Section 8517: A blunt instrument
When a plan member terminates from a DB pension plan and transfers her pension assets to a personal RRSP, a DC plan or a RRIF, the amount she can transfer is limited by annuity factors set out in Section 8517 of the Income Tax Regulations. The federal Department of Finance’s objective is to prevent DB plan members from receiving pensions that exceed the DB limit by transferring their benefits to RRSPs and deferring receipt of pension income.
However, in today’s low-interest environment, these annuity factors, loosely based on the “Factor of Nine”(see below), are much lower than annuity factors used to determine commuted values under the Canadian Institute of Actuaries’(CIA)standards. The annuity factors prescribed in Section 8517 may have been appropriate when bond yields were 11% to 12%, but they are nothing close to reasonable today, when long-term Canadian bond yields are in the 4.0% to 4.5% range. As a result, the maximum transfer value under Section 8517 will often be considerably lower than a CIA-commuted value. The difference must be paid out to the plan member as a taxable lump sum.
The table at the top of page 32 shows the taxable lump sum distribution for a member of a 1% plan, with average earnings of $50,000 and 25 years of service, who terminates entitled to a non-indexed 60% joint-and-survivor pension payable at age 55.
While Section 8517 was intended to prevent opportunistic income deferral by high-income earners, the reality is that it is a blunt instrument that unfairly targets large numbers of pension plan members with relatively modest incomes. As the table demonstrates, a plan member earning $50,000 and entitled to an indexed $12,500 annual pension could be taxed on $137,500 immediately. This doesn’t make any sense.
For a plan member who elects to take a commuted value and receives a portion of his pension assets in cash, Section 8517 effectively eliminates all hope of obtaining the retirement income that would have been available in the DB pension plan. Only a talented investor willing to take on significant volatility risk could hope to reproduce the same income stream with the amount remaining after the 8517 limit is applied.
As such, we believe that Section 8517 should be repealed. Here’s why.
• It imposes a heavy tax burden on individuals of modest income;
• It violates the principle of equal access to retirement savings;
• It is inequitable to plan members who want to sever their connections with a pension plan or a former employer;
• It interferes with pension benefit portability in an increasingly mobile labour market; and
• It is inconsistent with the policy goal of the Regulations to reduce dependence on publicly funded income support programs by facilitating private retirement savings.
While preventing abusive income deferral may well be a valid policy objective, Section 8517 is overkill because every pension plan member is already subject to hard retirement savings limits. Eliminating Section 8517 will allow DB plan members to defer receipt of pension income a bit longer, but this doesn’t mean that the government will collect less tax in the end. Funds sheltered in an RRSP must start to be paid out at age 71. When this happens, retirement income increased by sheltered investment earnings will generate increased tax revenue for the government.
If the Department of Finance remains concerned about deferral by high-income earners, a compromise approach would be to maintain the Section 8517 limit for “specified individuals”—those who earn more than two and a half times the Year’s Maximum Pensionable Earnings or who are connected with a sponsoring employer. While still not ideal, this approach would be fairer to the majority of pension plan members and a whole lot better than the status quo.
Section 147.2(2): More funding needed for a rainy day
Employer contributions to a DB pension plan can continue until there is an “excess surplus,” defined in the ITA as surplus that exceeds the greater of twice the employer’s annual current service cost(up to 20% of the employer’s liabilities)and 10% of the employer’s actuarial liabilities. For most pension plans, the 10% limit applies because it is usually greater than twice the employer’s normal cost.
Most pension experts agree that the 10% funding buffer isn’t enough to ensure reasonable benefit security. Pension plan-funded ratios can be volatile. With routine variations in investment return and bond yields, we can expect a typical plan’s funded ratio to change by more than 10% roughly one year in three. And when the change is down instead of up, it’s definitely a rainy day.
A reasonable surplus margin would ensure that, most of the time, funding volatility won’t result in a pension plan being underfunded. To establish an appropriate margin, you need to look at the real-world fluctuations that would be expected over a typical three-year valuation cycle.
As the table at the bottom of page 32 demonstrates, there is a 25% likelihood that a 10% actuarial surplus in a plan valued on a going-concern basis and with assets smoothed will evaporate over any three-year valuation cycle. If a plan’s assets are valued on a market basis, the likelihood is higher—33%. It’s clear that whether a plan’s assets are valued on a smoothed or on a market basis, 10% is not a sufficient margin to prevent a plan from going into deficit on a regular basis.
If a 10% margin is not enough, what is the right level of funding security? Pension plan members will say that a higher margin is better, because they like funding security. Questions of surplus ownership aside, employers would also appreciate more funding room. A larger funding buffer can make pension contributions more predictable by reducing the need to increase pension contributions when there is an economic downturn or market correction—exactly when many employers are looking to reduce costs.
Because pension funds are sheltered from tax, policy-makers have always sought to limit pension contributions to the amounts necessary to provide pension benefits. This is a legitimate policy objective, and it’s the rationale for the 10% surplus rule. But it’s worth noting that in 2003, the Department of Finance introduced new rules (Subsection 8516(4)of the Regulations) to permit contributions to a “jointly sponsored” pension plan until the plan’s funded ratio reaches 25%. We believe that a 25% margin would also be appropriate for employer-sponsored plans.
While the Department of Finance might reasonably object to a funding margin that insures against a one-in-100 event, it should not object to insurance against a one-in-20 event. A 25% margin would provide for better(but not perfect) benefit security. For a plan funded to the limit with assets marked to market, a 25% margin would reduce the chance of a deficit over any three-year valuation from one-in-three to one-in-20. In other words, with the current 10% limit, benefit security can be potentially at risk 33% of the time throughout an employee’s period of membership. With a 25% limit, benefit security would be at risk only 5% of the time.
Of course, the fly in the ointment is surplus ownership. Employers will have a strong disincentive to fund more than minimally as long as there is a risk of surplus distribution to members from an ongoing pension plan(i.e., on partial windup). There are, therefore, two changes that must be made to help ensure pension benefit funding security: allow a sufficient funding margin by increasing the 10% surplus limit and amend provincial rules to eliminate surplus distributions on partial windup.
Employers would be even more willing to fund for a larger surplus margin if they had control of surplus on full windup, and it would be welcome indeed to see regulators develop surplus ownership rules that reflect the assumption of funding risk. But even eliminating surplus distribution on partial windup will help reduce disincentives to fund more than minimally—partial windups are unpredictable events that happen during the course of regular business operations as a result of sales, divestitures and reorganizations, whereas the timing of a full windup is often within an employer’s control.
Taking action
We’ve advocated for two tax policy changes that will improve tax fairness and retirement income security for former members of DB plans and reduce risks to benefit security caused by underfunding. The good news is that both changes could be made with a minimum of technical amendments. Since Section 8517 is a stand-alone provision, it can be repealed while leaving the remainder of the Regulations fully intact. Similarly, it would be a relatively simple matter to amend 147.2(2)of the ITA to provide for a 25% funding margin for all DB plans.
As Canada’s workforce ages, retirement income sufficiency and security are increasing concerns for employers, employees and governments. Implementing our proposed changes will generate improved tax fairness, higher retirement incomes for former DB plan members and greater pension benefit security—all with no net cost to the treasury. Who could ask for more?
The Factor of Nine More than 17 years ago, new provisions in the Income Tax Act and Regulations replaced Revenue Canada’s administrative rules for pension plans. Along with significant complexity, the government introduced the “Factor of Nine” to equalize access to tax-deferred retirement savings. The Factor of Nine is used to calculate a defined benefit(DB)plan member’s annual pension adjustment, which is subtracted from his annual RRS P contribution limit. The Factor of Nine assumes that it costs $9 in pension contributions to buy a lifetime annual pension of $1. Effectively, each $1 of annual pension earned in the DB plan reduces the plan member’s RRS P maximum dollar limit by $9, regardless of the plan member’s age, interest rates or the form in which a pension is paid. Real-world annuity factors, on the other hand, vary substantially, so the Factor of Nine frequently overstates or understates DB pension plan benefits, as the following table demonstrates. |
James Pierlot is a lawyer and Steve Bonnar is a principal with Towers Perrin in Toronto. james.pierlot@towersperrin.com; steve.bonnar@towersperrin.com;
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