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March 2016

Research Paper on Tax-Deferred Retirement Savings in Canada

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By Doug Chandler, FCIA

The CIA, jointly with the Society of Actuaries, recently published a research paper entitled Tax-Deferred Retirement Savings in Canada. Starting from the basis that employers who sponsor retirement plans have almost universally adopted arrangements that qualify for deferral of taxes, the research paper re-examines this and other fundamental choices in light of current low interest rates. None of the reasons for employers to choose tax-deferred retirement savings arrangements are as strong as they once were.

Pension or Tax-Free Savings Account (TFSA)?

It is widely believed that individuals will be in a lower tax bracket during retirement than when they are working, and so will benefit from an arrangement such as a pension plan that defers tax. While the basic tax rate may be lower after retirement, once clawbacks and the phaseout of tax credits are added, the overall effect on disposable income is a higher tax rate after retirement. For example, the 2015 federal income tax calculation includes a non-refundable tax credit for taxpayers over age 65 (the "age amount"), but reduces this credit by 15 percent of earnings in excess of $35,466. This age amount is $7,033 and the tax credit rate is 15 percent, so the phaseout of the federal age amount is effectively an additional 2.25 percent tax on earnings in excess of $35,466 up to $82,353. For an unmarried person retiring in Ontario, additions to the basic 2015 marginal tax rates include the following:

  • Old Age Security (OAS) clawbacks (15 percent on earnings from $73K to $118K, net of taxes);
  • Guaranteed Income Supplement (GIS) and Guaranteed Annual Income System (GAINS) clawback (50 percent or more on earnings in excess of OAS, up to $22K);
  • Phaseout of federal and Ontario age amount tax credits (2.25 to 3 percent on earnings from $35K to $83K);
  • Phaseout of sales, property, and energy tax credits (4 to 7 percent on middle-income earnings both before and after retirement) plus phaseout of the Ontario Senior Homeowners’ Property Tax Grant (3.33 percent on earnings over $35K after age 65); and
  • The Ontario Health Tax (6 percent on earnings from $20K to $25K, plus 25 percent on three higher earnings bands of $600 each).

In addition to these broad-based clawbacks and taxes, many seniors will face incremental effective marginal taxes due to pharmacare deductibles, medical expense tax credits, and rent geared to income in assisted living facilities.

Historically, the tax-free accumulation of investment returns has meant that employer-sponsored registered retirement savings plans (RRSPs), pension plans, and deferred profit sharing plans (DPSPs) outperformed other investment vehicles even for employees who were in a higher effective tax bracket after retirement. With the emergence of TFSAs and persistent low interest rates, this is no longer true. TFSAs, and sometimes even non-registered savings, can outperform tax-deferred employer-sponsored plans. A spreadsheet accompanying the research paper provides a simple illustration of the combined effect of tax rates, interest rates, and time horizon on after-tax income.

Tax-deferred retirement saving through a pension plan or RRSP is still a good way to provide early retirement income prior to the commencement of OAS, GIS, and age-related tax credits. But the best strategy for lifetime retirement income after age 65 will depend on retirement age, investment returns, home ownership, marital status, and other factors. The best strategy could turn out to be one of the following:

  • Relying entirely on tax-deferred retirement saving prior to age 70, while deferring commencement of OAS and Canada/Québec Pension Plan (C/QPP) to maximize inflation-protected lifetime income;
  • Minimizing taxable income by drawing C/QPP at age 60 and relying on TFSA withdrawals to supplement OAS, GIS, and reduced C/QPP after age 65; or
  • A blend of OAS, C/QPP, taxable employer-sponsored retirement income, and TFSA withdrawals throughout retirement.

In order to adopt either of the first two strategies, employees will need to be able to unlock their employer-sponsored retirement income. Employers who provide locked-in, tax-deferred retirement savings through defined benefit or defined contribution pension plans might not be meeting their employees’ needs or optimizing their spending on retirement income.

Most older employees already have significant accumulations in pension plans and RRSPs. They have been able to make TFSA contributions only since 2009; a pure TFSA strategy is not an option. For younger employees, it is difficult to construct examples in which the use of a TFSA will seriously underperform an RRSP:

  • Employees with earnings less than the year’s maximum pensionable earnings (YMPE) can typically expect the best outcomes by relying entirely on the TFSA and OAS/GIS system after age 65.
  • Middle-income employees can use a pure TFSA strategy to preserve a portion of the GIS benefit, so this strategy can marginally outperform a pension or RRSP strategy after age 65, especially if the employees take a reduced C/QPP pension at age 60.
  • For higher-income employees, maximum TFSA contributions alone will likely be insufficient, but defined contributions to a pension plan or RRSP at the 18 percent limit might also be insufficient in a low interest rate environment.

With so many different taxes and clawbacks and so many different situations, it is impossible to anticipate the tax deferral strategy that will work out best for any given employee. The optimal strategy will depend upon the following:

  • Retirement age and the starting age for C/QPP and OAS benefits;
  • Home ownership, health status, and marital status throughout retirement;
  • Actual individual rates of growth in investments, income, and consumption;
  • Future changes in tax legislation and government benefit rules; and
  • Province or country of residence when contributions and benefits are paid.

Employer or Employee Contributions?

The choice between employer and employee contributions to a pension plan is also influenced by low interest rates. Employer contributions are considered more tax-effective because they avoid payroll taxes like the Ontario Employer Health Tax, employment insurance (EI) premiums, and C/QPP contributions. With low interest rates, the reduction in C/QPP contributions for low-income employees can be less important than the resulting reduction in C/QPP benefits.

For employees earning less than $140,000 per year, the 18 percent cap on defined contributions will become an important consideration. For example, with an employer making no pension plan contributions, an employee can contribute $18,000 to an RRSP on a salary of $100,000. If the total earnings, including employer pension plan contributions, are to remain fixed at $100,000, the employer can contribute only $15,250 on salary of $84,750. With low interest rates, this lower contribution limit might be insufficient to meet the employer’s and employee’s retirement objectives.

Asset Mix and Taxes

Efforts to maximize the use of registered saving and minimize the portion of total retirement benefits that must be paid from a supplemental non-registered plan will not be as important in a low interest rate environment as they have been in the past. Lower returns mean lower investment taxes and a smaller penalty for non-registered investing. In considering the consequences of non-registered investing, there are a number of factors:

  • While a TFSA, RRSP, or registered pension plan is free of Canadian taxes on investment earnings, it is not free of foreign taxes on foreign investment earnings, and the foreign tax credit is lost when foreign taxes are withheld. This can be a particular problem for a TFSA (which is not exempt from taxes on U.S. income) and for exchange-traded funds.
  • Reduced tax rates for capital gains and Canadian dividends are applicable only to non-registered investments.
  • Risky investments generate more risk to retirement income inside a TFSA than in a non-registered account or tax-deferred account because taxes dampen the fluctuations in investment returns.

Conventional wisdom tells us that an individual with both registered and non-registered investments should put interest-bearing securities inside an RRSP and equities in a non-registered account, in order to take advantage of the reduced tax rates on capital gains and Canadian dividends. In a low interest rate environment, the equity risk premium is large relative to the yield on fixed-income investments. With a big enough equity risk premium, the tax rate on equities will produce a bigger expected reduction to the gross rate of return than the tax rate on bonds. Nonetheless, this does not lead to the conclusion that conventional wisdom is wrong. The riskiness of the overall investment strategy should be determined by considering the variability of after-tax withdrawals, not nominal account balances. For example, if a TFSA and non-registered account are the same size, allocating the entire TFSA to bonds and the entire registered account to stocks (a 50/50 asset mix overall based on nominal account balances) has a better expected after-tax return and no more risk than allocating 60 percent to bonds and 40 percent to stocks in both accounts (this assumes a 15-year time horizon, an 8 percent return with a 20 percent tax rate on stocks, and a 3 percent return with a 40 percent tax rate on bonds).

The decline in long-term interest rates over the past three decades has changed everything about retirement income plan design. Squeezing extra after-tax retirement income out of better tax and investment strategies can help, but does not address the fundamental problem of affordability. The considerations presented here and in the research paper will only be part of the movement away from tax-deferred retirement saving and obsolete pre-tax replacement ratios.

Doug Chandler, FCIA, is the Canadian retirement research actuary at the Society of Actuaries.


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