Should your client consider a copycat annuity?

In recent years, we’ve come across more pension plan members thinking about exiting their defined benefit plans—receiving the commuted value (CV) of their plan entitlement and transferring as much as possible to a locked-in RRSP or RRIF.

When the CV is large, however, these members can face a massive tax liability. In today’s low interest-rate environment, which pushes up the liability relating to the plan’s future income (and thus the CV), we are seeing commuted values ranging as high as $2.5 million; of that total, as much as 70% might be taxable if and when the client commutes. A previous article reviewed how to calculate the maximum transfer value, which sets a cap on how much of a CV can be directly transferred to a money-purchase arrangement.

If a plan member living in Ontario has a commuted value of $2.5 million and 70% of that is taxable, the taxable portion is $1.75 million. At Ontario’s top marginal tax rate of 53.53%, the client faces a tax bill of $0.9 million if they commute the pension, with few—if any—opportunities for tax sheltering. (High earners in rich defined benefit [DB] plans typically have little RRSP room, as the pension adjustment reported each year has often eliminated the next year’s RRSP room.)

The bottom line for the client looking to commute? While they’ve successfully exited the pension plan, they’re also facing a significant tax bill that seriously erodes the capital available for retirement. Is there another option?

Introducing the “copycat” annuity

In 1997, Section 147.4 of the Income Tax Act (ITA) was introduced. In brief, it changed the rules governing the purchase of annuities with funds from a registered pension plan (RPP). The provision would allow our plan member with the $2.5-million CV to avoid the $0.9-million tax liability by using the CV to purchase a life annuity from a life insurance company. An annuity bought with the CV is colloquially known as a “copycat” annuity: in order to qualify for a tax-deferred transfer of the CV to the annuity, the annuity must match or “copy” the provisions of the member’s pension entitlement.

Avoiding the tax liability from transferring to a (locked-in) RRSP or RRIF makes this an attractive option. Purchasing an annuity also means the plan member is still in a defined-benefit environment, shielding them from the longevity risk we associate with the defined-contribution environment.

Further, members of poorly funded RPPs may not be confident that they’ll be able to collect their full pensions from the plan, so an annuity from a well-capitalized insurer may be preferable.

The pension-splitting rules also allow life annuities from a superannuation or pension plan to be split, regardless of the recipient’s age, which keeps the amounts paid from a copycat annuity eligible for this valuable tax savings opportunity. If the plan member transfers an amount to a (locked-in) RRSP, they would have to wait until age 65 to qualify for pension splitting—and could only then split the income if the form in which it was drawn qualified for splitting.

What if, for example, a 58-year-old who had transferred the CV to a (locked-in) RRSP or RRIF decided to immediately acquire an annuity? In contrast to a copycat annuity, CRA does not view an annuity acquired from a (locked-in) RRSP or RRIF in the same way as an annuity from a superannuation or pension plan, as it has “lost its identity” for tax purposes. Income from an annuity purchased from a locked-in retirement account only becomes eligible for splitting in the year the annuitant turns 65.

Why are these referred to as copycat annuities?

A copycat annuity is not a specific product available from a life insurer. It’s a payout annuity that meets the rules in Section 147.4 of the Income Tax Act—namely that it copies, without modifying, the rights for the plan member under the RPP. A copycat annuity can provide either full or partial entitlements under the RPP, meaning that if the plan allows for a commutation of part of the benefit, the copycat can be acquired with the CV for just that portion of the benefit.

Rights under an RPP include retirement income and other entitlements based on the plan, such as the right to a survivor pension or a guarantee of payments over a given period.

What this means in practice is that whenever Section 147.4 annuity quotations are requested from an insurer, the insurance advisor will need to understand the RPP’s provisions and the plan member’s entitlements to ensure the quotation meets the matching requirements.

If the annuity doesn’t replicate the rights under the RPP, the tax consequences can be catastrophic. Section 147.4 provides that “the entire CV is taxable to the member” if the annuity is materially different from the plan entitlements.

In our hypothetical case above, our plan member with a CV of $2.5 million would incur a tax liability of approximately $1.3 million if the rights under the annuity contract were found to be materially different from their rights under the RPP—a larger tax bill than the client would face by commuting to an RRSP.

(CRA so far hasn’t released the long-awaited guidelines on its interpretation of what it means for a copycat annuity to be “materially different” from the rights under the RPP.)

CRA is less strict than it used to be about acquiring an annuity when the CV is insufficient to match the member’s RPP income. When the CV is greater than the cost of a copycat annuity, CRA allows the excess amount to be paid directly to the member, taxable in the year in which it was paid. But since RPPs are also governed by pension standards legislation, payout of any excess will also have to be permitted by that legislation. In Ontario, pensions legislation was amended to permit such a refund.

Why advisors should know about copycat annuities

As clients deal with uncertain life expectancies, copycat annuities are of growing interest as a retirement income solution to hedge this and other risks, such as market and sequence of returns risk.

When dealing with large CVs, advisors place themselves at considerable peril if they don’t inform their clients about the copycat option—even if this means the client has to be referred to an insurance advisor. Returning to our hypothetical plan member: if they commuted their pension to an RRSP or RRIF and paid a tax bill of $0.9 million, only to discover later that all options—including the copycat annuity—had not been outlined, the advisor could face litigation.

Unfortunately, not everyone who commutes a pension can acquire a copycat annuity. Ontario’s legislation only allows an annuity to be acquired with the CV if the plan permits. Advisors will want to closely examine termination statements and plan booklets, and ask for a copy of the pension plan text for review.

In some circumstances, a plan member who is able to commute their pension might consider a transfer to an individual pension plan (IPP). This will be discussed in a subsequent article.

Lea Koiv, CPA, CMA, CA, CFP, TEP, is a tax, pension and retirement expert with Lea Koiv & Associates (info@leakoivassociates.ca). Alexandra Macqueen, CFP, provides financial planning advice through a strategic partnership with Koiv, focusing on retirement income planning for registered pension plan members.