Some retirees will be hit with 50% tax rates
Pooled Registered Pension Plans (PRPPs) — a new tax-assisted retirement savings vehicle introduced by the federal government with the intention of increasing pension coverage and lowering costs — have attracted some praise and some criticism since they were put forward in 2011.
A recent C.D. Howe Institute study suggests changes to tax rules that would make PRPPs a much-improved option over existing arrangements. PRPPs are still very much under construction. They will require provincial enabling legislation to be offered to most workers, and regulations have not been finalized.
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If done right, however, PRPPs could radically improve the pension landscape in this country by spurring innovation, enhancing coverage to millions of workers not covered under workplace pension plans, and improving retirement-saving outcomes through pooling of risks, economies of scale and lower-cost third party administration.
One crucial feature of PRPPs as envisioned is that a licensed third-party institution will independently administer the retirement savings of employees who come from multiple employers — unlike most defined-contribution plans, which are tied to a particular employer. This will allow PRPP participants to bunch their investments and enjoy economies of scale.
PRPPs will build on an existing infrastructure that should help ensure that low-cost options are widely available quickly. Provinces should pay special attention to institutional features such as fiduciary responsibilities, administrators’ licensing system, and well-thought-out default options.
But above all, it is the tax environment for retirement plans that is fundamental to their development. As currently proposed, tax rules for PRPPs are very much like those governing RRSPs — distributions are taxed, but contributions and investment income are not. Employers do not have to contribute to the plans; those who do will not have to pay payroll taxes on their contributions.
Other tax rules, however, may prevent PRPPs reaching their potential. As currently designed, PRPPs will not be allowed to pool the mortality risk of participants and provide low-cost self-insured target monthly pensions — a key aspect that retirees tend to expect from a pension plan. This is because tax rules prevent money purchase arrangements — such as defined-contribution (DC) retirement plans, group RRSPs, and now PRPPs — from providing retirement benefits in the form of a monthly pension insured for life. A life annuity must be purchased from an outside provider, and market rates can be unattractive.
The C.D. Howe Institute study argues that PRPP members should be able to fund for themselves the same pension benefits that accrue to defined-benefit (DB) plan members. This would require fundamental changes to federal tax rules to permit greater lifetime accumulation room based on an average of final or best career earnings, catch-up room to fund deficits resulting from experience losses, and the ability to fund and self-insure a life pension annuity. Together, these changes would allow PRPP providers to offer innovative and economical self-funded target pension benefits, thus affording all private-sector workers the opportunity to be part of plans that pay “true” target pensions — on par with their public-sector counterparts.
The goal of increasing retirement saving among people not currently covered highlights a further required tax change — potentially the most important of all. Many PRPPs will be funded by employees only, with no employer contribution. Many of these workers not covered by a workplace pension plan are low- to middle-income earners, who risk facing seniors’ benefit clawbacks on their pension income in retirement. The resulting all-in tax rate for these workers when they retire will exceed 50% — a tax hit far greater than the benefit they enjoyed when making their contributions.
The government cannot ensure comfortable retirements for low- to middle-income workers if it taxes and claws back their savings at exorbitant rates. Over a lifetime, these workers would be much better off to save for retirement in Tax-Free Savings Accounts (TFSAs) because then the tax rate they will face on their lifetime savings will be much lower. Therefore, the institute’s study also proposes allowing TFSA-style saving within PRPPs.
PRPPs have great potential to improve the retirement prospects for future Canadians. At present, however, Canada’s income tax rules stand in their way. We recommend changes to tax rules that would likely make PRPPs perform better for Canadians than their closest comparators — DC plans and RRSPs.
