RRSP/RRIF – Page 15 – Doug Carroll

Pension reform, retail retirees and the next advisory business model

This article should be of personal interest to retail retirees, current and future, being those of us who – partially or wholly – employ retail financial advisors to assist with RRSP account investments and their ilk.

It is also a sounding to those retail advisors themselves, because as the momentum of activity toward pension and retirement reform builds, the question for those advisors and their clients may very well become …

“Are you getting RRIF’d off?”

This is what I originally entitled this whole article, being the same name as on a standing presentation I’ve been delivering the last couple of years. While that title may seem a bit inflammatory, it is really just a rolling collection of retirement issues to mull over.

Still, RRIF minimum withdrawals are arguably a quarter century stale, and RPP source income has a 10 year headstart on RRIF income (the age 55/65 controversy) for both the pension income tax credit and pension income splitting. Indeed, a conspiracy theorist might intimate that there is a systemic bias favouring RPP retirees over RRIF retirees.

Whether or not that is actually the case presently, the results of the current review of the pension and retirement system will have large and longstanding implications for retirees – retail or otherwise – and inevitably for retail advisor business models.

Retirement income reform momentum

The most recent step (at time of writing) in the progress toward reform is the March 24 Department of Finance news release formally soliciting input by April 30. Details can be found at www.fin.gc.ca/activty/consult/retirement-eng.asp.

Within those details, there is one especially interesting graph illustrating current estimated income replacement by each pillar of the retirement income system, the three traditional pillars being 1) OAS/GIS, 2) CPP and 3) RRIF/RPP.

The model suggests that at low income levels, a large proportion of pre-retirement income will be replaced in the retirement years, with the dominant source of that retirement income being from pillars 1 and 2. Not surprising, as one’s pre-retirement income moves into higher income brackets, less income is projected to be replaced in retirement and pillar 3 emerges as the primary replacement source.

In that light, consider the three types of reforms that we are most likely to see, whether individually or in combination, as this process unfolds:

1. Government-sponsored, voluntary defined contribution pension plans

Individual contributions would be pooled with other contributors, and managed by a central body, possibly paralleling the CPP Board. While contributions would be voluntary, those committed contributions and related returns would be locked in until retirement, at which time benefits could be paid out using familiar defined contribution payout vehicles, including annuities and transfers to locked-in RRIFs.

A potential feature is auto-enrollment (with an opt-out provision) for those without a workplace pension – a kind of negative billing sign-up for one’s retirement savings.

2. Mandatory, defined benefit pension plans

Essentially this is an augmentation of both premium obligations and benefit entitlements under the CPP. Some proponents have suggested as much as doubling CPP pensions, either by increasing the replacement rate from 25% to 50% (of average earnings up to the Year’s Maximum Pensionable Earnings), or by doubling the YMPE itself while holding the replacement rate constant at 25%.

3. Increased flexibility for private-sector, defined-contribution pension plans and increased opportunities for private savings

The most prominent proposal in this category is the idea of private sector providers offering defined contribution pensions that do not require an employment relationship. This would appeal to the many self-employed, and to others who might prefer a private sector option to the voluntary pooled public plan outlined in option #1.

Also on the table are suggestions to perhaps raise contribution limits on RPPs, RRSPs, and even TFSAs, and modify tax deferral rules for RPP payout commencement, RRSP conversions, and those aforementioned RRIF minimum withdrawal factors.

Will retail retirees and advisors be left behind?

With past and prevailing emphasis on RPP source relative to RRIF source, this question begs to be asked. Even so, I ask it facetiously (with hopefulness), as I expect that the many bright minds devoted to these challenges will yield net benefit to all of us in the end. But the end could years or decades away – What about the meanwhile?

CPP enhancements (doubling or otherwise) imply that less low income people will need to supplement retirement income. For middle income and up, there will similarly be less need, and also less cash available for supplementary investment. Across the income spectrum and spanning the coming years, such a forced belt-tightening could bring clarity, resolve and commitment to ‘living within means’, both before and into retirement.

Come to think of it, that sounds an awful lot like the goals of the government’s current financial literacy initiative, and even more generically like classic financial planning.

Hey – a higher income threshold for those with money to invest, less money in the hands of those people, institution-like competitors for that investment money, and generally a more complex environment to navigate – Where does this leave our retail advisor?

It would be speculation to try to connect such disparate dots into a single coherent picture of the future, but at least two key issues come to mind:

How viable is a generalist approach, particularly one that does not skew to higher income clientele, or is not scaleable to that segment?
Will commission-based business models, whether transactional or asset-based, need to give way to fee-based advice-centered approaches?

It will be interesting to see how both reform and response play out.

Reconsidering minors as direct beneficiaries for RRSPs

When are children ready to be fully in control of their property and finances?

For most parents, the answer would be to employ a gradual process beginning at an early age, extending out to and beyond age of majority.

So, if tragedy struck and the parents were no longer there, how well served would those parental desires be by having named their minor children as direct RRSP beneficiaries?

Minor beneficiaries of registered plans

Provincial laws allow for the naming of beneficiaries on RRSPs, generally enabling the bypass of the deceased’s estate for both probate and estate creditor purposes.

Concurrently, the Income Tax Act (Canada) causes the RRSP value to be included in terminal year income, with deferral in limited circumstances. For present purposes, where a financially dependent minor child is named, these rules require that an annuity be purchased with payments continuing to age 18.

It is this rigid payment schedule that raises serious concerns whether it is in the best interests of parents to enable the child to use the rollover election, or for that matter whether it is in the best interests of the child to exercise that election.

Also bear in mind that, as opposed to life insurance where a trustee can be named to receive proceeds, it is not possible to hold an RRSP in trust. Accordingly, the parent’s death is arguably a divestiture of any continuing legal influence over the RRSP proceeds where a minor is named as direct beneficiary.

Options for succession to registered plans

There are a few ways that RRSP proceeds may be transferred at death:

Direct designation on the RRSP – This is the most common procedure, particularly as between spouses.
Direct designation using the Will or other instrument – This may be necessary if more complex instructions are desired that the plan administrator cannot accommodate.
Naming/allowing estate as beneficiary – The executor may jointly elect rollover to a qualified beneficiary or distribute after-tax proceeds as a legacy or estate residue.
Direct proceeds to a separate RRSP trust – Canada Revenue Agency (CRA) has commented that after-tax proceeds may go to a testamentary trust outside of an estate.

Estate planning factors in benefiting minor beneficiaries

In deciding how to proceed, there are some key tax and estate planning considerations that parents should keep in mind:

Preserving tax sheltering – Significant tax savings may result from initial RRSP rollover to a beneficiary. .But consider too that the terminal return is entitled to low brackets rates (particularly for deaths early in the year), tax credits and liberal loss carryforward rules.

Annuity income at low bracket rates – While registered annuity income is taxable to the minor at presumed low bracket rates, a testamentary trust is an effective tool for ongoing strategic management of graduated bracket rates of both the beneficiary and the trust.

Control post-transfer – Where a minor is the direct RRSP beneficiary, the proceeds are systematically released to the child until fully distributed by age 18.

Avoiding probate – While any probate tax/fee may be avoided, the naming of a direct beneficiary also entails that no testamentary trusts may be established using those funds.

Guardianship – A guardian has the legal duty to provide the child with the necessities of life. Absent permission of the Public Trustee’s office or court intervention, the child’s own assets, including annuity income, cannot be used for this purpose.

Custodianship – A custodian may legally control a minor’s assets. However, the custodian is a fiduciary with very high priority for safety of capital. If more diversified investments are desired, it may require approval and monitoring by the Public Trustee.

Migration to non-registered assets – For investment of after-tax annuity income, it is likely that financial institutions would limit it to low-risk interest options, as minors cannot legally contract. Similarly, the minor’s custodian would have to be very conservative. By comparison, a trustee can be given discretion to engineer preferred and deferred taxation using dividends and capital gains.

The use of trusts generally – A deceased parent can draft trust terms to allow access during minority, delay distribution beyond majority, pay expenses otherwise falling upon a guardian, and give wide investment discretion. Compared to custodian and guardian roles, a trustee is also a fiduciary, but far less fettered by government agencies or courts.

Testamentary trust taxation – Testamentary trusts have many useful tax characteristics, including initial year-end selection, graduated tax brackets (including coordination with beneficiary brackets), and ability to roll-out assets at adjusted cost base.

Obtaining the annuity

As a final note, here are some issues to consider with respect to purchasing the annuity.

Release from deceased’s RRSP – The plan administrator may await the appointment of a custodian or pay the proceeds into court, given that a minor cannot sign a binding release.

Proof of claim – The plan administrator may request a notarial copy of the Will, or possibly a probated Will, in order to confirm there is no superseding designation.

Available issuers – A registered annuity is generally obtained from an insurance company licensed for annuities, this type being a term certain annuity until the minor reaches 18.

Short-term annuities – For beneficiaries age 17 (and possibly age 16 or even 15 if there are significant delays), it may be a challenge finding an issuer to provide a term certain annuity spanning less than a year.

Rate of return – The pricing of a term certain annuity is based on the prevailing interest environment at time of purchase. Accordingly, the benefits of the rollover and year-to-year taxation to a low bracket minor may be somewhat blunted by presumed lower investment return inherent in the purchase price, especially for short annuity durations.

Yes Advisor, there is an RRSP season

It’s a decades-old debate: Should an advisor treat the first 60 days of the year as RRSP season?

From a technical perspective, investors are effectively timing the market by contributing strictly in the first 60 days. This could work for or against them, but it’s a risky proposition to skew the deposit timeframe to such a limited window.

From a tax perspective, many people are motivated by creating a tax refund. Of course, this is really an interest-free loan to the government, though of relatively short duration if one contributes as late as possible and files the tax return as soon as possible.

Finally, from a marketing and administrative perspective, many advisors extol the virtues of monthly PAC programs over the one-time hit. Combine that with reducing tax at source with CRA Form T1213, and there is a case to be made (with numbers behind it) that one can accumulate more by ignoring the first 60 days allure.

Still, the reality is that industry advertising ramps up – and therefore clients’ ears perk up – as March 1 approaches. In addition, many annual bonuses are paid after year-end, often near the end of February, so advisors who ignore such events may be doing so at their peril.

Thus whether we like it or not, there will always be those who, by choice or circumstance, focus their registered investment efforts on those first 60 days.

The TFSA era

While not specifically directed toward retirement, the tax-free savings account can be coordinated with the traditional RRSP to optimize savings.

No doubt clients have asked you whether they should be contributing towards RRSP or TFSA. For those who are awash in cash, it’s hard to imagine that one would not be maxing out both types of plans. Assuming limited resources, however, should a person contribute to RRSP, TFSA or both?

Recall the basic structure of the two plan types:

RRSP TFSA

Tax-free funding Y N

Tax-free growth Y Y

Tax-free withdrawals N Y

Viewed in this manner, it is clear that the name “tax-free savings account” is a bit of a misnomer. What the plan really does – relative to an RRSP – is change the point at which tax is applied, though both plan types are entitled to internal tax-free growth.

Assuming the same investment choices in each plan, where a person’s marginal tax rate (MTR) is the same on deposit as on withdrawal, the net money on withdrawal will be the same under either plan. Where deposit MTR is higher than the withdrawal MTR, the RRSP will result in more net money – The reverse is also true.

Relative marginal tax rate Favours

Contribution MTR higher RRSP

MTRs the same Neither

Withdrawal MTR higher TFSA

Of course the common expectation is that a working person moves to a lower MTR in retirement, but that may not be the case for those early in a career, taking a sabbatical or on variable commission income. As well, if the savings are targeted for sooner use, such as a house or auto purchase, then it is the MTR at that time that is relevant.

Consider also:

Unused contribution room carries forward for both plan types
For an RRSP contribution, the related deduction can be deferred to a later year, presumably when the person is at a higher MTR
Alternatively, a current contribution to a TFSA could be withdrawn at a later year to service carried forward RRSP room, and that withdrawal recovers TFSA room

Ultimately the appropriate option will depend on an investor’s current conditions and future intentions. Though not so simple, it can be reasoned out with good information.

Changes to the CPP

The Canada Pension Plan comes up for formal review on a triennial basis. A number of significant changes were recommended in the most recent review in the early part of 2009, and these have made their way into law with Royal Assent granted to Bill C-15 on December 15, 2009.

These changes, particularly the early and late take-up adjustments, present financial planners with an opportunity to provide insight and guidance to clients in determining how best to manage their CPP pensions.

Work cessation test – Until now, a person under age 65 had to cease working in order to commence a CPP pension, though there was no requirement that the person remain as such thereafter. Accordingly, a person might ‘retire’ to commence the pension, and return to work after two months. The work cessation test has now been eliminated, so that a pension may be commenced without this unnecessary work interruption. This change will not affect existing CPP beneficiaries or those who take their CPP retirement pension before 2012.

Working beneficiaries participating in the CPP – In the past, once a pension had begun, there would be no further CPP premiums paid. It is now mandatory for those under age 65 to pay the premiums, and voluntary from age 65 to 70. This includes the requirement that the employer pays its matching portion. These contributions will result in increased retirement benefits, earned at a rate of 1/40th of the maximum pension amount ($11,210 in 2010) per year of additional contributions. The exact amount of the additional benefit would depend on the earnings level of the contributor. The resulting pension could be above the maximum.

General low earnings drop-out – The pension entitlement calculation currently allows a pensioner to drop off 15% of the years where earnings are low or nil. This amounts to about 7 years. The drop-out rate will be increased to 16% in 2012 and 17% in 2014, being an increase to about 7.5 and 8 years respectively. This change will not affect existing CPP beneficiaries or those who take their benefit before the change comes into effect.

Adjustments for early and late CPP take-up – The current adjustments reduce a pension by 0.5% per month the pension begins before the normal age of 65, or increase it by 0.5% for each month after the 65th birthday month. The early pension reduction will be gradually increased to 0.6%, spreading the implementation over a period of five years starting in 2012. The late pension augmentation will be gradually increased to 0.7%, spreading the implementation over a period of three years, starting in 2011. Once again, these changes will not affect existing CPP beneficiaries or those who take their benefit before the changes come into effect.

Retirement savings and pension reform

The economic turmoil in 2008 played havoc with a wide swath of investments, but may have had especially dire consequences for those in retirement. While the preceding issues have a practical bent that an advisor may be able to act upon immediately, there could be some broad-reaching structural changes ahead.

At the May 2009 meeting of Federal-Provincial-Territorial Ministers of Finance, a Research Working Group was struck to looking into Retirement Income Adequacy, with six research tracks established for examination:

Justifications for government involvement in retirement income provision
Current and future retiree savings levels among Canadian households
Investment risk and longevity risk in the context of retirement income
Impact of investment performance and costs of pension and other retirement savings.
Efficiency and effectiveness of tax-sheltered savings instruments design in Canada
An international perspective of Canada’s retirement income system.

A 30-page summary document was delivered to the December 2009 meeting of those same Ministers in Whitehorse. That document is available at www.fin.gc.ca/activty/pubs/pension/riar-narr-eng.asp, including links to the six underlying papers. The Ministers have committed to conduct public consultations in their respective provinces/territories before reconvening in May with the intention to move toward more concrete decisions. The options being considered include (and these should not be considered as mutually exclusive):

Establishing a voluntary supplementary CPP program
Extension of the CPP itself, in terms of both premiums and benefits
Greater leeway to financial issuers to set up group savings plans
A stronger delivery of public education on the savings vehicles available

As a total aside

Kudos to the province of Quebec for allowing donations to the victims of the January Haiti Earthquake to be reportable for the 2009 tax year. In addition to providing tax relief to thoughtful donors a year earlier than otherwise available, the move is designed to encourage early action, with the qualification period ending February 28, 2010. As of publishing deadline, there was no similar relief in other provinces or at the federal level, but hopefully those governments will follow the lead.