A decade has passed since the government introduced tax-free savings accounts (TFSAs), giving Canadians a “tax-free” option to save, along with the existing “tax-deferred” registered retirement savings plan (RRSP). TFSAs are popular among all Canadians, but they are particularly suited to modest- and low-income earners.
The same option could – and should – be provided to workplace pension plans. Just as some of us are better off saving in a TFSA rather than an RRSP, some workers (and employers) would be better off with a “tax-free” pension plan than a traditional “registered” workplace plan.
A paper I wrote, released Tuesday by the National Institute on Ageing at Ryerson University and the National Pension Hub with the Global Risk Institute, advocates for the creation of workplace tax-free pension plans (TFPPs) as a tax-free option that would give Canadians another way to save for retirement.
Value of workplace plans
Workplace pension plans are an effective way to save for retirement, thanks to features such as automatic savings, employer contributions, substantial fee reductions via economies of scale, potentially higher risk-adjusted investment returns, and possible pooling of longevity and other risks. They help protect the retirement income security of Canadians while also limiting reliance on publicly funded seniors’ programs – which may relieve some of the inevitable burdens that Canada will face, as our proportion of seniors to workers more than doubles between 2010 and 2060.
And there are more than just financial gains. The financial security provided by workplace plans can enhance the mental health of Canada’s seniors, as well as their family and friends. A 2017 report by OMERS found that its pension plan has helped reduce financial stress, improving members’ outlook and sense of well-being.
Despite the clear advantages of workplace plans, the dynamics of income taxes and government social benefits for seniors lead to unclear and inconsistent financial rewards across Canadians.
That’s because workplace registered pension plans parallel RRSPs in terms of their income tax treatment and calculation of seniors’ social benefits. Contributions are tax-deductible and investments increase tax-free while they remain in the plan – but money is taxed as ordinary income when withdrawn and the tax deferrals are generally much more valuable to higher earners.
On the other hand, Canadians with modest incomes can face financial penalties, rather than incentives, within the current system. Like money coming from an RRSP, pension plan payments count as income and therefore reduce benefits from the guaranteed income supplement (GIS), as well as other provincial subsidies for seniors. Canadians with lower annual income end up paying an effective tax rate of 50 per cent or more on each dollar of workplace pension income they receive. These sub-par – or even negative – financial incentives are the main reason that modest-income Canadians are advised to save in TFSAs rather than RRSPs.
How TFPPs would work
These challenges could be avoided if, like TFSAs, there was an option to offer workplace pension plans in a “tax-free savings” environment, with after-tax contributions during working years and pensions that don’t count as income after retirement.
By replacing the existing tax deferral with “prepaid taxes” on contributions, workplace TFPPs would complement existing registered pension plans, removing the current disincentives for lower and middle-income earners.
As with TFSAs, contributions to TFPPs would be made using after-tax dollars and, therefore, would not receive a tax deduction. Once the money is in the plan, however, it would grow tax-free, and withdrawals would not be taxed or added to taxable income. Since it wouldn’t count as income, pension income from TFPPs would not be considered when determining eligibility for federal or provincial income-tested benefits, credits and subsidies.
All Canadians benefit from TFSAs, but TFSAs are generally more effective savings tools than RRSPs for younger Canadians and those with modest annual income. The same would be true for TFPPs compared with current workplace pension plans. In a nutshell, TFPPs could do for workplace pensions what TFSAs did for individual savings, helping those who need it the most.
By improving the menu of options – and offering better value to both workers and plan sponsors – TFPPs would open the door for more Canadians to benefit from the substantial advantages of workplace pension plans and, ideally, achieve a more financially secure retirement.
Bonnie-Jeanne MacDonald is the director of financial security research at the National Institute on Ageing (NIA) at Ryerson University, fellow of the Society of Actuaries, associate of the Canadian Institute of Actuaries and resident scholar at Eckler Ltd.