|
© Copyright 2002
Rogers Media. The following article first appeared in the February 2002 edition
of BENEFITS CANADA magazine.
More employees are counting on supplemental
plans to complete their retirement income. But the majority of these plans are
not funded, leaving members and employers questioning their security.
Plan sponsors offering supplemental pension plans are
under a lot of pressure these days. Escalating wages mean top-up plans now cover
a much broader range of employees than simply executives. With so many high-wage
earners counting on a substantial portion of their pension income to come from
supplemental employee retirement plans (SERPs), employers are being confronted
with tough questions about the security of top-up arrangements.
The root of plan members' concern lies largely with the
employer promise to provide retirement income over and above what's allowed for
in registered pension plans (RPPs). The big question employees are asking, and
many plan sponsors are trying to answer, is: 'Just how reliable is the promise?'
There are good reasons for high earners to worry about
whether they will actually receive pensions higher than the maximum of $60,278
set by the Canada Customs and Revenue Agency (CCRA) (see "The need for
supplemental plans," page 44). "For many executives, an increasingly significant
amount of their pension is at risk," says Ray Murrill, executive compensation
practice leader with Watson Wyatt in Toronto. "For instance, if a chief
executive officer is earning $400,000 as a base salary and only $100,000 of it
is covered under the RPP, then the next $300,000 isn't covered. If the person
gets a bonus of, say, 50%, that adds another $200,000 that isn't covered. It
becomes a very significant amount to cover under a SERP."
Even if an employee has a supplemental plan that promises
to provide a pension based on the higher amount, the fact is that less than
one-third of these plans are secured with prefunding, according to a Watson
Wyatt SERP survey. The rest are run on a pay-as-you-go basis. "Security is a
major concern these days and an issue that constantly comes up--especially since
a growing number of people are affected," says Murrill. "More people are
realizing the weakness of unfunded plans. It's nice for a company to offer perks
to top earners, but if you've only got the company behind the promise, that
doesn't necessarily mean much."
Shirley MacIntyre, director of pensions for TransAlta in
Calgary, agrees that funding is a major problem and many plan sponsors are
trying to find solutions. "There is definitely a concern. Unlike a registered
pension plan, there isn't a pool of money sitting there funding most SERPs."
The big difference between the security of an RPP and a
SERP is that not all top-up arrangements are secured with funding. There is also
a notable difference in tax status. When a supplemental plan is set up as a
retirement compensation arrangement (RCA), for example, the employer's
contribution, and in some cases the employee's, is taxable. Half of the
contributions and investment earnings are paid directly to Revenue Canada.
That means 50% of the book value of the plan is held by
Revenue Canada and the RCA trust. The government returns half of the value of
the plan when the pension is paid out. But Revenue Canada doesn't pay interest
on the money.
UNCERTAIN TIMES
At
a time when economic giants like Enron Corp., Lucent Technologies and Nortel
Networks are facing severe financial difficulties, it's no surprise employees
are leery about corporate promises and wonder if the pension funds will be there
when the time comes. "These days organizations can run into financial trouble
quickly," says Richard Beliveau, a partner with Morneau Sobeco in Montreal.
"That's often when people start thinking about security.
If a plan isn't funded, it is quite possible that someone could lose their
supplemental pension," he adds. "Imagine what it would be like for a 70-year-old
who is already in retirement to suddenly find that a big chunk of his or her
pension has disappeared. Who can predict what will happen down the road?"
Other possible scenarios include mergers or changes in
management, which could result in the non-payment of supplemental pensions.
Becky West deals with employees asking 'what if' questions about their
supplemental pensions all the time in her role as pensions manager for BCTelus
in Vancouver. Ever since BCTel merged with the Alberta-based Telus two years
ago, employees have been worried about their top-up plans.
The company has two supplemental defined benefit plans,
one designed specifically for the upper echelon of executives and the other a
top-up plan for all other management. The top-up plan is partially funded with a
letter of credit but the executive plan isn't. "It's scary for people," says
West. "There has been a fair amount of downsizing and early retirements and it
is beginning to hit people in the face that their retirement income isn't
secure. They want to know what will happen if the company goes belly up."
The same economic uncertainty that has made executives
and other top earners nervous about pension security also makes it difficult for
companies to put the funding in place to make these pensions secure. That's
because prefunding is complex and expensive. There are several ways to fund
SERPs and the method a company uses depends on the employer's tax status and the
amount it is willing to pay. But security definitely comes with a price (see
"Security strategies,").
ATTRACTION AND RETENTION
TOOL
With funding pressures building, employers face another
challenge which makes it difficult to back away from offering supplemental plans
in the first place. "Top-up plans have become a hot issue in relation to the
global competition for talent," says Rosemary Boyd, assistant vice-president of
human resources for Sun Life Financial in Toronto. "Executives get better
pensions in the U.S. and in other countries around the world than they do in
Canada."
Ironically, not that long ago some high-earners viewed
stock options as more valuable than supplemental pensions. But stock options
lost their appeal when the technology market collapsed. The pendulum has swung
back, putting attention back on supplemental plans, says Lyle Teichman,
principal and consultant with Towers Perrin in Toronto.
One way an employer can attract and retain staff is by
ignoring the cap set by the CCRA and offering the same pension plan to all
employees regardless of income, says Boyd. This is the approach at
Hewlett-Packard (Canada) Ltd., where the economic downturn has had a big
influence on the company's decision not to offer top-up plans to employees.
"All our employees, including executives, are enrolled in
the same pension plan," says Rick Schwartz, director of compensation and
benefits for Hewlett-Packard in Mississauga, Ont. "Although it's true government
limits are completely outdated, with expenses so tight in our industry these
days, it isn't the right time to add anything extra."
On the other hand, some organizations are linking
performance to SERPs for executives by including bonuses in the top-up amount.
Canadian tax laws make this tricky, though. "There is definitely a trend to
include bonuses in supplemental plans," says Teichman. "But if there is too
strong a link then you risk CCRA seeing it as a deferred salary arrangement and
that could have adverse tax consequences."
The funding issue is certain to be felt by more plan
sponsors as an increasing number of employers try to secure pension arrangements
for their top-income earners, despite the economic climate. This is the case at
Federal Express Canada Ltd. in Mississauga, Ont., where pension and benefits
manager, Imma Monardo, is busy trying to determine how to help high-income
employees save more for retirement. "We have people reaching their limit in the
registered plan and I'm wondering what to do with them," she says.
Still, for plan sponsors supplemental pensions are a bit
of a 'damned if we do, damned if we don't' dilemma. Without a doubt there are
many options to consider, but all of them are made more complicated by a weak
economy and the need to attract and retain top talent.
Even though the CCRA limit is expected to rise in a few
years, it will not necessarily lessen the need for SERPs. "The type of employees
who are eligible for supplemental plans tend to have rapidly rising salaries,"
says Teichman. "Although higher tax limits may slow the rate of growth of SERPs,
the need for good SERP design will still be there." BC
Sonya Felix is a
Toronto-based freelance writer and a regular contributor to benefits canada. sfelix@interlog.com.
|
THE NEED FOR SUPPLEMENTAL PLANS
More employees are finding
that their pension plans won't meet their retirement income needs. Tax limits
and plan design are not keeping pace.
Supplemental pension plans
were originally set up to provide executives with tax-effective retirement
savings above what they would receive through registered pension plans (RPPs).
In 1976, the Income Tax Act set the pension limit at 2% for defined benefit (DB)
plans, covering earnings up to nine times the average wage. The maximum pension
payable under a DB plan was set at $1,715 per year of service. This translated
into a pension of up to $60,025 for an employee who had worked 35 years.
In 1990, the 2% rate for DB
plans did not change, but the maximum pension amount allowed increased slightly
to $1,722 per year of service or $60,278 after 35 years of service. Although the
1976 limit was designed to cover earnings up to nine times the average wage, by
2006, Towers Perrin estimates that the maximum pensionable earnings under a DB
plan will be only twice the average wage. Unfortunately, the limit isn't
expected to rise again for another three years or so.
Thankfully, the limit isn't
as restrictive for money purchase pension plans and group registered retirement
savings plans, which allow a maximum contribution of $13,500 per year. But a
growing number of top earners in those plans still need a supplemental
arrangement to match their pension savings to their income.
According to Towers Perrin,
74% of large Canadian corporations now have supplemental plans and almost half
offer them to more than just senior executives. This means about one in five
employees enrolled in DB plans have some of their retirement benefits in a
supplemental plan. By 2005, that number is expected to rise to one in four.
"This movement towards
covering a broader range of employees has changed the plan structure slightly,"
says Lyle Teichman, principal and consultant with Towers Perrin in Toronto.
"There are less special deals and more with just basic coverage." The most
common top-up plans are designed simply to provide equity so that no matter what
a person's income, they will receive a comparable pension.
|
|
SECURITY STRATEGIES
Funding arrangements are becoming
more common today for SERPs. Here are some methods to consider.
A decade ago, prefunding of
supplemental pension plans was unheard of. Today, about 33% of these plans are
backed by some type of funding arrangement, according to Towers Perrin. Here's a
rundown of the most common funding methods:
* Fully funded retirement
compensation arrangements (RCAs). A trust fund is set up and taxed at
50%. When the pension is paid the government sends back half of that payment.
For example, if the payment is $20,000 a year, the Canada Customs and Revenue
Agency (CCRA) refunds $10,000 a year. This is probably the safest way to secure
a supplemental pension plan, but also the most costly.
* Letter of credit. A
letter of credit (LOC) from a financial institution guarantees the pension
amount is deposited into an RCA. The bank typically charges a fee of 1% for the
LOC paid on renewal each year. Half of the fee must be paid to the CCRA as a
refundable tax. The biggest drawback is that LOCs tend to tie up a company's
credit, and if the company isn't solvent banks tend to withdraw the credit just
when the risk to employees covered under the plan is greatest.
*
Other solutions. A universal life insurance policy is sometimes used
to secure a supplemental plan, but it is considered complicated and the
effectiveness decreases over time. U.S.-style secular trusts are rare in Canada
but are gaining some ground. |
|
THE
U.S. APPROACH
American plan sponsors face similar challenges with executive
pensions, but some of their solutions vary.
The trend in Canada has been
to extend supplemental pension plans to include non-executive high-wage earners.
This isn't the case in the U.S. That's because the pension compensation limit is
much higher there--almost three times the Canadian limit. U.S. supplemental
employee retirement plans also typically include special deferred compensation
arrangements or a richer formula for executives and mid-career hires.
Like Canadian plan sponsors,
U.S. employers want to make supplemental pensions more secure through funding.
"Executives worry that the company's promise will change with a takeover and
they worry about whether the company can afford the payout," says Matt Siegel, a
principal with Buck Consultants in Teaneck, New Jersey.
A variety of trust
arrangements in the U.S., such as rabbi and secular trusts, offer some
protection but all funding vehicles have their disadvantages. For instance,
rabbi trusts can protect pension money in the case of a takeover, where the new
owners decide not to pay out these pensions. But they offer no protection from
creditors. "In the case of Enron, a rabbi trust wouldn't do much good," says
Siegel. He adds although a secular trust can provide protection from creditors,
it doesn't have any significant tax advantages.
|
|
News
News
