The Tax Man And The Holiday
By: Ian Edelist
Like most people, you need to save for your retirement. To find out how much you should save, you arrange a meeting with your trusted financial advisor who tells you that you need to invest $7,000 each year until retirement in order to live comfortably in your senior years.
So, you start contributing $7,000 to your RRSP each year. You’ve chosen a good time to enter the market and the balance of your retirement account increases much faster than you could have hoped.
But there are tax limits on how much you can have in your account. In fact, after six years of above average returns, the tax man tells you that you have too much in your account. You’re not allowed to contribute $7,000 this year or for the next few years. You congratulate yourself on being ahead of the game, and decide to take it easy for a couple of years. You may even buy some presents for your family since you have the extra cash.
Eventually, the bull market ends. Two years into a bear market, your account balance has dipped well below where it needs to be to accumulate your nest egg. It looks like you’ll have to contribute $14,000 each year over the next few years, just to get back to where you should be. To make matters worse, things aren’t going well at your job and you’ve had to take a pay cut. Where are you going to get the money to contribute? You begin to wonder whether you should delay your retirement or lower your retirement expectations. You’re facing some tough choices.
A Familiar Story
Sound familiar? It’s a scenario that has been played out by many Canadian pension plan sponsors in recent years – and all because of Section 147.2(2) of the Income Tax Act (ITA). This section of the ITA requires plan sponsors with Defined Benefit pension plans to stop making contributions if they reach a point where surplus assets exceed 10 per cent of liabilities or two years’ current service cost. There’s no question of choice or timing. If it happens right in the middle of a bull market, so be it.
So, while some pension plan stakeholders may be under the impression that their plan sponsor chose to take a contribution holiday when markets were riding high in the ’90s, putting a stop to contributions was likely to have been a question of compliance rather than choice.
Having now endured three years of market underperformance (and, at least one triennial valuation), plans are beginning to feel the full brunt of any past breaks in contributions. Some are having to rethink their plan design and others are even being forced to terminate their pension plans or face bankruptcy because they can’t afford their pension payments.
Clearly, there’s something wrong when the pension tail begins wagging the corporate dog!
Fortunately, however, there’s a simple remedy. By amending the ITAto allow current service contributions to be paid into the pension fund regardless of surplus, the problem is removed at source.
The advantages of this approach become obvious if we follow the trajectory of a typical DB plan from 1991 to the present. Chart 1 shows a non-contributory pension plan with a funding ratio of 100 per cent in 1991 that has earned the median return of Canadian pension funds since that time. The employer’s annual current service cost in 1991 was eight per cent of earnings.
Under existing rules, the deficit at the beginning of 2003 requires special payments amounting to 18 per cent of payroll each year to pay off the deficiency over five years. If the amended rules had been in effect all along, the deficit would require annual special payments of only one per cent of payroll.
The issue of surplus ownership would, of course, need to be addressed. Plan sponsors would need to know where they stood if any temporary surplus arose from current service contributions. Bill 198, which was brought to the table and promptly withdrawn by the Ontario government, contained a workable solution that would allow plan sponsors to withdraw surplus above certain limits on approval by two-thirds of plan members.
Also, the current Canadian accounting standard limits the amount of surplus allowed on a plan sponsor’s balance sheet. Aspurious charge is made to the plan sponsor when its surplus falls below the threshold. The International Accounting Standards Board has addressed this issue by negating the charge.
Doubtless, any tinkering with the ITA is bound to create some new issues, but the health of plan sponsors and their impact on employment levels, not to mention security of pensions, should be enough of a carrot to convince the federal government to work them out.
Ian Edelist is a consulting actuary in the Toronto office of Eckler Partners Ltd.
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