Beyond IPP's: Truths and Myths - May 2005
At a CALU Conference a presentation was given that spoke of IPP's. Below you will find Gordon's comments regarding this Presentation titled, Beyond IPP's: Truths and Myths
Whilst I understand the authors prefaced their Presentation at CALU in Ottawa by stating that they were not opposed to IPP's, I have been asked by certain individuals who attended the presentation in Ottawa to provide comments relating to this Presentation.
My comments are based on involvement with IPP's since 1959 as an Actuarial Student in the U.K. and as an Actuary in Canada as well as a Participant of an IPP in the1980's and subsequently, with my spouse, as a Member since the mid 1990's of an IPP sponsored by our own Company.
The principal advantages I have found from my participation in IPP's are:
- This is a good forced savings plan.
- Assets are invested in a professional manner which certainly, in our case, provide greater returns at lesser expense than my RRSP.
- Assets are creditor-proofed, this is significant for the business owner.
- My wife and I are not subject to income tax on the investment income of the IPP whilst we are in our prime earning years.
- There are a number of options available at retirement including additional funding and the payment of a monthly pension from the Plan.
- The ability to add to the IPP other family members employed by the Company. CRA limitations on the Actuarial Valuation Assumptions of an IPP cease on retirement.
My comments regarding the MacFadyen/Van Steeg Presentation include many of those advantages.
A. Contribution limitations
There are essentially two different IPP contribution limits applicable to Current-Service benefits.
The first relates to the Past Service Contributions which are reduced by the requirement for an RRSP Qualifying Transfer, Where a Participant has unused RRSP room, the RRSP Qualifying Transfer may be reduced by voluntarily giving up such room.
The second relates to Current Service Contributions which depend on both the age and pensionable earnings of the Participant in that year. In addition, if there is an Excess Surplus determined in the last Actuarial Valuation Report, such Excess Surplus must be used to reduce or eliminate Current Service Contributions until it has been exhausted.
An Excess Surplus of an IPP is not the same as a Plan Surplus. The following is an Example of the two assuming a Participant aged 60 years in 2005 with maximum earnings of at least $100,000:
| Market Value of Assets | $500,000 |
| Actuarial Liabilities | $400,000 |
| Plan Surplus | $100,000 |
| Current Service Cost for year | $26,100 |
Excess Surplus
The Excess Surplus in accordance with subsection 147.2(2) of the Income Tax Act is calculated as follows:
The Plan Surplus ($100,000) less the least of:
(i) the actuarial surplus ($100,000)
(ii) 20% of actuarial liabilities (20% x $400,000 = $80,000)
(iii) the greater of:
A) 2 x Current Service Contributions for 12 months following the actuarial valuation date (2 x $26,100 = $52,200)
(B) 10% of Actuarial Liabilities (10% x $400,000 = $40,000)
As (iii) is less than (i) or (ii) and (iii) (A) is greater than (iii)(B) and equal to $52,200, the Excess Surplus is $100,000 - $52,200 or $47,800. This Excess Surplus must be applied against the 2005 Current Service Contribution of $26,100 and the balance of $21,700 ($47,800 - $26,100) applied against the 2006 Current Service Contribution.
How do Plan Surpluses develop?
Essentially there are three primary sources of Surpluses:
- Investment Earnings in Excess of those required to fund the Plan
- For Participants with earnings less than Revenue Canada limits on pension benefits, increases in the Average Industrial Wage (AIW) less than assumed in the Actuarial Valuation Basis. For Participants with earnings equal to or greater than Revenue Canada Limits, increases in the Revenue Canada Maximum Benefits less than assumed in the Actuarial Valuation Basis.
- Where a Participant of an IPP is retired and receiving a pension from the Plan, increases in the Consumer Price Index (CPI) less than assumed in the Actuarial Valuation. This, however is also offset by Mortality losses if the Participant and Spouse are both still alive.
Taking each of those variables individually
1. Investment Earnings
In order to maximize IPP Contributions for active Participants, the Actuary must use the assumptions set out in Regulation 8515(7) of the Income Tax Act, namely, 7.5% interest, 5.5% earnings increase (AIW increase), CPI of 4% (post-retirement indexing of CPI -1% gives an effective rate of 3%) and Retirement at age 65.
Thus the interest rate, net of investment expenses is 7.5% and assuming a range of investment expenses of 0.5% to 2.5%, the equivalent gross rate of interest is 8.00% to 10.00%. Looking at periods ending in 2004 among Canadian Equities, Canadian Long Bonds, Conventional Mortgages, 91 day T Bills and U.S. Common stocks in Canadian Dollars, only the Canadian Long Bonds at 8.79% and Conventional Mortgages at 8.76% were within the range of 8.00% to 10.00%. Over the 10 year period to December 31, 2004, Canadian Equities at 10.08%, Canadian Long Bonds at 10.60%, Conventional Mortgages at 9.05% and U.S. Common Stocks in Canadian Dollars at 10.62% met or exceeded that range. At 15 years to December 31, 2004 Canadian Equities at 8.18%, Canada Long Bonds at 10.35% Conventional Mortgages at 9.88% and U.S. Common Stocks in Canadian Dollars at 11.40% were at or above this range. In all cases, however the excess returns over the gross rates of 8.00% to 10% were not substantial.
Whilst individual Funds or Investment Managers were able to outperform those indices the vast majority of the experience of our clients IPP's, in particular over the last 5 years, have underperformed the valuation interest rate, resulting in actuarial losses (in many cases substantial ones) rather than gains.
In addition, many Financial Advisors arrange for their clients to invest in bonds and similar investments which are generally less volatile and lower yielding than equities. Their equity holdings are then held in Non-Registered accounts.
2. Increases in Earnings
There are two quite separate situations for IPP Participants:
- a) Where earnings are at maximum levels (e.g. $100,000 in 2005) they are subject to future increases in the Maximum Earnings Limits. In the mid-90's there were substantial Plan Surplus created as a result of the, then deferment from 1999 to 2005, of the indexing of increases in maximum benefits and earnings limits for IPP's. This had the impact of reducing Actuarial Liabilities for Participants with maximum earnings by approximately 27.5%. There was a partial offset in the 2003 Federal Budget which accelerated the future earnings limits from $86,111 in 2003 to $100,000 in 2005 and increased Actuarial Liabilities for Participants with maximum earnings by approximately 10% over the expected 5.5% per annum increases. The 2005 Federal Budget proposes increasing limits by just under 5.5% p.a. compound to 2009. Consequently, for Participants with maximum earnings, Federal Budgets impact positively or negatively on Plan Surpluses and Experience Deficiencies.
- b) Where Earnings are less than maximum, they are subject to future adjustments based on increases in the Average Industrial Wage (AIW). The IPP Actuarial Valuation Basis calls for a 5.5% annual increase in the AIW, and increases in the AIW averaged 7.48% in the period 1975-89 compared with 7.01% in CPI increases. In the 15 year period 1990-2004, however, the AIW only averaged 2.15% as against CPI increases of 2.19%. It is interesting that even in the depression years of the 1930's the AIW exceeded the CPI by approximately 2.00% per annum compound. The AIW increases in the last 15 years were extremely low and are extremely unlikely in the future to remain below CPI. For individuals with less than maximum earnings, the actual AIW increases for the last 15 years have in fact been on average 3.35% lower than the 5.50% assumption used in Actuarial Valuations. This has undoubtedly resulted in some Plan Surpluses for Participants with less than maximum earnings, which may or may not have been offset by investment losses (returns of less than 7.% net of retirement expenses). However, due to the calculation of the Excess Surplus, set out earlier, the collar or difference between the Plan Surplus and Excess Surplus, which in the example given above was $52,200 would in many instances have absorbed the Plan Surplus created by the then low levels of AIW.
3. Post Retirement CPI Increases
As the Regulation 8515(7) limits on the Actuarial Valuation basis do not apply to retirees and, in particular, if there are no active Participants in the Plan, the emergence of Plan Surplus after retirement has no impact as no Current Service Contributions are required to be made to the Plan.
B. Limitations on Withdrawals
CRA does limit withdrawals from IPP's when pensions are commuted into lump sums and transferred to LIRA's or similar deferment arrangements. This can cause a portion of the Participant's IPP assets to be subject to tax. There are various measures under which this situation can be mitigated, or even avoided, and one or more of them could be utilized by the Plan Sponsor to reduce or eliminate the problem:
- Payment of a Pension From the Plan
The payment of a pension from the Plan will at the least defer the tax, as a surplus may be maintained within the Plan. If a Joint and Survivor Pension is selected, taxation of any residual lump sum will be deferred until the death of the survivor - Adding Additional Participants to the Plan
If the Plan Sponsor is a family controlled business and more than one generation works for the Company, it may be possible to add additional family members to the Plan which would reduce or eliminate the Plan Surplus. - Purchasing an Annuity for the Participant
CRA will permit an Annuity to be purchased on the lives of the Participant and Spouse with guaranteed indexing of up to 4% per annum compound. This Annuity in today's interest rate environment would have a cost in excess of the additional funding available at retirement projected by our firm. - Reduction in Post Retirement Indexing
Where there is more than one Participant in the Plan, in order to avoid the taxation to the retiring Participant of a portion of the commuted value of the Pension, certain IPP's permit the Plan Sponsor, on the advice of the Actuary, to reduce or eliminate post retirement indexing. This can result in a reduction in the commuted value of up to 30% and, on transfer to a LIRA, reduce or eliminate any residual taxable lump sum, with the Plan Surplus remaining in the Plan for the benefit of the other Participants. - Transfer of Plan to other Operating Company or Holding Company
Most, if not all, jurisdictions in Canada will permit the transfer of Plan Sponsorship of an IPP to another Operating Company or to a Holding Company. Our firm has never in this respect, encountered a problem with CRA, provided the operating or Holding Company has a business purpose and has not been created for the sole reason to act as Plan Sponsor of the IPP. This is particularly useful if the original Plan Sponsor is sold to a third party. This will preclude having to wind-up the Plan and permit the Plan Benefits, assets and Plan Surplus to remain intact. - Transfer Plan Surplus to a Retirement Compensation Arrangement (RCA)
On Plan Wind-up, a Resolution may be drawn up, with the written agreement of the Participants, changing Plan Surplus ownership from the Participants to the Company. The Plan Surplus would then be paid to the Company and re-contributed by the Company into an RCA. In this manner the Plan Surplus could be taken into income by the Participants over a period of years.
C. Prescribed Assumptions
As previously stated CRA has set a set of Prescribed Assumptions applicable to IPP's in Regulation 8515(7) of the Income Tax Act. These assumptions are somewhat dated as they reflect the financial conditions and mortality assumptions which whilst relevant to the 1980's are no longer so in the 21st century. Updated assumptions would include a lower rate of interest for discounting actuarial liabilities, combined with lower CPI and AIW assumptions and a more modern mortality table with extended life expectancy. The combination of these changes should result in higher actuarial liabilities and enhanced current service costs. I have recently proposed to CRA a new set of Prescribed Assumptions but to date have not received a response.
As stated earlier these Prescribed Assumptions no longer apply following the retirement of the Participant.
D. Capital Required to Fund Benefits at Retirement
Due to the lifting of the funding restrictions at retirement, the contention made by the authors that the future rate of increase in CPI will severely lower the funding at retirement is erroneous, as the Actuary could substantially reduce the interest (discount) rate to account for the fall in inflation and presumably the rate of return on Plan Assets.
E. Reduction in Future AIW Rates
As stated above, recent increases in the AIW, in particular the fact they have, on average, been slightly less than CPI over the last 15 years is an anomally that is unlikely to continue into the future. In any event, this has not prevented the Finance Minister in the 2005 Federal Budget from increasing RRSP, and IPP, limits forward to 2010 at approximately 5.5% per annum compound. It would be my expectation that subsequent increases will be closer to this rate than to the AIW. This is mainly due to the fact that Canada's RRSP and Premium Limits max out at a very much lower level than its competitors, principally the U.S. and U.K.
F. Terminal Funding
As Terminal Funding applies on retirement and the CRA Prescribed Assumptions no longer apply at retirement, the proposition by the author that Terminal Funding could in many cases prove negative is spurious at best. A combination of enhanced Early Retirement Benefits, full CPI (against CPI - 1%) indexing and the removal of the Prescribed Assumptions should only in very rare situations result in Plan Surpluses. If all the Participants (in a multilife IPP) retire at the same time, which is often the case for married Participants, any Plan Surplus can remain in the Plan until the death of the survivor. It will also often be the case that one or more of their children employed in the Company can be added to the Plan to defer any possible taxation of remaining surplus for another generation.
As you can see, IPP's are not the simple arrangements which at first glance they appear to be. In order to obtain the maximum benefit for your clients you should work with an actuarial firm which is able to provide full service consulting services from in-house experienced actuaries. In this way the IPP can sing like a violin rather than become just an enhanced RRSP.
Gordon B. Lang FFA FCIA FCA ASA
President & Chief Executive Officer
Reprinted with permission from Gordon B. Lang
President & Chief Executive Officer
Gordon B. Lang & Associates Inc.
http://www.gblinc.ca/