Individual pension plans (IPPs) aimed at high net-worth business owners can be complicated and technical and need to be explained carefully to both financial advisors and their potential clients, say two experts in the field.
Stephen Cheng, managing director and senior consulting actuary at Westcoast Actuaries Inc. in Vancouver, says there has been some growth in the IPP market over the last couple of years, but most of it has been offset by retiring IPP members who wind up their plans and transfer them to locked-in investment vehicles.
IPPs are basically defined benefit plans set up for one employee and have many extra layers of complexity not found in their more well-known cousins – RRSPs and TFSAs.
IPPs are used for business owners or high net-worth professionals whose corporations fund the IPP and receive a tax deduction for doing so. The company can also contribute funds for past service, capturing the difference between defined benefit and RRSP funding limits. As the plan member gets older the past service contributions at implementation can be considerable, sometimes in the area of $200,000 or more. Unlike RRSPs where the limit depends solely on earned income, IPP contribution limits are set through the actuarial valuation process based on age and salary, as well as assumptions prescribed in the tax regulations.
Adding to everything else, annual federal and provincial reporting is required with an IPP as well as an actuarial valuation every three years.
Cheng, whose actuarial firm handles IPPs, said his focus is on educating both advisors and accountants and their potential clients so they understand the IPP concept. Teaching clients about IPPs gives them the ability to determine whether the IPP is the right vehicle for them.
“One of the reasons the popularity of the IPP hasn’t gained much ground over the last couple of years is mostly attributable to the fact that people don’t understand them,” Cheng said. “When people don’t have the right information, quite often they make the wrong decision. If an IPP is not a suitable vehicle then people are not going to be happy because of the IPP’s restrictions and inflexibility.”
In addition to the federal requirements, different jurisdictions may also have their own rules and regulations. Ontario, for example, requires IPP sponsoring companies to contribute a minimum amount every year for their plans, whereas British Columbia and Quebec don’t, says Cheng.
“In B.C., there is no minimum funding requirement so IPP clients who make under $500,000 one year would only get a writeoff of 13.5%. So they postpone the funding because they have the luxury to do that. In Ontario, the legislation requires the corporation to put in minimum contributions each year and if there is a deficit, the company must make amortization payments to liquidate those deficits.”
Abby Kassar, vice president, High Net Worth Planning Services with RBC Wealth Management Services, says she feels IPP numbers are now growing in popularity and awareness and more business owners are looking into how IPPs work.
Of special interest is the ability of an IPP to provide greater retirement savings than an RRSP, especially since IPP contribution amounts are partly a function of age, says Kassar.
“So as you get older, the IPP limit will increase and exceed the RSP limit.” The typical age to open an IPP ranges from 40-50. While many business owners have spent all their years growing their businesses, they realize around this age that they need to start stashing away money for their retirements.
In addition to being more highly regulated than RRSPs, IPP holders may not have the same kind of flexibility to split income on retirement as they would with an RRSP and pension benefits are locked-in under legislation until retirement. At that time, the funds must be used to provide retirement benefits through products such as a life annuity.
But Kassar notes there are also a number of advantages IPPs have over RRSPs, such as increased contribution room, the ability to deduct fees for costs associated with maintaining the IPP, as well as creditor protection. While there are a number of administrative procedures to go through, she says RBC Wealth Management uses an actuarial firm to make those requirements seamless.
An IPP also allows the holder to get a pension buyback. Corporations can make a lump-sum contribution dating back to before the plan was set up. The company receives a tax deduction for the retroactive contributions for these years – a deduction the holder would not have been able to receive as an individual. Not long ago, the federal government changed the formula for pension buybacks, which made it not as attractive as it used to be, said Kassar.
Cheng says one of the biggest competitors to an IPP is a non-registered dividend strategy being used by a number of accountants. Under this scenario, business owners pay the corporate taxes on their corporate income and leave the rest in retained earnings. They then pay themselves a dividend from the retained earnings as needed rather than drawing a regular salary for their income needs. During this time, the business owner will pay tax on the dividends, while the company income is taxed at a lower, small business tax rate. When business owners retire, they pay themselves a dividend from the corporate retained earnings and pay taxes on the dividend income.
Kassar said there are other strategies that can be used for incorporated individuals, but added that they may have more restrictions than IPPs.
Tax-exempt life insurance
One is the Insured Retirement Plan (IRP), which provides tax-free supplemental income through tax-exempt life insurance. Potential buyers of this product should already be topping their annual RRSP contribution limits and it is for individuals who need life insurance. Kassar said clients must be willing to leverage on that insurance policy.
The second is a Retirement Compensation Arrangement (RCA), often extended to a key employee, including the owner-manager of a business. Kassar said the RCA may be an additional product that can be considered if an IPP is already in place, supplementing the IPP.
There are a number of issues, both small and large that can influence a client as to whether an IPP is a suitable product for them, said Cheng.
“Education is key,” he said. “We need customers who understand what they are getting. We need happy customers.”