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Individual Pension Plans

Individual Pension Plans (lPP) are one option that should be considered for business owners and senior executives who have maxed out their RRSP contributions or who are looking for a solution that provides significant tax advantages and potentially higher pension benefits. Wise Financial Group Inc. can assist in the process of implementation of an Individual pension plan.

This increasingly popular strategy can provide you with tax savings, not to mention peace of mind throughout retirement.

Individual pension plans (lPPs) are an attractive alternative to RRSP's for the right consumer. Already accounting for nearly 40 per cent of the 6,500 private pension plans in Canada, this type of defined benefit pension plan's popularity is on the rise. There are several reasons many are starting to investigate Individual pension plans. Perhaps most important for people over 40, lPPs offer higher tax-deferred contributions than RRSP's. Furthermore, any surplus in the plan belongs to you. This is an advantage Individual pension plans have over other pension plans, where any surplus stays in the fund and is used by the company to pay for benefits for other members of the plan. That said, an Individual pension plan does require the services of experts and is therefore associated with higher fees than a self-directed RRSP - covering everything from setup to ongoing administration, actuarial services and trustee services, where applicable. In most provinces, the IPP is registered with the provincial pension authorities and they also require annual fees. In addition, pension legislation requires that the assets be locked in except in Saskatchewan, Quebec and PEI. This means there is generally no access to the funds in the plan until retirement - and even then you can only withdraw an income stream.

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Nonetheless, for many, the advantages offered by Individual pension plans far outweigh the disadvantages. And the qualifications are not difficult to meet. Specifically, to hold an Individual pension plan, you must:

  1. Have employment income reported on a T4;
  2. Be an employee of an incorporated company; and
  3. Be age 40 or older and earn an income of at least $75,000 from the company sponsoring the Individual pension plan.

»Know the Facts

Before you can decide whether or not an Individual pension plan is a suitable strategy for you, you need to be aware of the pros and cons.

IPP Advantages

  • Employees over age 50 enjoy an annual maximum contribution that is at least $6,000 higher than the maximum contribution for an RRSP.
  • When an lPP is established, past service contributions enable you to catch up for the previous years you worked for the company. Past service contributions are calculated on each of your years' annual earnings going back to the company's creation, the date you started working for the company, or January 1, 1991, whichever is most recent. For companies with excess cash, this is a great opportunity to move it from the company to a tax-sheltered Individual pension plan. For companies without surplus cash, past service obligations can be amortized up to 15 years.
  • Guaranteed lifetime income - the lPP offers a predictable retirement income. An actuary determines the annual contributions required.
  • Pension benefits are protected from creditors under pension legislation, unlike most RRSP's.
  • lPP contributions and expenses are fully tax deductible to the business. lf the company borrows money or amortizes the past service cost, the interest charges are also deductible.

IPP Disadvantages

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Unlike RRSP's, pension plans do not allow for income splitting – you cannot make spousal contributions to a pension plan.
Initial setup fees* can be as much as $3,000 and will increase if past service benefits are provided. Annual expenses and filing fees after the first year will average $1,000 or more, including an actuarial report every third year.
Any surplus that is not required to pay for the promised benefits is paid to the member in a lump sum and is fully taxable.
Funds are locked in (including any RRSP's transferred to purchase past service), meaning there is limited flexibility with respect to accessing cash.
Personal RRSP contribution limits are reduced considerably with an Individual pension plan.

* Setup fees include: preparation of the plan, registration with Canada Revenue Agency (CRA) and the provincial regulator, and initial valuation. This may vary depending on the actuarial firm.

In the 2003 federal budget, the Government of Canada increased the maximum pension limits to $2,000 per year of service. As well, this $2,000 limit will be subject to increases based on the industrial average wage beginning in 2006.

At age 50, the annual maximum contribution is more than $6,000 higher than the maximum contribution to an RRSP. As you get closer to retirement, the cost to provide the benefit increases. Consumers can also include service dating back to 1991. This is optional, but if the member decides to include extra years, it will significantly increase the amount that can be deposited into the plan.

»Contribution Rules

Individual pension plan contributions are established through an actuarial valuation of the plan. Contributions can be broken down into the following three categories:

Current and Future Service Contributions

These contributions are made to pay for the value of benefits being earned by the lPP member each year after the implementation of the plan.

Past Service Contributions

These contributions are made to pay for benefits earned in prior years. At implementation, past service contributions can be made for eligible service prior to the effective date of the lPP. With an ongoing lPP, past service contributions can also be made when there is a deficit resulting from the actual experience of the plan being different from the assumptions used for valuation purposes. An example would be the actual investment experience of the lPP fund being less than the 7.5 per cent per annum assumed in the lPP valuation.

Terminal Funding Contribution

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This type of contribution is only available at the actual retirement date or pension commencement date. This is most commonly used to provide early retirement enhancements at age 60.

In an RRSP, the maximum contribution for 2005, regardless of age, was 18 per cent of 2004 earned income up to a maximum of $16,500. On the other hand, lPP contribution amounts increase with age - so the older the lPP member becomes, the greater the advantage he or she will experience over an RRSP. Buying past service creates a past service pension adjustment (PSPA), which reduces RRSP room. Since the central reason for opening an lPP relates to saving taxes, most Individual pension plan candidates will have made maximum RRSP contributions for prior years. Therefore, they will not have enough RRSP room for the PSPA to be certified by the Canada Revenue Agency (CRA). This is usually satisfied through a qualifying transfer from an RRSP equal to the amount of the PSPA.

»Investment Choices

Investments that are RRSP-eligible generally qualify for an lPP and the plan can be managed in a similar way as a self-directed RRSP. lPPs are subject to foreign content restrictions, which currently stand at 30 per cent of the book valve of assets. Segregated funds offered by insurance companies are a notable exception since they are currently exempt from the 30 per cent foreign content rule. lPP assets can be invested in stocks, bonds, mutual funds, pooled funds, term deposits and GlCs. There are two major differences between Individual pension plan and RRSP investments:

Diversification Standard

If pension funds are invested into individual securities, such as a stock or a bond, each security cannot exceed 10 per cent of the fund on a book value basis at the time the investment is acquired. Mutual funds and pooled funds are already diversified in nature and they are not subject to the 10 per cent limit.

Prudent Person Standard

Pension assets are held in trust for the benefit of the Individual pension plan member and beneficiaries. Therefore, pension investments are subject to the usual prudent person standard for the investment of trust funds.

To enhance the likelihood of making additional contributions, the lowest yielding assets in an investment portfolio should be invested in the lPP. A trustee (either a corporate trustee or three individual trustees) is required unless the investments are with an insurance company where the contract provides for an annuity at maturity. The prescribed rate of return assumption for valuation purposes is 7.5 per cent per annum. The ideal investment strategy for an lPP would be to target a long-term net rate of return of 7.5 per cent per annum using a balanced investment approach and then structure their remaining retirement savings portfolio taking this into account. The lPP component should be slightly more conservative and other components - such as non-registered retirement savings and RRSP investments - can be slightly more aggressive. lf the lPP does not achieve the 7.5 per cent target, more tax-deductible contributions can be made. lf the non-registered component and the RRSP achieve a higher return, the client can keep all gains without affecting his or her ability to make lPP contributions. In other words, it is preferable for the lPP client to have excess investment gains in non-registered retirement savings or an RRSP, rather than in an lPP.

Quick Tip

Although you have to create the room to buy the past service by transferring RRSP or other pe

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nsion assets into an lPP, the transferred assets do not have to match contributions actually made since 1991. They can come from any RRSP. lf you are in a pension plan before and left that company when he or she started the business, you may have money in a locked-in RRSP. Alternatively, you may have been in a defined contribution pension plan along with other employees. When you set up the lPP, you can move the other pension assets into the Individual pension plan. This strategy enables you to use money that has already been locked in.

»IPPS and the Family Business

Normally, on the death of the second spouse, registered assets create a tax liability in the estate. An lPP is an ideal way to keep the assets in a tax-deferred vehicle when a family business is part of the equation. lf the business is continuing after the parent retires, the family member (usually a son or daughter) taking over the business can be added as a member of the existing plan. By leaving the
plan intact, any assets not used to provide benefits to the retired parent will remain and "transfer" to the second generation without triggering tax. lPPs can benefit families whodecide to sell their company, too. Most small businesses are sold to family members or partners. The proceeds from these types of asset sales are treated as taxable income. By setting up an Individual pension plan now using terminal funding, a deduction can be created against this income.

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