Start An Individual Pension Plan (IPP)

Introduction

Using pension legislation originally designed for large corporations (Registered Pension Plans), smaller employers can start their own Individual Pension Plans (IPP's). Employers can be incorporated, an unincorporated proprietorship, or a partnership. In certain circumstances, IPP contributions can be in excess of that allowed under the RRSP rules. IPP's offer better tax deferral opportunities than EPSP's, provide superior creditor protection, encourage key staff loyalties to a certain age, provide a mechanism to extract large cash surpluses tax deferred to make past service contributions or to make a sale of a business more economical to the purchaser, provide larger deductions for the corporate employer, and may result in more retirement savings than that generated by an RRSP.

Canadians can save for retirement using one of two general types of pensions, Defined Contribution and Defined Benefit. 

Defined Contribution Pension (DC)

Just as the name implies a DC pension has defined contribution limits set out by the government on how much can be invested. This creates certainty of contributions to the plan but uncertainty of the amount of retirement benefits. If the plan is registered by the government as a pension plan, the plan is called a Money Purchase Plan (MPP). If not registered as a pension plan, then the account is called a Registered Retirement Savings Plan (RRSP). The maximum annual contribution amount is defined as 18% of earned income of the prior year (employment income and some other types of income) up to a prescribed dollar maximum. Click HERE for the maximum amounts (equal to the RRSP maximum amounts). As there are limits on how much can be contributed, plan holders must rely on the investment returns to adequately fund their retirement. The risk, therefore, of the value of the plan rests with the plan holder. In times of good returns, then the plan holder may experience high values in their plan. However, in times of poor returns, the plan holder may find their plan is not performing well and possibly their retirement funds may be inadequate. Further hampering investment returns are restrictions on eligible investments.

Defined Benefit Pension (DB)

Just as the name implies, a DB pension has a predetermined future benefit which a plan holder can expect as a retirement payment. This creates uncertainty of contributions to the plan but certainty of the amount of retirement benefits. A DB must be registered as a pension plan with the government. The amount contributed to the plan is determined by an actuary who looks at the benefit required at the time of retirement and then calculates backwards to determine what contributions are required to fund the future benefit. As a result, depending on  the future benefit required and the performance of the investments in the Plan, the contributions will vary. Contributions are tax deductible by the company making them as long as payment is made within 120 days after the year-end of the company. Click HERE for the maximum benefits and the related earned income levels. Contributions go into a tax-deferred investment account called a Pension Trust. Typically, DB plans have many plan holders in a group which share a pool of pension funds, for example a Teachers Pension Fund. The risk of adequately funding the retirement of plan holders rests with the company which funds the DB pension. In times of good returns, the funding company may be able to curtail or eliminate payments. However, in times of poor returns, the funding company must make adequate contributions to ensure the plan will be able to pay the predetermined pension benefits. Similar to DC Plans, investment returns are hampered by restrictions on eligible investments.

How an IPP Works

An IPP is a DB pension set-up on an individual basis instead of a group basis. An actuary is still engaged to determine the plan costs and the corporation makes tax-deductible contributions into a Pension Trust. The investment income in the Pension Trust grows tax-free until the plan holder withdraws funds.

A plan holder can have both an IPP and and RRSP, but usually not in the same tax year. Contributions to an IPP (or any DB plan) creates a Pension Adjustment (PA) which reduces the amount eligible for RRSP contribution room. The calculation of PA is complex and beyond the scope of this discussion.

A plan holder can retire as early as age 55 and as late as age 69. At retirement, the money in the Pension Trust can either remain in the Trust and withdrawn as needed, transferred to a LIRA (if prior to age 69), transferred to a RRIF, or the assets can be used to purchase a life annuity.

If a large contribution to an IPP is required and the company does not have the cash flow to do so, there are opportunities to delay the contribution or opportunities to borrow the funds to make the contribution.

If a plan holder dies, the plan assets rollover tax-exempt to a spouse. This means the benefit of the remaining funds can pass to the surviving spouse. Where children are also employees of the corporation and members of the IPP, taxable distributions of the balance in the IPP can be deferred even longer. If there is no surviving spouse or the children cannot receive the funds on a deferred basis, the plan is normally wound up and the remaining funds becomes taxable to the estate. If the IPP no longer makes sense to continue, the plan can be de-registered and the assets transferred to a locked-in RRSP account (LIRA). In this case, any plan surplus is taxable to the corporation or the plan holder. 

A Pension Trust is one of the most creditor proof vehicles available in Canada. This offers more security than say RRSP's not administered by life insurance companies.

At approximately age 45, the amounts that can be set aside in an IPP exceed those that can be put in an RRSP. Each IPP contribution calculation is unique and case specific. Generally, it is not uncommon to see situations where an IPP was implemented beginning in say 2001 and then finding the 2003 IPP contribution at age 45 to be approximately $17,500 and a 2003 IPP contribution at age 55 to be approximately $21,200. These amounts exceed those available in an RRSP.

In addition to potentially higher annual contributions compared to an RRSP, when setting up an IPP program, a plan holder has the option to implement the pension retroactively and make a Past Service Contribution. Generally, a plan is set up retroactively to 1991 (date of major pension reform), the RRSP deposits made since 1991 are transferred to the Pension Trust, then an actuary calculates the Past Service Contribution necessary to properly fund the Plan. Past Service Contributions vary and are case specific, but in general is it not uncommon to see $30,000 to $90,000 in deficits that need to be funded. This means the company can make this lump sum payment and deduct the amount from income.

Costs

There are usually three main advisors, the accountant who provides tax advice, the actuary who calculates contribution amounts, and the financial advisor that administers the investments. The market rate for actuarial services is approximately $3,750 to set up the plan, $600 for the annual filing, and $1,800 for the plan review every 3 years. Possibilities exist to have a financial advisor and actuary work together to reduce these costs. Some of these arrangements result in flat yearly fees of $500 with the advisors sharing the investment commissions earned on investing the Plan assets. 

Tax Planning Opportunities  

A typical IPP candidate is as follows:

1. at least 40 - 45 years old. Exceptions exist for candidates younger than this when their RRSP portfolio value has been decimated and is not expected to recover. In this case, an IPP at an earlier age may make sense.

2. has steady employment income of over $75,000.

3. has already maximized RRSP's.

4. is an owner-manager of an incorporated business or a professional in a professional corporation.

5. is a key person with influence in corporate governance.

Situations where IPP makes sense include:

1. the corporation has lots of cash to fund past service contributions and annual contributions.

2. the owner-manager wants certainty of retirement funds.

3. salary income of an owner-manager or key employee is high.

4. large bonuses are paid each year to bring corporate income to the small business rate. Click HERE for more discussion. Bonuses can be reduced by the pension contributions.

5. a corporation wants to keep key employees from leaving (golden handcuffs).

6. a key person is concerned with the security of employment (golden parachute).

7. an owner-manager wants to sell or wind down the company and needs to extract value from the company to make the price more attractive to the purchaser.

8. RRSP portfolio value is decimated and is not expected to recover.

Pro's

1. Income earned in the Plan is tax-deferred until withdrawn and may therefore grow more quickly than the investments in an EPSP.

2. Better creditor protection than most RRSP's.

3. Ability to make larger tax-deductible annual contributions than RRSP's.

4. Ability to make large tax-deductible lump sum payments for past service contributions.

5. Employer paid interest on borrowed funds to make the IPP contribution and IPP fees are tax-deductible.

6. More security in client knowing exactly how much retirement benefits they will receive. Investment risk is on the corporation funding the IPP.

7. Can recover from a decimated RRSP portfolio

8. Bear investment environment can erode the value of an RRSP and make an IPP more attractive.

Con's

1. Administrative costs are high especially if the investment advisor and actuary do not offer flat fees.

2. Bullish investment environment could result in RRSP's being more attractive than IPP's. 

3. More complex and clients may not understand what is going on. RRSP's are very simple to understand, administer and keep track of it's value. 

4. Fixed rate of return set by the government of 7.5% in the plan could result in a plan surplus in a bullish market. May result in reduced pension contributions or eliminate pension contributions altogether in some years.

5. An IPP is like any DB Plan. There are very strict rules in order for a plan to remain registered with the government. Plans that violate the rules can be deregistered. Deregistered plans result in non-deductible contributions and Plan income becoming taxable.

6. If the employer-company is sold or key employee participant is terminated and an unfunded IPP liability exists, there may be concerns on collecting on that liability.

7. Unlike RRSP's, there is no opportunity to income split by making spousal contributions. 

8. Unlike EPSP's, IPP's and DPSP's result in Pension Adjustments which limits how much RRSP's can be purchased.

9. IPP's, DPSP's and RRSP's have strict upper limits on contributions whereas EPSP's do not.

10. For people under age 45, RRSP contributions will most likely be higher than IPP contribution.

Careful planning with a Chartered Accountant is warranted. Contact Keith Anderson CA at (780) 447-5830 if you need advice. 

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