If you were allowed to contribute more than the current registered retirement savings plan (“RRSP”) limit of $24,270, would you?

The answer for most Canadians is a simple “no.” The median RRSP contribution in Canada was only $2,830 in 2011, or only 12 percent of that year’s limit, suggesting that most Canadians are not capable of, or not interested in, fully funding their registered plans to the allowable limit. However, for individuals who find themselves outside that cohort and ready go above and beyond the prescribed limits of an RRSP, an Individual Pension Plan (“IPP”) may be an option. To help demystify IPPs and show us how they work, CFA Society Toronto recently hosted an event on this subject, led by Stephen Cheng of Westcoast Actuaries. Here are the highlights of what we learned.

What is an IPP?

First introduced in 1991, an IPP is essentially a defined benefit pension plan for a single person. It is similar to a government employees’ pension plan, in that the pension benefit at retirement is a function of an individual’s income history and their length of service. Specifically, the formula for the benefit is 2 percent of an employee’s T4 employment income up to the defined benefit maximum pension limit ($2,770 for 2014) per year of service. To be clear, the complexities of an IPP are many (e.g., setting up an IPP typically requires the services of a professional), but the main goal is to allow business owners or incorporated professionals to use pre-tax corporate income to help catch up with retirement savings, often above and beyond what might be possible in an RRSP.

Who are IPPs for?

IPPs are designed for shareholder–employees, senior executives of an incorporated business, or incorporated professionals (i.e., owner/managers of a private corporation, physicians, lawyers, accountants, and engineers). Ideal candidates are typically over age 50, part of a successful business or practice, and in a position to use corporate pre-tax profits to fund their pension in a tax-efficient manner. To be eligible for an IPP, an individual must receive T4-type employment income from an incorporated employer. Income derived from self-employment, interest payments, or dividend payments is not eligible under Canada Revenue Agency rules for IPPs.

How are contributions made?

To explain how an IPP differs from an RRSP, Cheng walked event participants through the three key types of IPP employer contributions:

Current Service Contributions: These are simply the contributions to the pension plan that can be made each year after the IPP has been implemented.

Past Service Benefit Contributions: These contributions account for the years of service prior to the implementation of the IPP. The rules governing this category of contribution are nuanced, but it is important to note that the “past” can be set as far back as the start date of employment or the date of incorporation.

Terminal Funding Contributions: This is an additional “bonus” contribution that can be made after retirement, once the pension commences. It is typically greater than $500,000 but can vary depending on the circumstances of the individual.

How does it work in practice?

To demonstrate how an IPP might work in practice, an example was provided for the hypothetical case of Robert Li. In 2011, at the age of 57, Mr. Li was debating whether to set up an IPP or just stick to the more familiar RRSP. His main goal was to provide himself with a retirement income stream by using his company’s profits in a tax-efficient manner.

The graph to the right illustrates the difference between the potential assets accumulated under an IPP versus a traditional RRSP and is tailored specifically to Li’s age, past income level, years of service, and existing RRSP assets. If Li set up an IPP in 2011, his allowable current contribution is higher than what would have been possible under his RRSP, allowing him to contribute an additional $37,620 from 2011 to 2013. At the same time, under the IPP rules, Li is allowed a past service contribution of $231,940, based on his employment income from 1991 to 2010, which was earned at the maximum employment income level ($138,500). Also, he is allowed the transfer of $406,120 from his existing RRSP (under a few conditions). With an assumed annual net investment return of 7.5 percent, Li’s total IPP assets after including the “bonus” terminal funding contribution ($1,063,408) are $1,974,964.

Within the constraints of this specific example, if Li had chosen not to create an IPP but instead contributed under a traditional RRSP, his resulting financial situation would have been much different. Li would have only $581,720 in registered assets within his RRSP.

At the end of the day, it is important to remember that an IPP is an investment vehicle, and as such, it cannot determine the investment performance of the assets within the vehicle. However, choosing the right vehicle remains an important consideration for those close to retirement, and for individuals with the appropriate circumstances, IPPs are worth bearing in mind.

IPPs: The Good and the Bad

Pros

• Ability to make higher annual contributions than possible under an RRSP
• Creates a set monthly pension payout during retirement
• Ability to make a one-time “past service” contribution at implementation
• Option to make significant extra top-up contributions after retirement
• Creditor protection
• Ability to split 50 percent of IPP pension income with a spouse for tax purposes

Cons

• Main limitation is that funds in an IPP must be used for a lifetime pension—you cannot take 100 percent cash
• Regulatory burden can be significant
• Funds are held in trust and can’t be used for loan collateral purposes
• Typically requires an initial set-up fee and annual maintenance costs
• Minimum employer contributions are required each year by provincial legislation, except in British Columbia, Manitoba, and Quebec