Jana Steele is a pension partner at Osler Hoskin & Harcourt LLP. Jill Wagman is an actuary and managing principal at Eckler Ltd.
Part of the social contract of living in a country such as Canada involves the payment of personal income taxes – fairly high income taxes, in some cases – in exchange for health care, schools, infrastructure and social services. As we all know, the tax system is complex; it sets out, at a high level, what deductions can be made or credits taken. The credits we take and deductions ultimately reduce our overall taxes payable.
One important income tax deduction relates to pensions or other registered retirement vehicles. However, under the tax regime, the current system can provide more income tax sheltering to individuals in one type of retirement vehicle. To understand the issue, it's necessary to understand the two primary types of retirement savings vehicles and the applicable tax regime.
First, there are defined-contribution (DC) pension plans or group or individual RRSP savings plans. These plans are essentially a pot of money that is set aside in an account and invested for retirement. At retirement, whatever money is saved in the account is used to provide retirement income. For tax purposes, there are limits on the amount of contributions that may be made, and deducted from income, each year by or on behalf of an individual to his or her DC or RRSP account (essentially, the lesser of 18 per cent of an individual's income and a dollar limit, which for RRSPs for 2015 is $24,930).
The money put into an RRSP or DC account can generally be invested in products such as stocks, bonds or mutual funds or kept in cash. If the market crashes and the individual loses half of his or her savings, that's too bad – the individual will just have less money saved for retirement. Or, after retirement, if the individual has not purchased annuities or otherwise immunized his or her account, if there is a market crash, the individual's retirement savings and income will be affected.
On the other hand, there are defined-benefit (DB) pension plans. These plans provide participants with a fixed income for life based on a formula, irrespective of how the market performs. DB plans also have the benefit of risk pooling. For example, investments are pooled, generally professionally managed and often subject to lower fees. Furthermore, longevity is pooled, so that an individual does not have to guess how long he or she may live and how much must be saved for his or her retirement. In a DB plan, the benefit is paid for life – some members may live longer than others, with the ones who die early subsidizing the ones who live longer.
DB plans are also subject to better tax treatment, from the participant's perspective. The tax rules essentially permit whatever contributions are necessary to fund the pension under the plan (subject to certain limits). Under these rules, those who are fortunate enough to participate in a generous DB plan (such as many public-sector workers, teachers and municipal employees) can effectively accumulate more retirement savings than their friends in DC or RRSP plans. And, because of how DB plans operate, participants in these plans are also generally protected from market downturns. (The employer ends up having to contribute more money to pay for the benefits under such plans.)
There is a formula under the tax rules to determine the "value" of a DB pension each year. The value attributed to generous DB plans is significantly less than what it should be in today's economic environment. The tax rules operate such that for older workers (40 and older), the tax value of the sheltered benefit in a DB plan can be significantly greater than the maximum an individual can contribute to an RRSP or DC plan. Depending on the plan terms and member's age, the value of the DB member's pension earned in a year could be twice that of the amount the DC or RRSP participant is able to save on a tax-preferred basis.
Here's a simple example. If Nazim, 55, with a salary of $120,000, has worked for 20 years at a public-sector organization that provides a 2-per-cent final average salary indexed DB pension plan, he would have earned a lifetime pension worth somewhere between $1-million and $1.5-million in today's economic environment.
Contrast Nazim with Jennifer, also 55, self-employed with that same salary of $120,000. Jennifer has contributed the maximum allowed into her RRSP each year for the past 20 years. Assuming she was able to earn 6 per cent a year on her contributions, she'd have accumulated just under $600,000 to provide for her retirement – about half of what Nazim has earned.
Not only do DB plan members have an advantage because the effect of any market crashes are overcome by additional contributions made by the sponsor, they also can effectively tax-shelter more income because the assigned "value" of the DB accrual is understated in today's economic environment.
This tax treatment is inequitable. The tax regime should be amended so that there is equity in the system between DB and DC/RRSP plan members and how much may be tax sheltered. Different employers and work forces may demand different retirement savings vehicles and there is not a right or wrong – for some, such as those where there is significant employee mobility, DC may be the better choice. For others, DB may be preferable. However, the tax system shouldn't provide a more favourable tax treatment to one retirement vehicle over another.
DC/RRSP contributors need additional tax-sheltered room to save more if they are expected to have adequate incomes at retirement. Now that we have a new government that's beginning to consider important pension matters, let's add this issue to the agenda.