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© Copyright 2000 Rogers Media. The following article first appeared in the June 2000 edition of
BENEFITS CANADA magazine.
Food for thought
DB pension plan sponsors must commit to a strong communications strategy. Their plan members have
important choices to make.
By John Miller
The growing popularity of money purchase plans in recent years has sparked a recognition among plan
sponsors of their duty to enhance communications with plan members.
Defined benefit (DB) plan investments, on the other hand, are not controlled by individual members and the
benefit is determined by a formula, so there appears to be few choices for members to make, and
consequently not as great a need for communication.
A closer look at DB plans reveals that there are indeed many decisions to be undertaken, and communication
with DB members is as important as it is for defined contribution and group registered retirement savings
plan (RRSP) participants. With diligent communication strategies, plan sponsors can be assured they have
equipped their members with the tools they need to understand the choices they face and make educated
decisions.
MANY CHOICES
Guarantees and early retirement issues are one example of the many options open to DB plan members. The
choice of guarantees and early retirement may be skewed for members whose pensions are limited by the
maximum pension allowed under the Income Tax Act. The Act imposes a maximum pension of $1,722 per year of
service. Most provincial pension benefits acts require that 60% of benefits be extended to the spouse after
the death of the retiree, unless the spouse waives this right.
But the form of pension determined by the plan formula may be based on some other guarantee, such as five
years. In such a case, 60 monthly payments would be issued regardless of the death of the member. When this
is the case, choosing the 60% option will require the benefit to be actuarially adjusted, usually resulting
in a lower monthly income.
However, the reduction may be lessened or effectively eliminated if the normal benefit exceeds the maximum
allowed in the Act. To take an example using earnings of $90,000, 30 years of service and a 2% factor, the
formula yields a pension of $54,000, while the maximum allowed is $51,660. If the formula is based on a
five-year guarantee, the actuarial reduction for a 60% joint and survivor option might be, depending on the
spouse's age and gender, $5,000. The resulting $49,000 pension is only $2,660 less than the normal pension
limited by the maximum. This makes the 60% option somewhat of a bargain--which should be considered when
making the choice.
EARLY RETIREMENT
Early retirement decisions are affected by the relationship between the Income Tax Act maximum and the
reduction required by early retirement.
Benefits must be reduced by at least 0.25% for each month prior to the normal retirement age unless certain
conditions are met as specified in the Act. The plan is not required to use an early retirement reduction
if the member has attained age 60 or has 30 years of service, or if the member's age plus years of service
equals 80.
When the member is subject to the maximum pension of $1,722 per year of service as well as an early
retirement reduction, the early retirement reduction may be lessened, or effectively eliminated, by virtue
of the maximum.
Taking the salary of $90,000 again, and assuming the member has acquired 30 years of service by age 60 and
the plan requires a reduction of 0.25% for each month prior to age 65, early retirement reduces the formula
pension of $54,000 by 15%, or $8,100 to $45,900.
Since the Act does not require the reduction in determining the maximum pension because the member is 60,
the maximum allowed is $51,660. This makes early retirement somewhat of a bargain, since the cost is
reduced to $5,760 annually instead of $8,100.
In the preceding examples, reductions for enhanced survivorship and early retirement were made from the
benefit and determined by the plan formula. The result was then compared to the maximum allowed. This
approach is more favourable to the plan member than comparing the unreduced benefit to the maximum first,
and if the maximum applies, then making reductions from it. Not all plans take this position, however, and
members need to have this crucial information so that they can investigate their options in the
decision-making process.
A LOCKED IN RETIREMENT ACCOUNT
Other options include taking the commuted value of the plan in lieu of a life income. The amount would be
transferred tax-free to a locked-in retirement account (LIRA). However, this option results in the member
surrendering all claims to the plan. It also requires spousal consent under provincial legislation and is
best reserved for sophisticated members who have sought professional investment advice.
Obviously a member who was convinced that the lump sum could be made to produce a better income than the
pension benefit would be inclined to choose the lump sum. Another important consideration is that control
over the capital could be retained for estate planning purposes.
LIRAs have provisions that ensure the retiree does not remove too much capital too quickly. The Income Tax
Act specifies the terms for a registered retirement income fund (RRIF). However, locked-in provisions
pertaining to RRIFs are a creation of provincial or federal pension acts. The locked-in retirement income
fund (LRIF) is available in Alberta, Saskatchewan, Manitoba and Ontario, while a life income fund (LIF)
exists in every pension jurisdiction except Prince Edward Island.
There are differences between an LRIF and LIF. For example, the Ontario Pension Benefits Act requires LIF
holders to purchase life annuities at age 80. A maximum annual withdrawal is also specified. In the case of
an LRIF, when the maximum is not withdrawn, the owner can carry forward unused room.
In addition to being subject to a maximum annual withdrawal, a LIRA is also subject to a minimum annual
withdrawal prescribed by the Income Tax Act. Use of a LIRA can be an important part of estate planning.
For instance, under the Act a deceased person is deemed to have disposed of all his property immediately
before death. Therefore the balance remaining in a LIRA is included in the retiree's income in the year of
death, but it may be excluded if the named beneficiary is the retiree's spouse or (if there is no spouse) a
dependent child or grandchild. If it passes to one of these beneficiaries it may be put into the
beneficiary's RRSP or RRIF so that it continues to earn tax-deferred income.
Clearly, choosing a lump sum, when such an option is available, involves a careful evaluation of both the
retiree's investment objectives as well as desire for cash flow flexibility and estate planning goals.
FLEXIBLE PENSIONS
One of the greatest sources of choice for DB plan members stems from the advent of flexible pension plans.
A flexible pension allows the member to voluntarily set aside additional funds which he or she uses at
retirement to purchase a choice of permitted pension enhancements. Contributions normally earn interest at
the plan rate of return.
The Canada Customs and Revenue Agency (formerly Revenue Canada) recognizes that calculations of pension
adjustments, which limit RRSP room, are based on a generous pension plan. Therefore, members of less
generous plans are permitted to purchase ancillary benefits which are not part of their basic plan without
using up further RRSP room.
The required contributions are tax-deductible within the specified limits. The permitted contribution to a
flexible plan is the amount, if any, by which: (a) exceeds (b), where: (a) is the lesser of: (i) 9% of
pension earnings; or (ii) $1,000 plus 70% of the DB pension credits for the year under the plan; and (b) is
the amount of current service contributions for the year.
Assuming a maximum pension adjustment of $14,900, (a) (ii) becomes effective at $127,000. For example, at
any salary less than $127,000 (and the member's required contributions are 5%), up to an additional 4% may
be contributed. The funds are tracked in an account in the member's name and the results are reported on
annual pension statements.
ENHANCEMENT LIMITS
There are some limits to the enhancements a member can purchase but it is not necessary to choose the
enhancements prior to retirement. If a member has more money accumulated than can be used to purchase
permitted enhancements, these excess funds are lost and become part of the overall pension fund.
This need not concern members other than young employees who expect to contribute over the course of a
career. Even for these individuals, proper account monitoring will ensure they are advised of the situation
in advance.
The enhancements that can be purchased at retirement include the following, subject to sufficient funds
having been accumulated:
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Early retirement without a reduction at age 60, with an 80 factor or with 30 years of service.
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Bridge benefit (a payment between early retirement and age 65).
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Post-retirement indexing of: the bridge benefit; the lifetime pension; combined lifetime and bridge
pension.
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Pre-retirement indexing during the deferral period (where a deferred pension is taken by a member
retiring before age 65).
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Enhanced survivor benefits.
The value of the flexible pension can be taken as a lump sum if the normal pension benefit is taken as a
lump sum.
When a member leaves a DB plan before retirement, he has a choice, if vested, between a deferred pension or
a transfer of the commuted value to a LIRA.
The reinstatement of the pension adjustment reversal (PAR) makes withdrawal from the plan a more viable
option than ever before.
While younger members may be frustrated by the low commuted value of their benefit, the PAR can
substantially offset this problem. A calculation of the PAR is now an important part of the decision of
whether or not to transfer the value of the plan.
Retaining a deferred pension may be the preferred choice when terminating members are not interested in the
responsibility of a portfolio of retirement funds, or when the commuted value and PAR are not as attractive
as the benefit that will be obtained from the plan at the normal (or early) retirement date.
All jurisdictions provide for a refund of small balances, usually expressed as a percentage of the Canada
Pension Plan yearly maximum pensionable earnings.
In the unfortunate case of shortened life expectancy, jurisdictions may allow an application to withdraw
money to be made to a pension plan administrator or the financial institution holding a LIRA.
Clearly, while DB plans seem to be a benefit with limited choices, they can result in numerous options that
require careful consideration and professional advice to ensure the most appropriate choices are made by
each member. In this light, plan sponsors of DB plans have a duty to review, and consider improving,
communications with their members.
John Miller is controller at the University of Western Ontario's King's College in London, Ont. and chair
of the college's pension committee and group RRSP committee.
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