The bankruptcy of the Hudson Bay Co. and subsequent loss of promised supplemental employee/executive retirement plan benefits to executives has caused many to rethink the value of these plans and the security of promised benefits.
SERPs are now common in most public corporations. In their simplest form, they can be nothing more than a letter promising to make additional ‘pay-as-you go’ benefits on retirement. Historically, SERPs covered the difference between the total pension promise under the pension formula and benefits allowed under defined benefit pension plans.
From 1990 to 2003, the maximum amount that a DB plan could pay per year of service was $1,722.22 or $60,277 for 35 years of service. This didn’t nearly cover what was owed to most executives under their pension promises.
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In 2004, the limit was raised to $1,833.33 per year of service. In 2025, the limit is $3,756.67 and for 2026, there has been a further increase to $3,932.22. That means an executive retiring in 2025 can receive a maximum of $131,483 for 35 years of service but, if they’re retiring in 2026, a maximum of $137,672.
Assuming a 70-per-cent DB pension, this represents a final five-year average compensation of $196,674 for retirement in 2026. That’s significant for many employees, but not for higher earning C-Suite executives.
For employees, many have learned the hard way that SERP letters offer little, if any, protection in the event of the employer’s bankruptcy. As well, post-retirement plans could be in jeopardy from changes in ownership, management or the board.
According to the Canadian Centre for Policy Alternatives, the top 100 chief executives’ average annual compensation was $13.5 million in 2023, with nearly half of those CEOs having a DB pension plan with an average payout of $1.1 million.
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For most C-suite executives, the pension promise is a critical component in long-term retirement planning. To have as little as 10 per cent to 15 per cent of that promise actually secured by their DB plan is a concern. Many investment decisions rely on total retirement cash flow — from both DB plans and SERPs — on the assumption that total benefits are secure.
It’s both unreasonable and unacceptable for any retiree to have to live with this uncertainty. As recent times have shown, many have suffered by the flameout of their former employer.
SERP promises are a legal liability of a company and, as such, they’re disclosed to shareholders and expensed annually as the liability accrues.
The Canadian Revenue Agency’s position is that if the expensed funds are set aside internally to secure the liability, they’re a deemed an RCA and refundable tax is owed.
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Although some big companies do set up RCAs to fund and secure SERP benefits — and, some big public pension funds have an RCA for excess benefits — for many, the expensed funds become mixed with the general assets of the company and, hopefully earn the company’s internal rate of return).
At the retirement of SERP members, these assets can be effectively utilized to pay benefits. Otherwise, the promise to pay has effectively become the cash flow liability of future shareholders. SERP members have no control over the assets to be used.
Some companies have resolved the security concerns of their executives over SERP benefits by establishing an RCA and, instead of funding, buy a letter of credit to secure the accrued total liability of the RCA, in the event of default of pay-as-you-go benefits. If a company can’t obtain a LOC to secure promised SERP benefits, these benefits should be funded.
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The RCA provisions of the Income Tax Act provides security of SERP promises, ensures the proper valuation of SERP liabilities and utilizes the cost of LOCs to the funding of benefits.
If it weren’t for an impediment in the RCA legislation — the Refundable Tax Account — SERP benefits likely would be pre-funded.
However, that impediment can be mitigated. In the U.S., the funding of SERP benefits is done through corporate-owned life insurance. Insurance is placed on individual executives with the cash values being used to pay benefits from retirement and the mortality values to pay survivor benefits and cost recovery to the company.
COLI was introduced in Canada around 1981 but ended in 1986 with the introduction of the RCA provisions in the Income Tax Act. These provisions specifically said that if a COLI policy was to provide SERP benefits, the policy was deemed an asset of an RCA with an amount equal to the premium being required to be remitted to CRA.
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After the first RCAs were established in Canada, it became evident that COLI products previously used to fund SERP benefits in companies could be reconfigured to be used in an RCA and mitigate the problems with the RTA.
The benefits to this approach include:
- Separating survivor benefits from primary benefits and mitigating cost;
- Reducing transfers to the RTA and enhancing performance;
- Providing longevity benefits at same cost of funding benefits to normal mortality; and
- Reducing long-term funding with excess mortality.
If an RCA is funded, the actual funding cost to shareholders reflects the earnings within the RCA. But, if a LOC is held in an RCA to secure benefits, the actual cost to shareholders is the pay-as-you-go cost plus the costs of the LOC.
In theory, the expensed cost of the pay-as-you-go benefits as they accrue are also earning the company’s internal rate of return or some other ROI. However, while the liability has been expensed, the plan sponsor must ensure the funds have actually been invested in a growing asset that can be accessed for the shareholder group when benefits are paid and the tax credit received.
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Another concern with SERPs is that the Income Tax Act allows for RCAs to be deemed salary deferral arrangements if entitlement, integration and funding guidelines aren’t followed. Unfortunate and expensive tax consequences can result. Managed RCAs can largely eliminate these concerns if RCA ledgers (done a triennial basis) properly track benefits for each plan member relative to CRA guidelines.
Sometimes forgotten SERP letters surface when an accounting firm asks to determine if the cost of funding was “meaningful.” Many companies are surprised at the total liability when all the letters are collected and valued.
A legal promise to pay supplemental pension benefits to cover the pension gap shouldn’t be left to the uncertainty of the future, even if security is provided through LOCs.
A fully-funded RCA should be used as intended. It isn’t fair that the SERP liability for current shareholders be transferred to future shareholders. By funding the RCA as the SERP liability accrues, current shareholders also receive the tax credit for funding.
Roy W. Craik is the executive partner and founder of Retirement Compensation Funding Inc.