A Group Pension Fix?

Jack Mintz's writes in the National Post, A group pension fix:

Governments are searching for new measures to help Canadians save for their retirement. One proposal among current federal consultations: Amend regulations to allow insurance companies or other providers, including government-sponsored pension plans, an opportunity to effectively provide multi-employer pensions.

Here is an alternative proposal that could have a big impact in helping business provide multi-employer plans at a relatively low cost: Eliminate the current discrimination against group RRSP plans by enabling companies to deduct their employer contributions from the tax base used to determine CPP, EI and other payroll taxes. At present, employer contributions to pension funds are deductible but not in the case of group RRSPs.

Why would this be important? Many companies are abandoning defined benefit plans — pensions with benefits based on years of service and salary levels — in favour of defined contribution plans or group RRSPs, both of whose retirement benefits ultimately depend on the investment experience of the funds held on behalf of the employee. From an employee’s perspective, the defined contribution plan and group RRSPs are similar in that the employee bears investment risk that determines how much wealth is accumulated at retirement.

However, from an employer’s perspective, group RRSPs and defined contribution pension plans are not the same. Since contributions to group RRSPs are not deducted from the payroll tax base, they are less favourable to provide than defined contribution plans. Larger companies will choose to set up defined contribution plans even though they are more costly to administer than group RRSPs. Small businesses have little choice since defined contribution plans are harder to set up for their employees.

Group RRSPs have grown very quickly in the past decade and are now as important as defined contribution pension plans. As an inducement to save for retirement, employers can contribute to a plan, often on a matching basis, thereby strongly encouraging participation. Employees can choose the type of investment on advice given by the provider. If the employee quits the firm, the amounts are transferred to individual-managed RRSPs.

Groups RRSPs can be reasonably inexpensive, especially if the funds are invested in indexed funds, although employees have often chosen to invest in actively managed funds that can be more costly. Current administrative, distribution and advisory costs are about 90 basis points on average, about 30 basis points more than defined contribution plans largely because group RRSPs are typically smaller accounts.

For employees who move from job to job, group RRSPs are much more flexible saving plans compared to defined contribution pension plans. If leaving an employer, defined contribution pension assets are kept in the plan or transferred to other pension assets or locked-in retirement accounts. Locked-in accounts require individuals to hold assets in plans until a certain age when they can be withdrawn but only up to a regulated amount (e.g. 8% of assets). While lock-in arrangements encourage plan holders to use assets only for retirement purposes, the arrangements make estate planning more difficult (for example when someone has a terminal disease) or for contingencies that come up before the age of retirement.

If contributions to group RRSPs became deductible from payroll tax bases, larger firms would likely be more willing to provide them, enabling them to be offered at a low cost. Employees might prefer them since group RRSPs are far more flexible than defined contribution plans in saving money and meeting future needs and contingencies.

Governments would see some decline in payroll tax revenues to the extent that new group RRSP plans are created, as opposed to substituting for current defined contribution pension plans whose contributions are already deducted from the payroll tax base. It could require a slight revision in CPP, EI and worker compensation payroll taxes or benefits to ensure full funding of these plans.

While eliminating the existing discrimination against group RRSPs would help many businesses to provide retirement income benefits for their employees, other policy changes would still be useful to consider.

Several experts have recommended changes to pension regulations to enable insurance companies or pension administrators to set up multi-employer plans that would enable the comingling of assets and allow a sponsor who is not the employer or employee. This would be another change giving employers and employees greater choices while achieving cost efficiencies and more risk pooling in handling their retirement accounts. Even with this form of regulatory change, it would still be quite appropriate to amend tax law to create a level-playing field among different plans.

Also, many employees worry that they could see their accumulated wealth decline when the market turns south, thereby reducing their retirement income. Defined benefit arrangements whereby employees contribute to a fund that provides a more secure retirement income, essentially by deferring their salary to retirement years, may be a preferable arrangement since employees avoid risk as much as possible.

The shift away from defined benefit pension arrangements addressed the risk faced by employers with funding shortfalls when credit becomes scarce, as witnessed with the 2008 downturn. However, as the labour force ages and employees become in short supply, many employees may wish to return to defined benefit plans to retain workers. Policies are needed to ensure that defined benefit arrangements are as viable as alternatives.

Group RRSPs may not be the best vehicle to provide defined benefit arrangements, although it is possible to develop more annuitized income arrangements for employees under these plans. As a supplement to help especially low-income workers, increases in CPP limits on a fully funded basis for existing workers might be needed if markets are unable to achieve alternative defined benefit arrangements.

Whatever reforms are being considered, it is a no-brainer to eliminate the tax discrimination against group RRSPs. It would help many businesses provide reasonable efficient retirement saving plans to their workers, especially small businesses.

Other proposals are coming in to fix the Canadian pension system. Jonathan Chevreau of the National Post reports, Pension Reform for Dummies: 5 simple "no-brainer" proposals:

This morning BMO Financial Group's BMO Retirement Institute released a paper by director of retirement strategies Tina Di Vito [pictured above] outlining five such simple changes. Those who read Tina's paper in the March issue of Policy Options may already be familiar with them. While I've borrowed the ideas from the paper, the exact wording here below is mine. You can find Di Vito's original here.

1.) Remove age restrictions for RRSPs

Currently, RRSPs have to be converted to annuities or RRIFs at age 71, or cashed out with a big tax penalty. This makes little sense in a world where mandatory retirement is a thing of the past. If Ottawa wants us to live longer and save more, it's sending us the wrong message in legislating unnecessary and unwanted RRIF payments that are fully taxable and may trigger OAS clawbacks. I agree with BMO that Canadians should decide when they need to withdraw the money from their RRIFs to live on -- it's inevitable that they will one day need to do so and when they do, the government will get its coveted tax bonanza.

2.) Reduce taxes on RRIF withdrawals

RRIF withdrawals are taxed as if they were interest/salary income even if the growth was derived from some combination of dividends and capital gains. We looked at this topic and Andrew Dunn's suggestion for fixing it in this blog last week. Di Vito is singing from the same song sheet and notes that had such growth been achieved outside registered plans, the income would have received preferred tax treatment and resulted in a lower tax rate. The current tax treatment "skews" investment behaviour in favor of sheltering the highest-taxed but lowest-yielding fixed income investments. At today's low interest rates, such retirees may not even keep up with inflation. The fix is to consider only the original RRSP contributions as "deferred employment income" while the growth in the plan should be taxed at a rate that mimics non-registered investments.

3.) Broaden opportunities for tax-free RRSP/RRIF rollover on death

Ottawa gets a big tax bonanza when a RRIF holder who is the second spouse to die passes away: the plan balance is included as taxable income in the year of the death. BMO suggests a tax-free rollover to the next generation's RRSP or RRIF. This would have huge implications for the much ballyhooed "trillion-dollar " intergenerational transfer of wealth. Of the five proposals this is the one Ottawa may balk at most and I'd think the industry would be content if 1,2, 4 and 5 were adopted at the expense of conceding number 3.

4.) Lower the rate of mandatory RRIF withdrawals

Seniors get understandably upset by the requirement to withdraw -- and be taxed on -- at least 7.38% of a RRIF's balance every year, a percentage that rises to 20% in one's 90s. These requirements were designed during an era of high interest rates but at current rates means retirees are in danger of outliving their money in old age. As medical science advances and longevity rises further, current policy puts those in their 90s at peril. As BMO says, "it is highly unlikely in today's investment world that investment returns will keep pace with the withdrawals" -- especially if invested in fixed income. To point number 2, seniors would have a better shot at it if invested in stocks but current policy motivates them to stay in low-yielding interest-bearing vehicles. BMO suggests Ottawa can extend the lives of RRIFs by lowering the withdrawal rate but doesn't specify what the new lower rate might be. I'd suggest it should be no higher than what 3- or 5-year GICs currently pay.

5.) Increase maximum contribution amounts for RRSPs

This recommendation parallels a similar one by the CD Howe Institute, as mentioned in this blog entry. BMO thinks RRSP contribution limits need to be hiked from the current 18% of earned income and $22,000 maximum to higher (but unspecified) levels. It suggests there be parity with current Defined Benefit pensions, which are able to make plan members whole in the event of investment losses. BMO notes an interesting fact I'd not seen before: that current RRSP rules favor households: a couple each earning $75,000 get combined RRSP room of $27,000 while a single taxpayer earning $150,000 can only contribute $22,000.

This particular paper focuses on just RRSPs and RRIFs but of course further tweaking is possible with the new TFSAs, of which Di Vito is a fervent advocate. We've looked before at Malcolm Hamilton's proposal to make TFSA contribution room retroactive to age 18, or to introduce a lifetime TFSA contribution room that might be some hundreds of thousands of dollars. There are also suggestions that it be made easier to make lump-sum contributions to RRSPs or TFSAs from special lifetime events like inheritance, severance and the sale of certain assets.

In short, the tools to fix a pretty-good system and make it into a world-beating system are all there now: all we need to do is get Ottawa to bring them into the 21st century. BMO's suggestions are a good place to start.

This morning, I appeared before the Senate Standing Committee on Banking, Trade and Commerce. James Pierlot, pension lawyer and consultant also presented his views. After us, the Committee heard from Kevin Milligan and Richard Shillington. The minutes of the proceedings will soon be available here.

James and I agreed on many fronts, except he was touting more the benefits of large multi-employer pension plans, whereas I was arguing more for a universal pension plan (UPP) managed by several large public defined-benefit plans (not just CPP Investment Board) spread throughout the country, and incorporating world leading governance standards.

I enjoyed this meeting but it was too short. The senators asked great questions but I feel like we only scratched the surface here. Hopefully they will invite us back so we can discuss pensions, the financial system and the economy. I thank them for giving me the opportunity to discuss my thoughts on this important issue.