Individual Pension Plans - Comprehensive Information
Introduction
IPPs have existed for some time, but only recently have their rules changed to make them a viable and potentially very attractive alternative to RRSPs for business owners who are 40 years of age or over. They are attractive because the tax-deductible contribution for IPPs increase significantly with age.
While IPPs require the involvement of qualified actuaries, which have been traditionally fairly expensive, new aggressive actuarial firms have appeared on the scene that “package” their IPP service very cost-effectively and efficiently. IPPs have become accessible to virtually any businessperson.
IPP Eligibility
To be eligible to participate in an IPP, there must be a bona-fide employer-employee relationship. Compensation for these services must be included as personal taxable income under Sections 5 & 6 of the Canadian Income Tax Act (these are the basic sections that require millions of Canadians to declare their employment earnings on their personal tax returns). Almost all business owners would have a history of this type of compensation from their businesses.
The type of income covered is that which is normally reported on forms T4, T4A, or T4PS, such as salaries and wages, bonuses, director’s fees, taxable benefits and allowances, and distributions from employee profit sharing plans.
The two key exceptions are dividends and self-employment earnings. This can be problematic for those business owners who, while technically drawing a salary, have not reported the income as such on their tax returns, nor have they had a T4 slip prepared accordingly. We are informed that it may be possible to qualify this type of income regardless, but the process is cumbersome and not guaranteed. Consequently, IPPs are generally recommended to clients with a good history of T4 earnings from their businesses.
“Connected persons” are significant in these rules - those are people who basically control the employing corporation, or persons related to them, such as children or their spouse.
If the IPP is intended for connected persons only, then the maximum period that can be looked at for retroactive coverage goes back to 1991. For any employment years prior to 1991 to be considered by the actuaries in their calculations, then the business owner must be prepared to include other, non-connected persons (i.e., key employees), and whatever benefits are enjoyed for pre-1991 service by the connected person must be shared, 50:50, at least, with the unrelated employees. Generally, we find that IPPs are set up exclusively for the business owner and his spouse, so we look at the T4 earnings history from 1991 and subsequent years, only.
Comparison to RRSP
The IPP is a defined-benefit pension plan, distinguishing it from an RRSP, which is simply a money-accumulation arrangement.
Both IPPs and RRSPs are registered with the Canada Revenue Agency, and as such, earn investment income free of tax, thus affording maximum accumulation of retirement capital. Further, contributions to both types of plans are tax-deductible.
IPP advantages over RRSPs include:
- higher contribution limits for the year in which the member joins the plan;
- higher contribution limits for future years (up to and including the year the member reaches 69 years of age);
- significant deductible contributions are possible for past service (years after 1990);
- IPPs can be more creditor-proof;
- IPP contributions are deductible within the fiscal year or 120 days of the (corporate) fiscal year-end, allowing additional time for planning and consultation;
- further deductible contributions are possible if subsequent IPP actuarial valuations reveal a shortfall in investment yields from the original actuarial assumptions (currently 7.5%, which can be difficult to achieve with “safe” investments these days);
- higher investment standards, with quality and diversification requirements.
Disadvantages include:
- income splitting is not possible;
- there is no access to the fund while employed, so funds are locked in;
- IPPs have higher administrative costs (for actuarial involvement at the start, and throughout the life of the IPP);
- possible reduction in future contributions if investment results within the IPP actually run higher than the original actuarial assumed rate;
- there may be minimum annual contributions, depending on provincial regulations (not so in BC).
IPP Plan Design
The governing benefit formula is equal to 2% of indexed earnings (T4 for the year, indexed until the year of retirement).
Maximum pension limit = $2,000 per year of service.
Example: for an IPP member retiring in 2005 with 15 years of pensionable service, the maximum annual pension would be 15 years x $2,000/year = $30,000 per year, or $2,500 per month. The $2,000 limit will be indexed after 2005. For pre-1991 past service that may have been factored in to the IPP contributions, the annual pension is limited, by 2/3rds for those pre-1990 years only, to $1,333 per year.
If a spouse exists, the standard pension is a joint survivor annuity with a 2/3rds continuation to spouse with a minimum 5 year guarantee; if no spouse, the requirement is for a life annuity guaranteed for 15 years.
Benefits are increased post-retirement, indexed to the consumer price index, less 1% (although the company can avoid the 1% reduction by a special company contribution at the time benefits commence (i.e., retirement).
IPPs are just like RRSPs, except that IPPs must comply with all registered pension plan rules.
Eventually, all plan assets will either be paid to the member, or paid to the member’s beneficiaries, as:
- termination of employment benefit, paid to the member;
- pre-retirement death benefit paid to the member’s spouse or beneficiaries;
- pension benefits paid to the member (the typical case);
- post-retirement death benefits paid to the member’s spouse as a survivor pension, or to the member’s beneficiaries as a lump sum;
- any remaining surplus paid to the member or the member’s beneficiaries.
IPP Benefit Options
If you leave employment or retire or terminate the plan, you can receive benefits as:
- an immediate or deferred pension from the pension plan;
- an immediate or deferred annuity purchased from an insurance company;
- a lump-sum commuted value of accrued pension benefits, to be transferred to a locked-in RRSP, a life income fund, a locked-retirement account (LIRA), or a locked-in retirement income fund, depending on the provincial jurisdiction.
This lump-sum transfer is subject to a maximum amount, prescribed by Income Tax Act regulations.
Funding Vehicles
IPPs must be operated either by a life insurance company, or a pension trust (the latter are the more common arrangements).
Pension trusts can be set up with either a corporate trustee (this involves higher fees) or, more commonly, through a group of individual trustees.
The relatively common individual pension trust must comprise at least 3 individuals (who must be over the legal age for the jurisdiction - 19 in B.C.) and who all must be Canadian citizens, and one trustee must be “independent” of the sponsoring company. There is some latitude with respect to the third trustee issue - this can be an adult child of the family, provided that they are independent of the corporation - in some cases, this can be difficult to arrange. Identifying and convincing a third party to become a trustee can sometimes be one of the more difficult aspects of setting up an IPP, as there are fiduciary responsibilities that come with it. It might be necessary (although rare in our experience) to arrange for compensation (in writing) for that outside trustee.
Individual trustees’ fiduciary responsibility includes the obligation to maintain accurate and detailed records of the invested funds within the IPP, as well as providing a statement of account each year. Usually, these requirements are met by the financial institution with custody of the IPP funds.
IPP Investments
IPP assets can be invested in stocks, bonds, mutual funds, pooled funds, term deposits, GICs, T-bills, etc.
Unlike RRSPs, IPPs are subject to a diversification standard, which means that each security acquired cannot exceed 10% of the fund value, based on the book value when acquired (but mutual funds and pooled funds are already diversified, so are not subject to this limit).
The prudent-man standard also applies.
If an IPP has an actuarial deficit (determined during the mandatory triennial actuarial valuation), more tax-deductible contributions can be made to the plan. Alternatively, if there is a surplus, there will be suppression of future IPP funding levels.
Generally, it is wise to make your IPP investments the most conservative in your entire investment spectrum, so as to take advantage of the triennial opportunity to make extra contributions, should the conservative approach fail to generate 7.5% rates of return (as is probable, given today’s interest rates).
Thus, it makes sense for clients to plan their investment strategy to keep aggressive (and potentially high-yielding) investments outside of IPPs, since investment success outside of IPPs does not affect funding limits within an IPP.
IPP Contributions
These are governed by Section 147.2 of the Income Tax Act.
All contributions must be made on the recommendation of an actuary, must be approved by the Minister, and made pursuant to an actuarial valuation that is not older than 4 years before the contribution.
Obviously, reasonable actuarial assumptions are a required element of IPPs, and any licensed actuary should be able to provide these figures.
The maximum annual contribution is generally based on the total of current T4 earnings (for a connected person). This can be reduced if there is an actuarial surplus in the plan. However, in most cases, the actuarial calculations will permit at least some portion of an annual contribution, even if there is a surplus, which as noted above will be rare in any event.
As an example, a 64-year old would find that his or her current service contribution limit to an IPP would be the lesser of 28.4% of current T4 income, or $28,442. That becomes $30,575 in 2006, and $32,868 in 2007.
Some provinces in Canada exempt IPPs from registration and minimum funding requirements. Those provinces are BC, Manitoba, Quebec and Prince Edward Island. Thus, corporations operating in these jurisdictions have no minimum funding obligation to IPPs.
For IPPs operating in other jurisdictions, the minimum IPP funding is generally the sum of the company’s current service contributions for the year, and an amortization payment of sufficient size to eliminate an actuarial unfunded liability over a period of 15 years.
Note that the Federal maximum contribution limits supersede the provincial or federal legislation minimum limits.
Contributions to an IPP can be made in kind - for example, from the corporation’s general investment accounts. The value of the investment at the time of transfer will be the relevant figure for measuring the contribution.
Generally, with an IPP in place, an individual's RRSP eligibility shrinks to almost nil: $600 per year, in most cases. This phenomenon is the result of an obligation on the part of employers to calculate and report the "pension adjustment" for the year on the T4 slip. When an IPP is involved, the pension adjustment invariably increases to a size which, when reported and processed through the RRSP deduction rules, results in the very small RRSP eligibility noted.
In B.C., IPPs do not have to be registered with the provincial regulator. Therefore, there is no minimum funding requirement. Technically, the employing corporation is not obligated to ever put even one dollar into the plan. So, if maximum contributions are not being made, that will simply create more contribution room in the future (assuming the assets which are already in the plan do not "over-perform").
IPP Contribution Types
There are 3 possible types of IPP contributions:
1. Current and future service
2. Past service
3. Terminal funding
Current service limits vary by age. As of 2005, for someone age 55, the maximum is 25% of T4 income to a maximum IPP contribution of $24,965. For a 65 year-old, the limit is 30.1% to a maximum of $30,122. Compare this to the 2005 RRSP contribution rate, which is capped at $18,000 for all. IPP contribution limits increase with age, while RRSP contribution limits do not.
Past service funding opportunities can work out to very large numbers. Depending on age and income, figures in excess of $300,000 are possible. However, certain adjustments and transfers effectively limit what can be contributed by way of “new funds”, and consequently deducted for tax purposes.
An example: if a past service liability of $300,000 is calculated, there would likely be a qualifying RRSP transfer to the IPP of $200,000, leaving a difference of $100,000, which, when added to the current service contribution of, say, $25,000, can yield a total first-year deductible IPP contribution of $125,000.
IPP set ups often involve a mandatory transfer (tax-free) of existing funds within an RRSP. Thus, the investment advisor with responsibility for a client’s RRSP is also involved in the IPP process.
IPP Terminal Funding
This is a discretionary option available to a corporation with an IPP. The basis for calculation of the terminal funding amount is complex, but can result in a substantial additional deductible funding opportunity.
Can IPPs be established retroactively?
We are informed by actuaries that we have worked with in the past that it is generally possible to register an IPP after a corporate year end has passed by, so long as it can be designed, registered and funded within the standard 120 day funding deadline (from the end of the particular fiscal year in which the deduction is sought).
However, the actuaries suggest that the deduction cannot be considered to be assured, and there have been instances in which CRA has denied the deduction of a lump-sum past service contribution for a taxation year of a corporation that pre-dates the creation of the IPP itself.
Selection of Actuarial Firm and Service
Most of Canada’s actuaries are situated in Toronto and Winnipeg, as those are the centres where life insurance companies and other financial institutions tend to be based. However, Vancouver has several high-quality actuarial firms, and indeed some of those are leading-edge when it comes to IPP knowledge and service, at very reasonable fixed rates.
We can make introduction to these firms for any client interested in pursuing an IPP.