Commuting a registered pension plan

The why, when and how to your decision

Whether you are headed into retirement or changing jobs at an earlier stage of your life, one of the largest financial decisions you face when you leave an employer is what to do with your retirement savings.

If you have been saving in your own registered retirement savings plan (RRSP), there’s not much more to say as it already belongs to you. Even when it is a group RRSP arranged through your workplace, generally the accumulated amount is yours to keep, though you’ll likely have to transfer to other investment choices.

If instead your work has a registered pension plan (RPP), there’s more involved.

Distinguishing registered pension plan types

You may be allowed to stay in your employer’s RPP, move to a new employer’s plan, or transfer into a locked-in retirement account. Depending on the type of RPP, that last option can be relatively straightforward, or it can be a multi-part process to arrive at the pension value, including potential immediate tax fallout.

Pensions come in two main varieties: defined contribution (DC) plans and defined benefit (DB) plans. Some plans are hybrid arrangements that have elements of both.

Defined contribution plans

Under a DC plan (also called a ‘money purchase plan’), the employer’s obligation is the amount to be contributed.

The employer as the pension sponsor must contribute a certain amount to the plan each year. Sometimes there may also be employee contributions. You will be able to choose among the investment options within the plan, with all income and growth tax-sheltered. The accumulated value is what is available to provide your retirement pension, which by default is paid as an annual annuity.

If you leave prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account, where your investments may continue to grow tax-sheltered. The main feature of being ‘locked-in’ is that there is a maximum amount you can draw from it each year, which is intended to limit depletion so that it is sustainable through your retirement years.

Defined benefit plans

By contrast, under a DB plan the employer’s obligation is the pension benefit to be paid in future.

The employer must provide a retirement pension as determined by a formula. An actuary calculates the employer’s required contributions, based on the number of plan members and their respective rights. Those contribution amounts are adjusted from time to time according to past investment experience and future economic expectations.

You will be entitled to a retirement pension according to a formula in the plan (more on that below). If you leave before retirement and want to take your funds with you, once again an actuary is needed to determine the value. That’s where the complications really set in.

The remainder of this article focuses on commutation of a DB plan, first in terms of valuation and tax effects, and then on to how to approach this decision based on your particular needs.

Between you & your employer: Gross commuted value

A DB plan annual retirement pension is determined by multiplying a base income times a credit rate times years of employment. The base income and credit rate are negotiated between employer and employees. The base could be (for example) the average of your last five years of employment income, or better yet your best three years’ income. The credit rate generally ranges from 1% to 2% per year of employment.

If you leave prior to retirement, an actuary has to determine the value of your entitlement in the accumulating pension fund. On the face of it, it’s that annual pension discussed above multiplied by a present value (PV) factor. The PV factor is essentially an interest rate, but one requiring numerous inputs to derive, the main ones being current age, assumed commencement date (less any reduction for starting early), continuation provisions (e.g., to spouse), any guarantee period and any annual indexation.

The result is the lump sum current amount that would be required to pay the projected annual pension to you over your expected lifetime. For the sake of the calculation, it is assumed that the lump sum will be invested at long-term interest rates. Accordingly, commuted values tend to be higher when prevailing interest rates are low, and lower when interest rates are high.

Between you & the CRA: Maximum tax-free transfer to a locked-in plan

The commuted value from the actuary’s report should not be confused with the amount that can be transferred into a locked-in retirement account.

In structure, the tax rule is similar to the commuted value calculation above. In tax terms, it multiplies your “lifetime retirement benefits” by a PV factor. In this case though, the PV factor is less generous than the commuted-value PV factor outlined above. For example, it doesn’t account for any indexing or early retirement benefits. As a result, the tax transfer value is often less than the commuted pension value. In a sense (though not literally), you might think of the tax calculation as what you would have accumulated under the RRSP rules, and therefore that’s the amount that you are allowed to transfer into a locked-in retirement account.

The excess amount will be taxable in the current year. While this is obviously not a pleasant prospect, it is applying tax to the more generous terms of the DB RPP, but you still get to keep the after-tax amount. The impact of this may be deferred if you have unused RRSP contribution room and choose to make a corresponding contribution.

Considerations before deciding to commute

Apart from the value of the commuted plan and tax transfer, here are some surrounding issues to review before committing to a course of action:

1. Investment of the commuted value may ultimately deliver a larger retirement income, but this should be balanced against downside investment risk. Some people like to make investment decisions, while others shy away. A conversation with your financial advisor can help you decide.
2. Are you comfortable leaving behind indexing and guarantees that may have been part of the original pension?
3. Do you want to be able to adjust income from year to year, or ever make a lump-sum withdrawal? As locked-in plans put a cap on annual withdrawals, a commuted pension may be needed for this kind of flexibility.
4. Some pension plans allow continued health and dental coverage (at least for some period of time), which can relieve your budgetary costs in retirement.
5. On the other hand, if you have health concerns that may affect your life expectancy, you may prefer to take the commuted pension as a sure thing to be able to pass on the remaining value to your beneficiaries, especially if you have no spouse.
6. Spousal pension income splitting is available under age 65 from a registered pension plan, but generally only from age 65 for an individual life income fund. Does this affect your income plans?
7. Beyond a spouse, you may wish to leave a legacy to family or charity. Managing a commuted pension amount may provide an avenue for that kind of planning.

IPP suitability scorecard – Business owners and professionals

Expanded retirement tax-sheltering using defined benefit pension rules

Registered Retirement Savings Plan (RRSP) contribution room is calculated based on a percentage of an employee’s annual income. Comparatively, a defined benefit registered pension plan (your own RPP) combines income with actuarial factors such as an individual’s age and the plan’s features to open the way toward significantly larger tax-deductible deposits.

Qualified business owners and incorporated professionals may establish a plan for one person, or up to three pension members – including spouse and family employees.

Check the boxes here to see if it is suitable for you:

❏ Is the business owned by and run through a corporation? Or if it is a professional practice, is it operated through a corporation?

❏ Does the owner draw annual income of at least $70,000 to $100,000, either as employment income alone, or combined with dividends?

❏ Is the business owner or professional at least 38 years of age, but no older than age 72?

❏ Has the owner maximized RRSP contributions, but is still seeking more CRA-approved tax-sheltering opportunities?

❏ Is there surplus corporate cash that is exposed to the punitive corporate tax rates on passive income?

If you have at least three checks so far, then this could be your route to expanded tax-sheltered savings, and here’s more to consider.

❏ Would it be appealing to increase the amount for annual spousal income splitting, and make it available before age 65?

❏ Are there any concerns that business creditors may get access to corporate assets meant to fund the owner’s retirement?

❏ Are there family employees for whom the owner would like to arrange a tax-deferred estate transfer, bypassing creditors and probate?

❏ Is there an anticipated or pending business sale where excess assets may threaten the owner’s claim to the lifetime capital gains exemption?

❏ If planning to retire abroad, would the owner like allow for greater tax-deferral by limiting emigration tax on deemed dispositions?

The ideal candidate for this kind of retirement pension will have at least six checks.

To learn more about how this can work for you, see the article IPPs – Individual pension plans.

IPPs – Individual pension plans

A business owner’s option for retirement savings

As a successful business owner, you likely maximize your annual registered retirement savings plan (RRSP) contributions and still have more to invest. So, is there is a way for you to make even more use of tax-sheltered retirement savings tools?

As it turns out, the Income Tax Act allows you, as the owner of a corporation, to set up an individual pension plan (IPP) for yourself as an employee of the business. By doing so, your corporation will be able to make larger tax-deductible contributions than available under RRSP rules, which in turn means larger deposits into retirement tax-sheltering for you as an employee.

Larger contributions with an IPP

Every worker is entitled to RRSP contribution room based on 18% of the previous year’s earned income. There is a dollar limit to that, which is indexed from year to year. The 2024 limit is $31,560, reached at 2023 income of $175,333. Any RRSP room not used in a year can be carried forward to make contributions in future years.

Unlike this direct calculation of RRSP contribution room, an IPP is a ‘defined benefit’ arrangement where the amount to be contributed is based on the benefit that will be required to be paid out of it. For both RRSPs and IPPs, investment growth is tax-sheltered while in the plan, with tax being deferred until payments come out to the annuitant/pensioner.

An actuarial calculation is required to make the IPP contribution determination, based on factors such as the employee/pensioner’s age, past employment income and projected future employment income, and the amount and terms of the eventual pension to be paid. Up until about the age of 40, RRSP rules provide more contribution room, but an IPP allows increasingly greater room as you move beyond that age.

Additional administration

An individual RRSP can be set up with fairly simple administration and low cost. An IPP has more complexity and higher cost, but for qualified candidates this is more than compensated by the added flexibility the IPP provides for retirement savings. As well, all fees involved in arranging an IPP are deductible to the employer corporation.

As a conscientious business owner, you will want to do a cost-benefit analysis with your investment advisor and tax professional. With larger start-up and periodic maintenance costs, an IPP will likely only come into consideration for those at higher income levels, generally at least $100,000. Still, sometimes it may be desirable to establish one while at a lower income level, in anticipation of moving up in income as the business builds.

A trustee must be appointed to manage the IPP under a formal pension agreement, and tax filings are more involved than for RRSPs. An actuarial report must be prepared when the IPP is established and triennially (every three years) thereafter, and provincial pension reporting may be required.

Provincial Developments

Pension rules protect pensioners from potential mismanagement of funds by employer-sponsors. Given the connection between pensioner and employer in an IPP, some provinces allow IPPs to opt out of pension rules, exempting the employer from mandatory contributions, and reducing reporting obligations and associated fees.

Provinces currently allowing opt-out are British Columbia, Alberta, Manitoba, Ontario and Quebec.

IPPs that have opted out of provincial oversight still employ actuarial rules to determine the maximum amount of contributions that may be made to a plan. All IPPs must be registered with the Canada Revenue Agency, and must fulfill annual tax reporting obligations.

Source and timing of contributions

On startup of the IPP, it is possible to fund past employment service as far back as 1991. The allowed amount is calculated by an actuary, then funded by:

1. Transferring-in existing RRSP holdings;
2. Making a deductible employee/personal contribution up to the amount of unused RRSP room; and,
3. Making a deductible employer contribution for the remainder.

Ongoing, annual employer contributions by your corporation are also deductible. There is no income inclusion or tax benefit reported by the employee in the year those employer contributions are made.

The triennial actuarial test may reveal at some point that more has accumulated in the plan than is necessary for it to meet its pension obligation, based on the continuing contribution schedule. This would usually be a result of investment returns exceeding earlier expectations. When there is such a surplus, the employer/corporation’s funding will be temporarily reduced or suspended until things are back in line.

On the other hand, if the triennial test indicates a shortfall then the employer/corporation may be required to make further contributions. This built-in top-up feature allows an IPP to be replenished if investments underperform expectations, something that is not available under RRSP rules.

Per the information in the callout box on the first page, for an IPP that has opted out of provincial pension oversight the employer is exempt from mandatory annual contributions. For such plans, unused contribution room in a year may be carried forward to be used in future years at the discretion of the IPP trustee.

For all IPPs, the employer may be able to make a final deductible contribution before the pension begins if the actual conditions at that time differ from the assumptions used to fund the plan. This is called terminal funding.

Allowable investments

An IPP can usually invest in the same types of investments allowed for RRSPs. The rules are a little more restrictive, however, in that no more than 10% of the assets may be in any one security. This restriction does not normally apply to pooled investments like mutual funds, which themselves hold a basket of securities.

Pension payout time

There are three options on retirement:

1. Take the pension pursuant to the terms in the pension agreement;
2. Use the accumulated value in the IPP to purchase an annuity from an insurance company; or,
3. Commute the value to make a tax-free transfer into a locked-in retirement income fund. Often the commuted value will exceed the tax-free transfer limit, owing to the generous IPP contribution rules. The excess is taxable, but there are no restrictions on the pensioner’s use of the net amount after the tax is paid.

As a final point, IPPs may be entitled to greater creditor protection compared to RRSPs, though this may not be the case if the IPP has opted out of provincial pension supervision. This may be an important issue for an entrepreneur looking to balance business and personal financial risk.