Pensions: Defined Benefit Plans: Death Or Rebirth?
The past two decades have seen a dramatic decline in the number of defined benefit pension plans offered by large employers in the private sector. A variety of factors explain this decline. These include:
the increased volatility of markets making it harder for employers to properly plan their retirement expenses
the aging of the workforce
the decline in unionization rates where DB benefits were often collectively bargained
changes to the accounting rules around DB costs
Chief financial officers in search of cost-control have responded by making their employers begin the process of converting DB pensions into money purchase or defined contribution arrangements.
For many commentators, including the Expert Commission on Pensions of Ontario (ECP), the trend is alarming since traditional DB plans continue to be, in the eyes of many pension experts, the gold standard of retirement programs due to their unique features: scale, professional management, and tax-effectiveness. The burning question thus becomes: are we truly witnessing the death of the DB plan in Canada?
The answer depends in part on where one looks within the marketplace. Certainly, within the public sector or the ever-shrinking unionized sector, the DB coverage ratio is still extremely healthy and high. In the large private sector, however, the downward trend highlighted by Professor Harry Arthurs during the mandate of the ECP is real.
There is, however, one segment of the economy where DB plans are making a comeback: the owner-operator and incorporated professional submarkets, thanks to the recent introduction of the Personal Pension Plan that INTEGRIS Pension Management Corp. brought to the industry in 2012. While the PPP has many similarities to an existing structure, the Individual Pension Plan (IPP) this article will focus solely on the advantages of the PPP structure.
Structure Of The PPP
The PPP is a combination registered pension plan set up for a single individual, the owner of the company. It combines a DB component (incorporating all of the benefits of an IPP) with a money purchase or DC component and an additional voluntary contribution (AVC) sub-account (see Figure 1).
Every year, the plan member gets to decide whether to build up a pension benefit under the DB component, using actuarially calculated contributions, or via the Defined Contribution and AVC accounts – where the mandatory contribution levels are much lower.
This flexibility provides the business owners with the option of creating greater tax deductions than what is permitted by RRSP rules, yet retain the flexibility as to when the business will make the cash outlay towards retirement savings.
The PPP also comes with a virtual ‘pension committee’ governance structure fully staffed with pension officers, compliance officers, and actuarial consultants to manage every aspect of the plan, except investment management, since that functionality remains with the client and their trusted financial advisors.
Advantages Of The PPP
PPPs rely on the same tax rules as traditional DB plans when it comes to the level of contributions capable of being set aside for retirement with one exception, the designated plan funding restrictions. Thus, assuming the exact same rate of return on assets over a 20-year period, someone utilizing the more generous tax deductible contribution limits of the PPP would accumulate over $1 million above and beyond what could be achieved within the more restrictive RRSP contribution limits.
Beyond the ability to generate a much larger nest egg to retire on (without taking additional market risk), the PPP also provides superior creditor protection especially in bankruptcy where the current service cost contributions owed to the PPP fund rank above the claims of secured creditors due to changes made to the Bankruptcy and Insolvency Act in 2008.
For Ontario-based business owners, the PPP is considered a ‘comparable plan’ and is, therefore, exempt from the scope of the proposed Ontario Retirement Pension Plan (ORPP). Business people who would rather trust their investment advisor to manage the 3.8 per cent ORPP contributions should start the conversation with their accountant and advisors to be ready for when the ORPP becomes effective starting in 2017 (see Figure 2).
Additional Advantages of PPPs over RRSPs
Creditor protection of assets
Ability to invest in non-qualifying investment asset classes creating further diversification
Potentially increase the tax deferral limits by $1 million over 20 years beyond RRSP maximums.
Deductibility of investment management fees
Ability to pension income split 10 years prior to normal retirement age
Intergenerational wealth transfers on the death of retired plan members
Ability to claim HST pension entity rebate
Ability to make up for investment losses with additional tax-assisted contributions
The main focus of this article is to examine how these additional assets may be deployed in creative ways by financial advisors to generate additional value.
Pension Plans – Investment Options
Large pension plans can take advantage of an expanded opportunity set over RRSPs. While RRSP investments are restricted by the ‘qualified investment’ rules, investments in registered pension plans do not face such restrictions.
Asset classes such as infrastructure, private equity, real estate, and hedge funds often fall outside of the qualified investment criteria. With very long time frames, these types of investments are ideally suited for a registered plan which is intended to provide a retirement income many years in the future.
Most of these asset classes also tend to be very inefficient from a tax perspective. If one holds these in the corporation’s investment account, one may receive highly-taxed interest income or unwanted distributions of dividends and capital gains. This ‘tax drag’ reduces the long-term rate of return and it is, therefore, preferable to hold these types of investments in a tax-deferred environment. A PPP provides the business owner with the opportunity to hold tax-efficient investments in the corporation’s non-registered investment account while holding tax inefficient investments within the registered pension plan. An investor considering a PPP should ensure that they are working with an investment advisor who has access to these unique asset classes to maximize the investment opportunity set within the pension plan.
How To Invest In PPPs
PPPs using the DB component have a prescribed return of 7.5 per cent per annum to maintain full funding. We set out below two distinct strategies (see Figure 3) to optimize investments within a PPP environment. Both of these strategies potentially present a few unique opportunities for a smart investor that are not available to RRSP investors.
Target the 7.5% p.a. Prescribed Return Assumption
In today’s environment of very low interest rates, an investor would need to have a more aggressive portfolio in order to achieve the desired upside potential. Three outcomes are possible:
Return is 7.5% p.a. ‒ Plan is fully-funded and no action is required.
Return is greater than 7.5% p.a. ‒ Plan is overfunded and future contribution room could be reduced or eliminated altogether (depending on the size of the surplus generated).
Return is less than 7.5% p.a. ‒ Plan is underfunded and the plan sponsor must make additional contributions (known as “Special Payments”) to bring the Plan back on track. Special Payments are tax-deductible.
Target less than the 7.5% p.a. Prescribed Return
Another strategy is to intentionally invest in low-returning assets such as GICs. Let’s assume an investor built a 5-year GIC ladder yielding 2% p.a. Each year, the investor would accumulate a deficit of say 5.5% which would put the plan into an under-funded state. The company would need to make special payments to bring the plan back on track.
They offer the ability to make additional tax-deductible contributions to the plan. This shifts passive assets out of the corporation into a tax-deferred and creditor-protected plan (thus introducing another level of diversification for the business owner). With proper planning, this could be a way to move passive assets out of a corporation ahead of a sale, potentially qualifying as a Canadian controlled private corporation for the lifetime capital gains exemption.
There is also an ability to ‘top up’ investments after a negative return. An RRSP investor has very limited ability to add additional funds after a year of negative returns. An investor with a PPP can take advantage of the underfunded status of the plan to make a very large one-time contribution (in addition to the normal annual contribution). This gives the investor the ability to ‘buy low,’ assuming that the original investment thesis holds true, and eventually ‘sell high,’ without facing immediate taxation.
John Sanchez is an investment advisor with the Horwood Team at Richardson GMP Ltd. (John.Sanchez@RichardsonGMP.com).