upfront tax deduction and long-term tax sheltered growth. With an RRSP or defined-contribution registered pension plan, there's a limit on the amount of money going in each year. Defined-benefit plans face no such limit. Instead, the govt set controls on how much they can pay out. Whatever is needed to meet that promise is allowed to go in. Inflation-indexing increases the cost of the promise and thereby increases the amount of tax-deductible funding allowed. The closer you are to retirement, the higher the allowable funding. NewHand, those limits rise sharply for plan members in their 50s.

A well-designed flex plan will let young members, who are usually cash-strapped, forego the extra contributions now and make catch-up payments later.

Bruce,

The problem I was having in figuring this one out was that in New Hand's case there was to be NO Pension Adjustment for the "catch-up" contributions!

I still haven't completely figured this one out, but it appears that the gov't is saying that the pension plan originally OVER estimated the amount of PA, and so now they can make their "catch-up" contributions, deduct the contributions, and not have it affect their current RRSP contribution room!

Rob#1,

No. Assuming NewHand has been offered a typical flex plan, there's no PA for the extra funding because the money is being used to buy benefits like inflation-indexing and unreduced early retirement that don't count in the PA calculation. All that's happening is that he's being given the opportunity to fund a pension that's as good as those for public employees. In many ways it's quite similar to the Individual Pension Plans others have discussed. The reason that you can put in so much money is that the plan has made some very costly promises.

Continuing on Pensions - and flexibility -

Seems that some of the privatized (former government) operations are starting to talk about withdrawing from the Local Authorities Pension Plan (LAPP). (Alberta)

My question is as follows:

Currently this is a defined benefit plan, with the premiums defined by the government according to its whim at the time. (yes I am bitter about some of the changes instituted previously - 4% annual return during the 70s and 80s, and then a claim of unfunded liability - great deal for the Alta Provincial Gov.)

3 options are being discussed. Stay in LAPP, Move to private plan that mimics LAPP, or Move to Private plan that operates in a different manner. Specifically, you can go with a Defined benefit, a defined contribution, or a mixed plan. The mixed plan appears to be defined benefit from the Employer's portion and defined contribution from the employee's portion. For those of you out there who would care (dare?) to comment, what do you think. Is the flexibility of a private plan vs a public services plan worth the change in security? What about the difference in Defined contribution vs defined benefit or mix?

I know pretty vague, but this is just starting to be addressed. Need some further info to be able to ask the authority some rather pointed questions.

BL (feel-good site below)

Bruce,

I understand the basics of what's happenning, my problem is that I don't see how they're able to get away from what the PA was SUPPOSED to be doing. Obviously the flex pen is avoiding the calculation of the PA, but it SHOULDN'T. If I'm in a IPP, I lose RRSP room, if I'm in a DC, I lose RRSP room, if I'm in a DB I lose RRSP room, why should the Flex Pen be any different?

Here are replies for Rob#1 and BemusedLurker.

Rob#1: Let me take a different approach in explaining this. The pension adjustment formula is:

(Pensionable earnings x 9 x accrual rate) minus offset

$9 is the amount of deemed value. It's based on actuarial work in the 1980s that found that $9 must be invested to produce $1 of yearly retirement income for a public service-quality pension plan.

Accrual rate is a key percentage used in calculating the pension due and the allowable funding for it. This rate varies among plans but is capped by law at 2%. If you assume a 35-year career, a 2% accrual rate produces the model 70% pension. Most, if not all, public service plans have 2% accrual rates, as would a well-designed IPP. Many private sector plans have accrual rates in the 1.5% range.

Offset is minimum RRSP room. Originally it was set at $600 when the system was designed in the late 1980s but then raised to $1,000 in 1990 when MPs forced the Finance Dept to scrap the pension adjustment reversal that was included in the proposed overhaul. This year, the offset was cut back to $600 in preparation for restoration of the PAR.

Say a civil servant has $50,000 of pensionable earnings. The PA will be (50,000 x 9 x 2%) - 600. That's $8,400. The fact that his plan includes full inflation-indexing, unreduced early retirement and other valuable ancillary benefits is not taken into account, although he's paying pretty high pension contributions, maybe 7, 8 or even 9% of covered earnings. Indexing et al don't count because years ago govt decided that it would provide model pensions in hopes that the private sector would follow.

Now consider a $50,000 private sector worker who also has a 2% pension plan but without automatic inflation-indexing, unreduced early retirement etc. His PA calculation is exactly the same -- $8,400 -- though his pension contributions are likely much lower than the civil servant's. If this guy has a progressive employer, the company could bring in a flex pension that lets him buy inflation-indexing and the other no-PA ancillaries if he wants. Since those features are then part of the pension plan, they become part of the promise that must be funded by retirement. With a defined-benefit plan, the more costly the promise, the higher the allowable funding. That's why people with IPPs contribute at levels well above RRSP limits. First, they're typically 50 or over and the closer you are to retirement, the more that must be put into a DB pension plan to secure the promised benefit. Secondly, IPPs typically include all of the PA-free ancillary benefits allowed.

I hope that explanation helps.

BemusedLurker:

First, no defined-benefit pension plan sponsor -- govt or otherwise -- sets contributions at its whim. At least every three years an actuary must value the plan against its future liabilities and funding is set accordingly in line with controls contained in the Income Tax Act. The 4% return you cite was likely a 4% "real" return, which would have put the fund in the 10-15% range for much of that time. I know nothing about the plan you cite but an unfunded liability is not a sweet deal for the sponsor, who must make up the shortfall over time.

Now to choosing between DB and DC plans.

Security versus control. That's the key tradeoff. A DB plan sets your pension amount in advance, based usually on service and some form of average earnings. Then the employer must ensure there's enough money to fund it, even if the investments don't do well. In some cases, unions share in plan management so their members could face higher contributions if there's a shortfall but generally performance is the employer's problem. I believe Alberta is like the other provinces which require the employer to pay at least 50% of the cost of the benefits delivered.

Some DB pensions, especially in the public sector, are automatically indexed for inflation. With others, especially in the private sector, there might be ad hoc adjustments from time to time but that is not guaranteed. It has been fairly common in recent years for DB members to be offered generous early retirement packages, often funded with pension plan surpluses.

A defined-contribution arrangement obligates the employer to do nothing more than contribute a certain amount every year. Your pension is not known in advance or guaranteed by the employer. Your pension amount will depend entirely on how much goes into the plan, how well it's invested and on interest rates or market performance in retirement. You carry the investment risk and normally get to make the investment decisions although you may be limited to one menu of investment funds and GICs.

DB plan members who leave before retirement are often penalized through the RRSP pension adjustment process. The PA calculation assumes their plan is as good as those for public employees and that they will put in a full career. Thus, PAs are too high for many in the private sector and for younger people. The implementation of pension adjustment reversals later this year will address much of that because a departing workers' RRSP room will be increased by the difference between his cumulative PAs and his pension transfer value. But he still won't be compensated for lost growth on the RRSP contributions he couldn't make. In that respect, a DC plan is better because the PA is just a dollar-for-dollar reduction based on total plan contributions by the employer and employee. Also, when you leave a DC plan you take the full account value unless you're still within a vesting period.

So a DB plan offers the security of a pre-set pension with no market risk and possibly inflation-indexing, a very valuable feature. But you may not get any added benefit if the plan really does well and you may be penalized through the RRSP system if you leave early. A DC plan shifts the market risk to you but you'll also benefit directly if the plan does really well and face little or no RRSP penalty if you move.

Before the govt announced the PAR last year, PA discrimination was a big and growing problem for mobile DB plan members. So many employers brought in more flexible arrangements. Often a DB plan was topped up with a DC plan (which includes group RRSPs). You'd then have a hybrid compromise between security and flexibility.

Some employers set up novel arrangements in which a group RRSP acts like a DB plan but is not subject to the DB PA formula -- and may even have a slightly higher accrual rate. (I was in one at a former employer and it worked very well for me in that I was able to make maximum RRSP contributions and, thanks to good market performance, the plan value on leaving exceeded the DB projection. Of course, a down market would have made me a loser. The plan I was in gets valued every three years. If it's below the DB projection, the employer kicks in more. If it's above, the employer scales back. I left before that valuation)

There's also a wrinkle based on funding. If possible, an ideal arrangement is to go DC until your mid-40s. During that time, allowable DB funding normally lags allowable DC funding. Then, from mid-40s on, switch to the DB plan. Allowable DB funding takes a big jump up when you enter your 50s.

This was all quite long-winded. In summary, you have to consider your personal need for security versus control and mobility. And make sure to check if the DB arrangement has automatic inflation-indexing; that's a very valuable feature. Also, if you hope to retire early you're more likely to get a subsidy from a DB plan -- especially since so many DB funds are running up big surpluses.

I hope this helps.

Great answers Bruce. Could not have said it better. Thanks.

Warren.

Bruce Cohen,thank you.I have been on holiday so only checked into the Library now and discovered your answers.For the first time, it begins to make sense.

Our Human resources people could use you as a consultant; they are struggling to understand Flexpen so they can explain it to a number of totally confused but intrigued employees. We are indeed in a Db plan, being offered a whole bunch of ways to improve our not-so-good pensions by contributing up to 9% of total compensation. I went into the office today and(fingers crossed that it was the right thing to do) signed up.I hope Mclean Budden does better by me than my dreadful SDRSP.

Rob 1 and 2, thank you for your help too; hope it can be of some use to your and other's clients.

New hand

Brucecohen didn't say anything about the role of government schemes in determination of defined benefits and I wonder if he'd like to? I discovered fairly close to retirement that in the case of my employer's scheme, the 2% included calculations of CPP and OAS. It was a bit of a surprise, although it is probably unlikely that my financial behaviour would have been any different had I read the small print sooner. And for all I know, this may be standard practice.

Since I have already retired, it is a matter of no consequence to me, but I wonder how plans such as the one I was in will handle things down the road, given the uncertain future of the government plans (clawbacks etc). Bruce can perhaps tell us whether this is a matter of any consequence in "the industry".

If they don't already know, I would certainly advise people in defined benefit plans to find out whether the annual pension projections they get from their employer include or exclude the government plans and to consider whether this should have an impact on their current financial planning.

Bruce,

Thank-you! I knew the information you presented, but the way you worded it finally "clicked" with me and I understand - it's appreciated!

Re: the CPP/OAS being mixed in with DB plans - that's actually pretty common. Every plan is a little different. Most allow some "options" when it comes time to actually retire. Do your homework here, as once you've chosen, that's it for life!

This thread, thanks to Bruce and others, contains invaluable information, and hopefully will be preserved by Bylo for posterity.

A question on inflation indexing. I will receive my first pension cheque next week. My pension is indexed (retired teacher) but not fully. In 1982 and subsequent years, full indexing was reduced to CPI minus 3%. Thus 18/34 (it is a 34-year or 68% pension) will be fully indexed, and the balance, 16/34, will be less than fully indexed. While I suppose this is better than the private sector, how does it stack up against other public service pension plans?

Clarification for Brucecohen:

When I said governments set contributions at its whim - here is the context:

The Alta gov put the contributions into general revenue - much like the CPP has been. They arbitrarily picked a return for the time period leading up to the review, and then guess what - unfunded liability. Well you can guess who has to make that up.

It was the transition from being part of general revenue to being segregated that allowed the government to act in an arbitrary manner, and boy did they ever. (Right after changing the rules for THEIR pension plan.)

BL (Should see the screwups the changes have caused, especially when the administrators don't have a clue. One suggestion - get EVERYTHING in writing)

Kaskazi:

Many pension plans are "integrated" with CPP but not normally with OAS. Integration can take one of many forms but reflects the fact that the employer has made half the CPP contributions posted to your record. Sometimes, a pension plan uses a lower accrual rate up to the income level on which maximum CPP contributions are paid and a higher accrual rate on income over that. Other plans will reduce the pension payout by the amount of CPP due at 65, though not necessarily dollar for dollar. A few plans have a seemingly low accrual rate but actually end up paying decent pensions because they are "stacked" -- there is no reduction at all for CPP benefits.

rge-1:

I don't have an overview of all public service pension plans. You might be able to get that from one of the large public employees unions or, particularly in your case, from the Canadian Teachers Federation.