Severing ties

(April 2008) Markets are volatile and a recession is looming large. If the Canadian economy falters, advisors may soon be faced with another problem — clients who’ve lost jobs and need to know what to do about their pension plans and severance packages.

When clients arrive with news that they’ve been let go from the company they were working for (if they think to come to you during this tumultuous time), there are a number of rules and options for them to consider, and some planning strategies that need to be acted on — nearly immediately.

Remind your clients and prospects how important it is to visit you soon after receiving news that affects their financial plans. Download this customizable tip sheet on severance package optionsto help with this dialogue.

While managing the tax implications of a cash settlement or the time limits for converting group coverage into an individual policy might seem like the most pressing issues to you, for some clients, losing a job they’ve been dedicated to for many years can be like losing a spouse.

“You don’t just walk away from that,” says Kevin Vaughan, an advisor with Money Managers Inc. in Peterborough, Ont. “The best way to deal with these issues is the way we deal with everything else: listen. If we let our clients get things out, then sometimes we don’t need to ask as many probing questions to get the information we need to make appropriate recommendations.”

The rules

The Canada Revenue Agency defines a retiring allowance as the payment an employee receives when his or her job is terminated, paid either to recognize long service or to compensate for the loss of employment. This includes money paid for unused sick leave or damages (in the case of a wrongful dismissal, for example). Retiring allowance, though, does not include superannuation, pension benefits, funds given in lieu of termination notice or amounts paid for unused vacation time.

Under section 60 (j.1) of the Income Tax Act, an employee may be able to transfer some or all of a retiring allowance directly to his or her registered retirement savings plan (RRSP) to avoid paying tax on it. The amount eligible for transfer does not use up existing RRSP contribution room.

The amount eligible for transfer depends on the length of time your client has been with the company — the amount is equal to $2,000 for each year or part year the employee worked with the company before 1996, plus another $1,500 for each year or part year before 1989 if they did not earn (or have vested rights to) benefits in a registered pension plan or a deferred profit-sharing plan. The amount of the retiring allowance that’s eligible for transfer will be reported in box 26 of a T4A slip, while the ineligible amount will be shown in box 27.

For people who do not qualify under the retiring allowance rules — for example, those leaving an employer they joined in 1997 or later — the amount of severance that can be tucked away inside an RRSP will depend on the contribution room they have available. If your client’s RRSP is full, the severance package will need to be reported as income in the year it is received.

Larry Short, vice-president and investment advisor with TD Waterhouse in St. John’s, Newfoundland, says timing can play a key role in managing this kind of tax liability. If possible, he suggests that advisors meet with their clients before the details of any severance package are finalized so clients can negotiate to have funds paid out in the following year.

He gives the example of a worker earning a salary of $60,000 who receives a $30,000 severance package. “If they are laid off before December 31, they may have a $90,000 income in their last year,” he says. “Delaying the severance to January 1 means that their income this year would be $60,000 and next year $30,000, putting them in a lower bracket.”

After the severance package has been sorted out, there’s the client’s pension plan to consider.

Short recalls a time when several government departments became privatized. Clients wanted to know whether they should leave their funds inside the pension plan or move them out into a locked-in, self-directed retirement account. He says that decision boils down to a present-value calculation: Determine the internal rate of return (IRR) of the pension plan and compare that return to what one could reasonably expect to receive in the market over the same amount of time.

“I found when I did the math, the government plans were usually much better for the client, but I do know of several advisors who made careers out of such transfers. They either did not know how to do the math or they just ignored it.”

That said, he does point out that conditions have changed dramatically since the early 1990s. At that time, IRR calculations revealed that government plans could offer former employees a guaranteed return of up to 14%. “Nowadays, that is closer to 3 or 4%,” he says. Locked-in plans are also on a different footing — in the past, payouts either stopped at death or paid a reduced income to a surviving spouse. Thanks to recent pension regulation changes, though, there is no longer a requirement that funds inside locked-in retirement accounts (LIRAs) be converted into a life annuity at age 80.

This means, he says, that company or employer pension plans can still stop or reduce their payments on death, while the locked-in plan can be constructed in such a way that payments are not reduced and may even provide an inheritance. “This sways us in favour of the locked-in plan” these days.

Vaughan, meanwhile, points out that “most advisors look at the pension, what to do with any excess payments,” but adds that benefits also need to be addressed since clients losing their jobs may also be losing life and health insurance benefits. “These things should not be left to fester,” he says. In some cases, clients may have only a short period of time — 30 or 60 days — to convert existing group insurance coverage into an individual policy without having to provide medical evidence. If someone isn’t in good health, this may be their only chance to obtain insurance coverage at a standard rate.

Client questions: How long were you with your employer? Did you have a pension plan or deferred profit-sharing plan at work? If you have a pension plan, is it indexed? What kind of pension plan do you have? (Defined contribution? Defined benefit? Group RRSP?) What are the actuarial assumptions? Is there an option to delay receipt of your severance package? Will you need to use the severance funds to pay bills, or can you set them aside for longer-term investment? What kind of medical benefits did you have at work? Can you convert any of them? Did your employer pay for any other perks, benefits or services that will affect your cash flow? Do you have any employer benefits that need to be paid back (e.g., computer loans)

What do you think? Let us know by sending your letters to feedback@advisor.ca.

(04/01/08)