It’s no secret that ever since the launch of the tax-free savings account a decade ago, Canadians have wholeheartedly embraced the idea of being able to save for retirement (among other goals) on a tax-free basis, using after-tax dollars. Now, a new report out this week calls on the government to take the next step and pave the way for the introduction of tax-free pension plans (TFPP) as a new option for Canadian employers and their workers.
Employer-sponsored workplace pension plans have long been considered by actuaries, economists and other experts to be the most effective vehicle to save for retirement due to features like automatic enrollment, forced savings, employer contributions, potential for substantial investment management and administrative fee reductions due to economies of scale, potentially higher risk-adjusted investment returns, and the possible pooling of longevity and other risks.
Yet, despite this, the number of workplace pension plans has been on the decline over the past number of years. For example, according to Statistics Canada, in 2017 there were 16,619 registered pension plans in Canada, down from 18,236 in 2013. While total membership in RPPs has remained relatively constant at 6.3 million or so Canadians over this period, the clear trend has been away from defined-benefit pension plans (where the pension you will get is based on some formula tied to earnings and length of employment) to defined contribution plans (where what you get depends on the amount you contribute and how the underlying investments perform).
There are a variety of reasons why employers may choose not to offer a pension plan to their workers. Some employers believe that the cost, administrative and governance burden is too high for them while others simply recognize that their workers would prefer to have the cash today instead of additional financial security at some distant, future retirement date. But, according to the report, there are also employers who understand that providing a RPP does not significantly benefit parts of their workforce due to our current tax and social benefit system.
In her report entitled Filling the Cracks in Pension Coverage: Introducing Workplace Tax-Free Pension Plans, author Dr. Bonnie-Jeanne MacDonald, the director of financial security research at the National Institute on Ageing at Toronto’s Ryerson University, argues that a TFPP could be beneficial for many lower-income Canadians who are otherwise penalized by current pension plan design. Both defined-benefit and defined-contribution pension plans pay out taxable pension income, which can often trigger a loss of income-tested government benefits upon retirement resulting in egregiously high marginal effective tax rates on relatively low amounts of retirement income and benefits.
“Better options are needed to support employers’ efforts to offer pension plans that help their entire workforce — benefitting not only workers, but also employers’ business objectives. For example, financially secure employees are better positioned to meet their retirement goals and retire on time, which supports employers’ succession planning needs,” writes MacDonald in the report.
The report argues that workplace pensions go a long way to help protect the retirement income security of Canadians while at the same time limiting reliance on various publicly funded seniors’ programs and benefits. As the proportion of seniors to workers is expected to double between 2010 and 2060, MacDonald suggests that workplace pensions “have the potential to relieve some of the inevitable burdens that Canada will face.”
Prior research cited in the report shows that Canadians’ private savings are often inadequate without the support of workplace plans. Canadian families in which no adult is a member of a pension plan have only $3,000 in median retirement savings as they approach retirement age, that research shows.
The current retirement pension system provides “clear financial incentives for Canadians at the upper end of the earnings spectrum to participate in workplace registered pension plans, versus sub-par (or even negative) incentives for those at the middle to lower end.”
The reason for the discrepancy lies with our progressive income tax system combined with income-tested government benefits. In theory, a workplace pension plan allows current workers to defer income as well as tax on that income to a time, later in life, when we are not working and presumably our tax bracket would be lower. But these tax deferrals are often much more valuable to higher earners. Indeed, Canadians with lower annual incomes often ending up paying a marginal effective tax rate of 50 per cent or more on each dollar of pension income they receive, due to the income-testing underlying the eligibility calculation for senior social benefits, like the Guaranteed Income Supplement (GIS). The result of this is that modest-income Canadians can face financial penalties, rather than incentives, within the current RPP system.
To address this disparity, the white paper proposes a new class of workplace pension plans, similar to current plans, but with one critical exception: rather than operating like a registered savings plan or RRSP, they would operate in a “tax-free savings” environment, with after-tax contributions during working years and pensions that do not count as income when taken upon retirement.
The problem with the current design of traditional pension plans, be they DC or DB plans, is that when they are ultimately converted to a pension income stream, that income could be taxed at marginal effective tax rates (including the effect of government clawbacks) that were even higher than the period of contribution.
It’s this same logic that generally discourages lower-income Canadians from contributing to an RRSP and has them preferring the TFSA. While both the RRSP and TFSA offer the same opportunity for tax-free investment returns, if your marginal effective tax rate is expected to be higher during some future period of RRSP/TFSA withdrawal than it was in the period of contribution, then the TFSA trumps the RRSP as you’re paying tax on your income at a low rate in the year of contribution and not paying any tax in the year of withdrawal. The introduction of a TFPP framework in Canada would provide that same opportunity for workers in employer-sponsored DB or DC workplace pension plans.
Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Financial Planning & Advice Group in Toronto.