Over the past forty years, organizations across Canada have taken steps to reduce their financial liability by capping and phasing out their defined benefit (DB) pension plans.
Those plans had for generations provided millions of working Canadians, in both public and private sectors, with guaranteed income in retirement.
CAPs - Defined Contribution Pension Plans
The significant vacuum left by the decline of DB plans came to be filled by Capital Accumulation Plans (CAPs) such as defined contribution pension plans. Unlike DB plans which placed the investment risk on plan sponsors, CAPs shifted the risk and responsibility to employees who had to ensure they had saved enough to fund their retirement.
Although CAPs come in different formats, defined contribution pension plans (DCPPs) are perhaps the most outcome-oriented. They are also the only non-DB plan to still be referred to as a pension plan. As this blog will explore, there are significant advantages to using a DCPP as the main retirement plan of an organization. But just as there are advantages, there are also potential drawbacks that plan sponsors should be aware of.
How they work
Similar to a group RRSP, DCPPs allow employees to make tax-deductible contributions which are usually matched up to a certain limit by the employer. The balance at retirement is therefore based on total contributions made as well as investment growth.
Unlike a DB pensioner, a DCPP member would not have a guaranteed income in retirement and the onus is normally on the plan member to develop a sustainable drawdown strategy to minimize the risk outliving their savings.
Alternatively, some retirees opt to purchase an annuity with all or part of their retirement savings to gain some level of guaranteed income.
Unlike RRSPs which provide plan members with the ability to make withdrawals prior to retirement, DCPPs are by design locked in, meaning an employee would not be able to tap into their savings until they retire. While RRSPs offer more flexibility, DCPPs allow for a more disciplined saving strategy.
Being registered pension plans, DCPPs are regulated by provincial legislation. To be set up, DCPPs require a plan text and trust agreement. Whereas in previous years, plans that exceeded $3 million in assets under management (AUM) required an annual audit, in 2019 this was raised to $10 million in AUM, thereby reducing administration costs for sponsors of small and medium sized plans.
Perhaps one of DCPPs biggest strengths is the fact that they restrict plan members from prematurely tapping into their savings. As mentioned above, this is something that RRSPs permit, albeit at the cost of paying a withholding tax and possibly a higher income tax. Thus for plan sponsors that wish to ensure that retirement plan contributions would go only towards funding retirement, DCPPs are the best option among all the CAPs. Indeed when we consider recent statistics showing that millions of Canadians are not financially prepared for retirement, it can be argued that adopting a somewhat more restrictive approach with a DCPP is warranted.
Another major benefit of using DCPPs is the fact that employer contributions do not count as earned income for the employee and are therefore not taxable. This contrasts with RRSP employer contributions which are taxable for the employee. When it comes to tax efficiency, DCPPs are undoubtedly a superior option.
While most would agree that DCPPs are the most effective vehicle (among CAPs) to ensure that plan members are saving enough for retirement, they do have some drawbacks.
Paradoxically, a potential drawback can be found in one of DCPPs biggest strengths. Whereas restricting plan members from prematurely tapping into their retirement savings is generally a positive, younger individuals with other more immediate priorities (such as purchasing a home) may find the restrictiveness of DCPPs off-putting. RRSPs by comparison allow plan members to make tax-free withdrawals as part of the Home Buyer’s Plan (HBP) and Lifelong Learning Plan (LLP). The former is a particularly desirable feature nowadays considering the increasingly expensive housing market. This is why some plan sponsors opt to offer their employees a DCPP as a well as a voluntary RRSP.
Another drawback DCPPs present is increased administrative cost for larger plans. As mentioned above, plans with more than $10 million in AUM must be audited once a year. This generally costs in the range of $20,000 or more. It should be noted though that plans exceeding $10 million tend to be found in medium-sized and large organizations which are unlikely to be materially impacted by the auditing expense (particularly when compared against the overall cost of offering matching company contributions).
The Bottom Line
Overall, DCPPs continue to be the most robust of all CAPs available to plan sponsors today. Their relative rigidness, particularly for younger employees more interested in saving to buy a home, is certainly a factor to consider. As is their potential cost to employers. But there can be no doubt that DCPPs are also the most reliable option (DB plans excluded) for employers who want to ensure that plan contributions are going exclusively towards funding the future retirement of their employees.
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