Why high earners and business owners may not have fully funded pensions

The tax rules and assumptions used in preparing valuations for pension plans have not been updated since they were added to the Income Tax Act in the early ’90s. As a result, actuaries are forced to use outdated assumptions for designated defined-benefit pension plans. These assumptions are contrary to professional standards and may affect your high-income clients, including business owners setting up individual pension plans (IPPs).

Actuaries are required to use the maximum funding value (MFV) methodology to value designated plans. Compared to other valuation methodologies, the MFV artificially caps the contributions. While the policy goal may be to limit the tax deduction for high-earning plan participants and business owners, the rules leave designated plans underfunded.  A similarly compensated person belonging to a non-designated plan would not face the same restrictions.

Designated plans and specified individuals

The tax rules for designated plans refer to “specified individuals.” These include:

• Connected persons, who either own 10% or more of the employer participating in the pension plan, or are “related” to the employer.
• People who earn more than 2.5 times the year’s maximum pensionable earnings. For 2023, this would be 2.5 x $66,600, or $166,500.

A pension plan is a designated plan when more than half of the value of the pensions being accrued under its defined-benefit provision, in any year, is for specified individuals.

Let’s look at some examples.

Katrin

Katrin owns 50% of the shares of ABC Co. She is the only participant in an IPP that the ABC Co. sponsors. That means she is a connected person, so the plan is a designated pension plan.

Jonathan

Jonathan is a 50-year-old CFO of a privately owned manufacturer. He and his fellow executives each earn about $250,000 per year and participate in the employer’s executive pension plan. Even though none of the executives are related to the owners and none has an equity stake (so they are not connected persons), this is a designated plan because the executives are high earners and therefore specified individuals.

Specific rules govern how an actuary must prepare a valuation for a designated plan. For designated plans, that means using the MFV.

The maximum funding value methodology (MFV)

An actuary must use the MFV methodology to value a designated plan. This valuation governs the allowable contributions to the plan for tax deduction purposes. The regulations to the Income Tax Act specify the assumptions that must be used — even if the pension plan text uses different assumptions.

The actuary must assume that:

• The pension is payable monthly in advance;
• Post-retirement indexing is capped at consumer price index (CPI) minus 1%, and
• The pension will have a five-year guarantee (with a 66.67% survivor benefit paid to any spouse or common-law partner thereafter).

Then, in preparing the valuation, the actuary must assume:

• The pension starts no earlier than age 65;
• The plan member’s spouse is the same age as the member;
• Wages are assumed to increase at 5.5% per annum;
• The CPI will increase by 4% per annum;
• There is no pre-retirement death or termination prior to retirement;
• Assets will earn 7.5% per annum, and
• 80% of the unisex mortality rates from the 1983 Group Annuity Mortality Table.

What is the impact of the MFV methodology?

Significant outcomes include:

• The MFV places an artificial cap on the contributions. Contributions are reduced from what they would be were the MFV not in place. Hence, the pension plan is likely underfunded and the plan doesn’t have the funds needed to fund the promised pension. The pension is thus not fully secured.
• Plan members may face challenges when seeking to commute their pensions as they may not be able to withdraw their full commuted value at the time of their termination.

Case study

Meet William, whose company has sponsored an IPP. He wishes to retire at 60. His spouse is 10 years younger. As a result, he is penalized by the MFV assumptions. The pension related to his early retirement cannot be funded. Nor has the fact that his spouse could live longer than him been considered. Further, both William and his wife may live longer than is reflected in the 1983 mortality table.

Assumptions used with other valuation methods

When examining other possible valuation methods, it becomes even clearer how disadvantageous the MFV methodology can be.

Going concern method

This method aims to show the real long-term costs of the plan and is used by actuaries for pension plans that are not designated.

The assumptions are very different from those used for the MFV:

• The actuarial assumptions used are based on long-term interest rates (4.5%–5.5%) as selected by the actuary;
• Wages are assumed to increase at 4%–4.5% per annum;
• CPI will be in the 3.5%–4% range;
• The 2014 Canadian Pensioners’ Mortality Table with projection to 2023 is used; and
• The member will retire at age 60.

For a 50-year-old plan member retiring at age 60 with 20 years of past service, the going concern method produces liabilities and costs that are 60% larger than under the MFV method. What’s more, the pension’s funds under the MFV method will be exhausted at age 81, while they would last until a person is in their 90s under the going concern method. (We’ll examine this further in a subsequent article.)

Solvency/windup method

This method is for information only and determines the liabilities as if the plan were to be wound up immediately. It is the basis upon which commuted values are determined on termination of employment.

The assumptions chosen are based on the current economic environment, and are very different from those used for the MFV:

• The actuarial assumptions used are based on short-term interest rates (4.0%–4.5%) as selected by the actuary;
• Wages are assumed to increase at 0% per annum;
• CPI will be 3.5% per annum
• The 2014 Canadian Pensioners’ Mortality Table with projection to 2023 is used; and
• The member retires immediately.

For a 55-year-old plan member, the solvency/windup method produces liabilities that are 50%–60% higher than under the MFV method.

In the next column, we’ll examine the impact of these rules by looking more deeply at Jonathan’s case and identifying some planning opportunities.

Lea Koiv, CPA, CMA, CA, CFP, TEP, is a tax, pension and retirement expert (info@leakoivassociates.ca). William C. Kennedy, FSA, FCIA, is senior vice-president at Lesniewski Moore Consulting Group.