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© Copyright 2000 Rogers Media. The following article first appeared in the February 2001 edition of
BENEFITS CANADA magazine.
The SERP solution
Income tax restrictions and rising salaries mean an increasing number of employees face a shortfall
in their pensions. Supplemental Employee Retirement Plans are one strategy that can ensure plan members
have sufficient retirement income.
By Danielle Éthier, Salim Hajee and Ian Markham
Many Canadian employees earning $65,000 or more will not be able to rely on their company-sponsored pension
plans to provide them with adequate retirement income. This is because tax-sheltered pension income for
executives represents a much smaller proportion of final annual pay today than it did 30 or even 20 years ago.
This reality is also affecting an increasing number of non-executive employees.
The situation is a direct result of continued restrictive limits imposed by the Income Tax Act (ITA)--some
of which have been frozen for 25 years--as well as increasing inflation rates and higher salaries.
Plan sponsors now find themselves in a predicament as they look for ways to ensure adequate retirement
income for employees.
Consider the following example. An organization has a defined benefit (DB) pension plan with a 2% formula
and the average salary for a retiring junior executive is $125,000. The executive in question has worked
for the organization for 35 years. Ideally, his pension would replace 70% of the final average salary upon
retirement, giving rise to an annual pension income of $87,500 ($125,000 x 2% x 35). The sad reality,
however, is that this executive will only receive a pension income of $60,278 per annum. That is due to
government limitations, which prohibit a pension plan from providing annual pension payments that exceed a
total of $1,722.22 multiplied by the number of years of service ($1,722.22 x 35 = $60,278 per annum).
Watson Wyatt's 2000 Supplemental Employee Retirement Plan (SERP) survey reveals that one out of every six
salaried employees in Canada is affected by government limitations. This figure is up from one in eight
employees just three years ago, according to a similar survey the firm conducted in 1998, and it is
expected to rise to one in four by 2005. As inflation and salaries continue to rise and the government
fails to address this issue, the situation will only worsen.
One solution is a SERP. These plans mitigate the impact of the restrictive limits imposed by the ITA. Yet,
surprisingly, they are neither widely used nor well understood. What's more, many organizations say that
they don't fully understand how SERPs work and how their employees can benefit from them.
Organizations with SERPs appear to value them as an attraction and retention tool. They are increasingly
extending these pensions to employees below the executive ranks. Watson Wyatt's 2000 SERP survey--conducted
last spring and incorporating responses from 430 organizations--reveals that 52% of organizations offer a
SERP and 37% of organizations with SERPs cover all employees affected by government limitations compared to
31% in the 1998 survey. In addition, almost 20% of participating plan sponsors indicate that they are
likely to broaden the eligibility for employees covered by their SERP over the next two years.
The three most prevalent objectives cited for SERPs are:
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Replacement of benefits that cannot be paid under registered plans due to the limits imposed by the ITA
(89%).
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Retention of highly paid key employees (46%).
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Preservation of internal equity by providing consistent replacement ratios for all employees (32%).
SERPs can be based on either a DB or a defined contribution (DC) plan. They can be fully or partially
funded, and may provide for additional enhancements such as spousal and inflation protection.
Only 14% of organizations that participated in the study have a DC SERP. This may be due to the prevailing
misconception that SERPs can only be used to top up registered pension plans, which are primarily DB.
For DC SERPs, the survey shows that most plan sponsors do not require any employee contributions, and the
average employer contribution rate is just over 11% of pensionable earnings. Where the SERP is funded,
contributions are almost equally made either as actual contributions or on a notional basis. Having a
supplemental pension plan, which requires no employee contributions, is certainly an attractive benefit to
employees.
CLOSING THE GAP
Here's how SERPs can help close the pension gap. Assume your organization has a mid-career employee with an
average salary of $200,000. The company provides for a 2% DB plan for each year of service and a SERP to
top up the benefit to the targeted amount. Let's also assume that this employee has 10 years of employment
with the company. The accrued pension is $40,000 ($200,000 x 2% x 10), with the portion up to the ITA limit
payable from the registered pension plan and the balance from the SERP.
Plan sponsors can use SERPs in a variety of ways (see "SERP strategies").
SERPs are also effective attraction and retention tools that ensure employees have adequate retirement
income--providing that they are well designed, sufficiently funded and adequately documented. This is
important to note as the 2000 study reveals that SERPs are typically unfunded and/or inadequately
documented.
Indeed, almost one in 10 organizations provide no formal documentation and seven out of 10 organizations do
not provide any prefunding despite the security concerns with pay-as-you-go arrangements. Of those SERPs
that are prefunded, the majority use trust funds, while about a third use letters of credit. Survey
participants indicated they rarely use life insurance policies or annuity purchases.
The need for an effective total rewards strategy has never been more critical than it is today. Employers
that want to ensure that their organizations are well positioned to attract and retain key talent cannot
overlook the value of an adequately funded and well designed SERP.
Danielle Éthier and Salim Hajee are consultants and Ian Markham is a senior consultant with
Toronto-based Watson Wyatt Canada. infocanada@watsonwyatt.com.
SERP strategies
For a mid-career employee with an average salary of $200,000 and a 2% company-sponsored DB plan for each
year of service.
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TYPICAL PLAN PROVISION
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POSSIBILITIES
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Eligible earnings
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39% of surveyed firms use base salaries only ($200,000 x 2% x 10 = $40,000).
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Some organizations use base + bonus (if the bonus component in the final average earnings
is $40,000: $240,000 x 2% x 10 = $48,000).
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Use average bonus over a number of years to better reflect the earnings while the employee
was most productive (you don't necessarily have to use bonuses immediately before
retirement).
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Use a DC SERP and recognize bonuses paid in every year of service.
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Percentage formula
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Same percentage as the basic plan (with a maximum of 2% per year allowed by the ITA).
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A percentage that varies every year depending on the employee meeting certain performance
targets (may be more than 2%).
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A lower accrual percentage early in the career (i.e., 1% for 5 years) and a greater
percentage afterwards (i.e. 3% for 5 years): ($200,000 x [1% x 5 + 3% x 5] = $40,000).
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Credited service
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One year of credited service for each year of employment with the employer.
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Give one additional year every two years with a maximum of five additional years ($200,000
x 2% x [10 + 5] = $60,000).
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Recognize one year of past service with previous employer(s) for each year of current
service with or without a maximum.
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SOURCE: Watson Wyatt
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