Deep Dive Into Individual Pension Plans

December 5, 2022

Prepared By: Mitchell A. Shields, CFP®, CLU®, TEP

As a fellow professional providing guidance to incorporated clients on their financial affairs, you may be familiar with an Individual Pension Plan. However, you may not know the IPP intimately enough to confidently determine which clients it would benefit or how it would benefit them. Within this article, I hope to dive deeper into this powerful plan to help you identify when an IPP should be considered for your clients.

An Individual Pension Plan (IPP) is a defined benefit pension available to owners, incorporated professionals, and in some cases, executives of incorporated businesses. Typically, these plans are set up for 1-4 individuals and are primarily used for ‘connected employees,’ defined as owning 10% or more of the sponsor company. Although, employees who are not considered ‘connected’ can also be added to the plan (as long as one member is connected). However, this is not often done in practice as the funding requirements can be more stringent.

The IPP will provide similar benefits as an RRSP (Registered Retirement Savings Plan) in that it allows you to accumulate assets invested for retirement. The IPP, however, will allow you to contribute larger deductible amounts to the plan, especially as you near retirement age.

An IPP is not a one size fits all solution and would need to be considered as an element of the overall wealth and estate plan. They tend to be best suited for owner-managers, incorporated professionals, farming families, and corporate executives who are in their mid-40s or older and are high T4 earners. However, this can still be suitable for low T4 earners with a long history of taking T4 income – for example, farmers) who have been maxing out their RRSPs every year.

As a defined benefit pension, the IPP will be established with a guaranteed retirement benefit that is pre-determined. From here, an actuary will assess the plan and determine what can be added to the plan to fully fund the pension guarantee. Which can result in much larger deductions that the RRSP would otherwise provide.

To illustrate this point, review the example figure below:

The following criteria will determine the amount that one can contribute to an IPP; member’s age, declared employment income, investment returns, and actuary calculations. Calculations will be completed by an actuary firm when the plan is initiated, on a tri-annual basis, and at retirement.

Contributions to an IPP are made at the corporation level for the plan member’s benefit, not at the personal level, so when the corporation contributes to the IPP, it will be deductible against the income of the corporation and therefore the contributions will be exempt from payroll taxes. which is different than an RRSP. An RRSP contribution process is as follows; the corporation pays a salary to the shareholder that would include the portion to be contributed to the RRSP, and then the shareholder makes the contribution personally.

In addition to the IPP contribution’s deductibility, the corporation can also deduct any actuary fees, financing costs of the contribution if borrowed funds were used, and in most cases, investment management fees.

Once the funds are contributed to the IPP, they are locked into this account until retirement, unlike RRSPs, which can be taxably drawn down at any point in time. This can be argued to be a negative from a flexibility perspective or potentially a positive from a behavioural finance perspective.

When initiating an IPP, it is set up as a trust (unless utilizing segregated funds due to the trust nature of the product) and, as such, is not considered an asset of the corporation. This provides protection from creditors (assuming the IPP wasn’t established in an effort to defraud creditors) and is a consideration when looking at corporate taxation for Small Business Corporations (SBCs) and the associated passive income or lifetime capital gain rules.

As a trust, there will be an obligation to file a T3 pension report each year by March 31st (March 30th on a leap year). This is typically handled by the contracted actuarial firm and is not the responsibility of the accountant.

The actuarial support required to start and maintain an IPP does come with some additional costs above the administrative and management costs from the investment dealer housing the plan. These costs will vary by actuarial firm but can be expected to be in the range of $2500 to establish the plan and an additional annual fee of roughly $1500. These costs would be paid from the sponsor corporation not from within the fund and would provide a deduction to the sponsor.

VALUATION METRICS

IPPs are considered a designated plan and are subject to maximum funding valuations in regard to the regulations around determining the service costs (contribution amount) of the plan.

The metrics stipulate that a rate of interest of 7.5% per year is assumed for the investments within the plan. If, at the tri-annual review, the portfolio has performed below the 7.5% assumed return, this will allow a larger contribution to be made. In most provinces, legislation has changed for connected plans where funding for this
shortfall is available but no longer enforced. On the flip side, if the portfolio has performed above the assumed return, it is possible that contributions would be temporarily paused. This can provide a great potential benefit over an RRSP that has no stipulations around market performance.

This also opens the door to a strategy I would provide caution around. Some would look at this and decide to park the funds in the IPP in securities that provide a low annual yield, such as GICs or Money Market Funds. Theoretically, this would allow you to move larger amounts into the plan every three years and provide some large deductions; however, there is a need to be cautious, not letting the tax tail wag the dog. Keep an eye on the primary utilization of the plan, which is to save a nest egg for retirement.

In some cases making contributions will not be optional, and the rules around whether or not the contribution can be skipped can vary from province to province. For example, Ontario recently amended the legislation to allow IPPs to be underfunded for ‘connected employees.’ The amendment will give greater flexibility if, for instance, due to business reasons, the funds aren’t available in the corporation to make the obligatory contributions. A good case study came in 2020 with the onset of the Covid-19 pandemic, where many corporations were in a position where cash on hand was valuable to weather the storms ahead and skipping a contribution to an IPP would have likely been prudent, or in some cases not optional.

Within these same valuation metrics, salary is assumed to increase at a rate of 5.5%. This will provide potential value to those who have had a long history of T4 earnings from their corporation, even if those amounts were quite low. This is where we can often see a case for farming families receiving a great benefit from the IPP over an RRSP, which does not index the income within its calculation. Lastly, in these valuation metrics, an inflation rate of 4% is utilized.

INITIAL FUNDING AND YOUR RRSPs

When the actuaries are contracted to complete the initial assessment for funding, they will determine the amount that can be contributed to the plan in the first year.

As a part of this exercise, it will be a requirement to move a portion of your current RRSP to the plan to account for a Past Service Pension Adjustment (PSPA). In simple terms, this represents the amount that would have been contributed to the IPP over the years that you declared T4 income to fund the pension benefit. If the pension had been in place, you would have had a pension adjustment (PA) during those years that would have reduced the amount you could have contributed to an RRSP personally.

In order to compensate for that and to ensure there isn’t a double dip happening, the calculated portion of the RRSP will need to be moved to the IPP. This is a plan-to-plan transfer, and as such, there are no tax implications for this transfer. In many cases, there will be a portion of funds that can be maintained as an RRSP. However, those funds are not required to stay in the RRSP.

You have the ability to complete an Additional Voluntary Contribution (AVC) and move those RRSP funds into the IPP in a separate account within the IPP. These funds will not be subject to pension legislation and the same investment limitations as the other IPP funds (See investments below). However, this portion of the IPP, unlike the primary bucket, is not locked in and can be transferred back to an RRSP in the future.

Proceeding with this transfer would reduce the number of accounts to manage, which can reduce complexity as well as administrative costs. In addition, investment management fees are deductible, which is not the case with an RRSP.

OPTIONS WHEN YOU RETIRE

1. Take the Pension

The IPP is, first and foremost, a pension, and as such, the primary option that people would opt for at retirement is to begin to take the pension benefit from the established plan. The pension benefits can begin for the member as early as 55 or as late as 71 years old.

When an individual is about to take the pension, an actuary calculation will be done to ensure it is fully funded based on the established guaranteed pension amount. This will often result in one more contribution called a ‘terminal contribution” that accounts for all of the benefits being attached to the plan, such as indexing and survivor benefits. This terminal contribution amount will also likely increase the earlier the member of the plan opts to retire.

2. Copycat Annuity

Another option when looking at retirement is to move the funds into what would be referred to as a copycat annuity.

This would be the act of taking the value of the plan and using it to purchase a life annuity to provide the same benefit but passing the risk to the insurance company. The copycat annuity could provide adverse tax consequences if the difference in benefit is considered ‘material’ from the CRA. This would only typically come into play if the pension amount expected from the annuity was higher than the benefit from the IPP. This would be far less likely with an IPP than with a traditional defined benefit plan.

An additional risk with this route is if the annuitant of the annuity passes away early in life. It would be possible that the funds moved to the annuity may be lost to the estate in the case of death early in life. (See section on death below)

3. Collapse the Plan and Take the Payout

It is likely that this will be the option that is the most ill-advised when it comes to the funds at retirement. It is possible to collapse the plan and move the funds to a Locked-In Retirement Account (LIRA). This transfer, however, is based on the Maximum Transfer Value (MTV) calculation which accounts for the amount that can be moved from a defined benefit plan to a LIRA (in Ontario, Quebec and PEI, it would be moved to an unlocked RSP). Any amount above MTV would be potentially subject to tax.

If the member of the plan has RRSP room available, they can transfer a portion of the cashed-out proceeds directly to an RRSP to shelter the tax. However, there will likely be little room available after all the pension adjustments, and little will be sheltered in the RRSP.

This option comes with a large tax hit which will reduce the benefit of being in the plan. That being said, collapsing the plan and taking the payout is an option and one that pension members choose a shocking amount of the time.

INVESTMENTS AVAILABLE

The eligible investments in an IPP will generally be the same as an RRSP, with some exceptions. The scope of all investible assets is beyond what I hope to accomplish in this piece, but I wanted to address two key differences from an RRSP that are covered under the Federal Investment Regulations as outlined in the Pension Benefits Standards Regulations.

First is that related party investments will not be permitted in the IPP (i.e., shares of the sponsor company).
Second, there are diversification rules that stipulate that any one position cannot make up more than 10% of the portfolio total. There are some exceptions to this rule that can be granted, one of which would be investments in investment funds, segregated funds or investments that are low-risk in nature (ie., Investments that have CDIC or Assuris protection).

In practice, no pension regulator monitors how a pension fund is invested. The trustee does have a fiduciary responsibility to any members of the pension; however, since the trustee and member are often the same person, it would be reasonable to assume the member won’t go after themselves for a breach.

TAX TREATMENT

As previously mentioned in this article, one key tax benefit to the IPP is the ability to deduct the contributions and associated administrative costs at a corporate level, with deduction limits much higher than an RRSP. This can provide some much-needed relief to a corporation attempting to keep the small business tax rates in order.

The IPP is not considered a passive income, which will help with the grinding down of the Small Business Deduction limit, as well as providing potential preservation of the lifetime capital gains exception. This strategy can also provide some relief to those who had their tax strategies affected by the new Tax on Split Income Rules and who have had to salary or bonus out more income.

If there is more relief required beyond what is available from the IPP, it may be wise to also consider the Retirement Compensation Arrangement (RCA) as an additional source of needed corporate deductions; however, we will not address that matter further in this particular article.

On a personal taxation level, when funds are contributed to the IPP, the member would be issued a Pension Adjustment (PA) that would reduce the amount of personal room they had to contribute to an RRSP. When the IPP is being funded, this would effectively result in the member gaining $600 in RRSP room each year due to the pension adjustment calculation. This is to stop the member from being able to benefit from two sources of tax deferral and, in turn, give them an advantage over other Canadians. Beyond the disadvantages of the IPP, which we have already discussed, this also introduces the disadvantage that the member will not be able to contribute to a spousal RRSP in any meaningful way. This may reduce some income splitting that could otherwise be accomplished with the spousal RRSP. However, the pension income in retirement can be split with the spouse. The IPP would be eligible for income splitting before 65, unlike an RRSP, which could help reduce this disadvantage. However, in some cases, it may be more beneficial to push more into a spousal RRSP and not split the income in retirement.

As a pension, when the funds begin to be withdrawn for retirement, either the member or the member and their spouse, if the income is being split, would be eligible for the pension tax credit.

WHAT HAPPENS WHEN A BUSINESS IS SOLD?

If/when you sell your business to a third party, that acquirer wouldn’t want to carry the liability associated with keeping the IPP. With that, the handling of the IPP would need to be addressed in the purchase agreement. As you are selling your business, this is likely when you will retire, in which case, the options detailed above may be how to handle the IPP.

If you aren’t ready to turn on the benefits yet, it is also possible in some cases to transfer the sponsorship of the IPP to your HoldCo until you are ready to start the benefits. From that HoldCo, it would be possible to continue to make contributions on a tri-annual or terminal basis; however, without active income to deduct against, there may be less reason to do that. In the case that your HoldCo did provide T4 income, ongoing annual contributions may also be possible, although again may provide less benefit. Caution must be taken that there is a T4 history with the Holdco in years prior to the change in a manner that would be reasonable for CRA.

WHAT HAPPENS WHEN I DIE?

In practice, this is likely one of the most overlooked areas when discussing IPPs. When you have an IPP that is funding your retirement, you will likely have a surplus in the plan when you pass away. Dependent on provincial statutes, you have the opportunity to name a beneficiary who will receive the IPP on your death instead of it forming part of the estate.

In Ontario, this is covered under section 51 of the Succession Law Reform Act, which stipulates that a beneficiary can be named in a will.

When a beneficiary is named in the will, the remaining funds can be taxed in the hands of the beneficiary pursuant to sub 56(1)(a)(i) instead of the estate, which can provide some significant savings if the beneficiary of the plan is in a lower tax bracket.

In the case of a bonafide family business, where there is a clear succession plan with the Adult children, they may be added to the plan, and this would allow for the assets to remain tax deferred within the IPP for their retirement.

WHAT IF I LEAVE CANADA?

For those who are planning to spend their retirement years abroad, the IPP could be a good complement to that plan.

A key consideration for those planning to sever their residency in Canada is the departure tax. This is when the departing resident is required to pay taxes on the fair market value of their Canadian assets. This allows the Canadian government to capture deferred taxes from past years. The IPP is not caught in this, and no departure tax on the value of the IPP will be due.

This would not be the case if those same funds were invested within the corporation, as the value of those corporate shares would be caught in departure tax.

As a non-resident, the taxation you would pay on withdrawals from the pension would be determined by the treaty between Canada and the country that you choose to reside. It would be typical to pay taxes of 15% in Canada and then declare that pension income in a foreign jurisdiction. In many cases, individuals move to countries with a lower income tax rate than Canada and, in turn, can save a lot in tax from making this move.

Reference:
https://www.canada.ca/en/revenue-agency/services/tax/registered-plans-administrators/registered-plans-directorate-technical-manual-18.html#:~:text=Paragraph%208515(7)(b,increase%20in%20the%20CPI.
https://www.canada.ca/en/revenue-agency/services/tax/registered-plans-administrators/pspa/past-service-pension-adjustment-pspa.html
Payout as early as 55 – https://www.canlii.org/en/ca/laws/regu/crc-c-945/latest/crc-c-945.html?searchUrlHash=AAAAAQAEODUxNQAAAAAB&offset=0#:~:text=of%20the%20member%3B-,Early%20Retirement,-(c)%20whereor
As late as 71 – https://www.canlii.org/en/ca/laws/regu/crc-c-945/latest/crc-c-945.html?searchUrlHash=AAAAAQAEODUxNQAAAAAB&offset=0#:~:text=(e)%20the-,plan,-(i)%20requires
https://www.canada.ca/en/revenue-agency/services/tax/registered-plans-administrators/newsletters-technical-manual/no-20-1.html
https://www.canlii.org/en/ca/laws/regu/crc-c-945/latest/crc-c-945.html?searchUrlHash=AAAAAQAEODUxNQAAAAAB&offset=0#:~:text=Prohibited%20Investments
https://www.fsco.gov.on.ca/en/pensions/investment/Pages/fed-invest-reg-change.aspx#:~:text=Changes%20to%20the%2010%20Percent%20Rule
https://www.canlii.org/en/on/laws/stat/rso-1990-c-s26/latest/rso-1990-c-s26.html?autocompleteStr=success&autocompletePos=1#:~:text=s.%C2%A063%C2%A0(4).-,Designation%20of%20beneficiaries,-51%E2%80%82(1)