Module 11: Other Employer-Sponsored Plans

Question 1

Explain why employers provide supplementary executive/employee retirement arrangements (SERPs).

Answer 1

SERPs contribute to attracting and retaining executive and highly skilled employees. A SERP is a flexible tool that can provide more or less generous pensions on bases that differ from those normally used in a registered pension plan (RPP). For executives hired at mid-career for whom the RPP can provide only a relatively small benefit, a SERP can be designed to compensate for short service, subject to Canada Revenue Agency guidelines.

Where the market for talented executives is competitive, a supplementary retirement arrangement can be an important element of the total compensation package.

Question 2

Describe two approaches to eligibility used in supplementary retirement arrangements.

Answer 2

In top-up plans, enrollment is automatic as soon as any employee’s registered pension plan entitlement is restricted by the ITA maximum.

In selected enrollment arrangements, the criteria to determine who participates in selected enrollment plans vary widely (e.g., chief executive officer (CEO) only, automatically for all selected officers, at board discretion for selected officers, all employees above a certain position or all employees above a certain salary).

Question 3

Outline special criteria that may influence how SERP provisions are structured to meet the needs of employees in senior positions and outline the SERP provisions that may be included in order to meet those criteria.

Answer 3

SERP provisions may be structured to:

(a) Provide an attractive retirement income for executives hired in mid-career, or to make up for pension credits forfeited as a result of leaving prior employment; and,

(b) Help retain key executives as they approach retirement age.

Special SERP provisions may include:

(a) An accrual rate higher than 2%

(b) Additional service credits

(c) A pension benefit formula based on a flat percentage of final average earnings (i.e., 60%), irrespective of service or after a specified number of years of service such as 15 or 20 years

(d) In a defined contribution SERP, an employer contribution schedule that increases as the employee’s service period increases.

Question 4

Outline the Canadian Securities Administrators (CSA) disclosure requirements for named executive officers (NEOs).

Answer 4

Under CSA disclosure requirements, publicly traded companies are required to disclose the compensation of named executive officers (NEOs). The NEOs include the chief executive officer (CEO), the chief financial officer (CFO) and the three other most highly paid executives whose total compensation exceeds $150,000. The required Statement of Executive Compensation (a summary table of compensation) must include a “pension value,” including the “compensatory value” of benefits provided to each NEO under all registered and nonregistered defined benefit (DB) pension plans and defined contribution (DC) pension plans.

Benefits provided under DB and DC plans are to be disclosed in separate retirement plan benefit tables. Details to be reported for DB pension plans include the number of years of credited service, the annual benefits payable assuming retirement at the end of the most recent financial year and at the age of 65, the accrued obligation at the start of the plan year, the accrued obligation at the end of the plan year, and the breakdown in the change in the accrued value during the plan year between compensatory and noncompensatory amounts must be shown for each NEO.

Details to be reported for DC pension plans include accumulated values at the start and end of the year as well as the compensatory and noncompensatory changes in value that occurred during the year.

Question 5

Explain an employer’s considerations when deciding whether employees will be required to contribute to a funded Retirement Compensation Arrangement (RCA)

Answer 5

Almost all supplementary employee retirement plans are noncontributory. For those that are contributory, most use the same contribution formulas as are contained in the underlying RPP. Plans that are contributory will almost always be funded SERPs, characterized for tax purposes as Retirement Compensation Arrangements (RCAs).

In order for employee contributions to a funded RCA to be tax-deductible, the contributions must be mandatory and must not exceed the amount of employer contributions made to the plan in respect of that employee. Nondeductible contributions can still be made to the RCA, and the payment of benefits at retirement will not be taxed until the total amount of employee contributions has been paid out.

Question 6

Describe the key characteristics of a retiring allowance and reasons why they may be paid.

Answer 6

A retiring allowance is an amount received upon or after retirement from an office or employment, in recognition of long service or in respect of loss of office or employment. It is usually paid as a single sum, but it can also be paid out in a limited series of installments.

Retiring allowances are used mostly as severance payments to long-service terminated employees, or as “sweeteners” to induce long-service employees to accept an early retirement offer. To the extent that tax relief is available, it makes sense to use a retiring allowance at the time of an employee’s planned retirement.

Question 7

Identify the limits under the Income Tax rules on retirement allowance amounts that can be transferred to RPPs or RRSPs.

Answer 7

A retiring allowance must be included in the recipient’s income in the year received, but there is provision for income tax to be deferred if transferred to a registered pension plan (RPP) or a Registered Retirement Savings Plan (RRSP). The amount that can be transferred to these vehicles is limited to:

(a) $2,000 times the number of years (including partial years) before 1996 during which the employee was employed by the employer or a related employer, plus

(b) An additional $1,500 for each year of service (including partial years) prior to 1989 in respect of which employer contributions to an RPP or a deferred profit- sharing plan (DPSP) had not vested in the employee.

As time passes, the tax relief available in respect of service before 1996 is becoming less relevant.

Question 8

Outline the reasons for funding and not funding a supplementary retirement arrangement.

Answer 8

The tax relief that makes funding RPPs attractive is not available when assets are set aside to fund the benefits promised under a supplementary retirement arrangement. Therefore, historically, few supplementary retirement arrangements have been funded. Where supplementary retirement arrangements are not funded, the pension benefits are paid as they fall due out of the company’s current revenues (i.e., on a pay-as-you-go basis).

The lack of funding can be a source of concern to employees who expect to receive supplementary pensions. There is a risk that the financial health of the employer will deteriorate, rendering the employer unable to pay. On the other hand, some companies feel that funding executive pensions is inappropriate (the logic being that executives should not be protected from the implications of company failure). Depending on the reasons the supplementary retirement arrangement was put in place, a company might consider the supplementary pension to be part of incentives for active employees rather than as a provision for the employee’s retirement security in the future.

Question 9

Explain the main advantage of funding a supplemental plan by using an RCA.

Answer 9

The main advantage of funding through an RCA is that it provides security to participating employees, since the assets in the RCA are typically separate from company assets (transferred to a trustee or held in trust by the employer) and are therefore protected from the employer’s creditors.

Question 10

Describe specific arrangements that the Income Tax Act excludes from the definition of an RCA.

Answer 10

Specific arrangements that the Income Tax Act excludes from the definition of an RCA include:

(a) RPPs, salary deferral arrangements (SDAs) and plans that are dealt with under other provisions of ITA, such as DPSPs, employee’s profit-sharing plans (EPSPs), RRSPs, tax-free savings accounts (TFSAs), employee trusts and certain health, disability and unemployment benefit plans as well as certain foreign service plans for nonresidents

(b) Plans established for the purpose of deferring the salary of a professional athlete

(c) Life insurance premiums and insurance policies (except in instances where a life insurance policy can be deemed to be an RCA)

(d) Certain “prescribed plans or arrangements” under ITA regulations.

Question 11

Describe a letter of credit and explain how it can be used to provide security for an RCA.

Answer 11

After the funded RCA, the most common mechanism to provide security for a supplementary pension arrangement is an RCA that holds a letter of credit. Although the letter of credit is not an immediate source of funding, it can provide a form of security in circumstances such as bankruptcy, change of control or failure of the employer to pay SERP benefits.

A letter of credit is an irrevocable promise by a financial institution, usually a bank, to pay a specified amount if certain conditions unfold, such as the failure to pay a pension benefit. Normally, the term of a letter of credit is one year. If an employer sponsoring a SERP fulfills their commitment and pays the employee the agreed-upon pension, the most recent letter of credit will be allowed to expire. For purposes of securing a long-term obligation such as pension income, successive letters of credit are put in place, each of which becomes payable for the benefit of the RCA trust if the employer fails to provide the next letter of credit.

The annual premium (fee) paid to the bank by the employer for the letter of credit is analogous to an insurance premium for coverage that facilitates payment of these benefits (with the fee reflecting the amount needed to secure the unfunded accrued pension promise to employees).

Generally, the employer will establish an RCA and will contribute twice the fee charged by the financial institution issuing the letter of credit, and 50% of the contributions are paid to the Receiver General. This contribution is made on an annual basis as letters of credits are put in place. The RCA uses the contributions to purchase the letter of credit from the financial institution. As there is no property held in the RCA, other than the letter of credit, there are no earnings inside the RCA subject to the refundable 50% tax.

Benefits would be paid out to the employee on a pay-as-you-go basis, and the letter of credit is called upon only where the employer fails to make the payments or some other specified event occurs that triggers the letter of credit. If the employer does not fulfill their commitment, the RCA trust must obtain monies from the LOC in order to pay the pension. At that time, upon request of the appointed trustees of the RCA, the lending institution advances the face amount of the letter of credit to fund the benefits and thereby becomes a creditor of the employer. The trust must remit 50% of the face value of the LOC to CRA as a refundable tax payment, and the balance is available to the trust. Then, at time of retirement, the 50% refundable tax is recouped and the trust pays the agreed-upon benefit to the employee.

Question 12

Explain the implications of the special deeming rules under ITA that apply when an employer acquires an interest in a life insurance policy with the intent to use that policy to fund retirement benefits.

Answer 12

As a result of special deeming rules under ITA, when an employer acquires an interest in a life insurance policy that may be reasonably considered to have been acquired with the intent to fund retirement benefits, RCA rules apply.

These special deeming rules are:

(a) The employer that purchased the policy is deemed to be the custodian of the RCA

(b) The policy is deemed to be the property of the RCA

(c) Twice the amount of any premium paid in respect of the policy is deemed to be a contribution to the RCA and is subject to the 50% refundable tax

(d) A repayment of a policy loan is considered to be a contribution to the RCA

(e) Any payments received pursuant to the policy, including policy loans, are treated as distributions from the RCA and will trigger the 50% tax refund.

Question 13

Describe a secular trust.

Answer 13

A secular trust is an arrangement whereby the employer pays to the employee additional salary on the condition that the employee will in turn establish a trust to hold the additional amounts. The employee is the beneficiary of the trust. To ensure the funds are used to provide retirement income, the employee agrees that the trust will contain terms that constrain the timing and amount of income the employee can withdraw from the trust. The capital used to establish the secular trust is taxable income to the employee and, as a result, a gross-up may be required to offset the taxes paid. The employee pays tax on the income of the trust so such trusts do not defer tax. The employer can normally obtain a deduction for the additional salary paid. A secular trust can be tax effective if the top marginal tax rate is less than the 50% rate applicable to RCAs, since under the current tax regime, capital gains and dividends enjoy a tax rate below 50%.

Question 14

Explain why an employer might establish a profit-sharing plan.

Answer 14

Profit-sharing plans are designed to reward good performance and to instill a sense of partnership between the employer and each participating employee. An employer would expect the plan to lead to increased productivity and increased profit. The intention is to establish a common interest for employees, management and shareholders.

Question 15

Outline the types of non-pension profit-sharing plans operating in Canada.

Answer 15

Non-pension profit-sharing plans can be established to provide immediate or deferred benefits.

Immediate benefits can be provided through a cash profit-sharing plan, while non-pension plans that provide deferred benefits include:

(a) Deferred profit-sharing plans (DPSPs)

(b) Employee’s profit-sharing plans (EPSPs).

Question 16

Describe the key characteristics of employee’s profit-sharing plan (EPSPs).

Answer 16

Under an EPSP, amounts are paid by the employer to a trustee to be held in individual plan member accounts and invested for the benefit of the employees who are members of the plan until such time as a member’s account is paid out. Funds may be invested in shares of the employer as these plans are not subject to investment restrictions. There is no limit on the amount of deductible employer contributions.

Employer contributions must be calculated by reference to the employer’s “profits” or “out of profits,” which are current profits and/or accumulated undistributed profits from previous years. If contributions are made by reference to “profits,” the minimum contribution is 1% of current year profits. If the contributions are made by reference to “out of profits” (either current profits and/or undistributed accumulated profits), the minimum contribution is $100 per employee.

The employer sponsoring the plan establishes eligibility for participation, and may, within the constraints of human rights legislation, designate any employee to be eligible for participation. Contributions made by the employer may be based on a proportion of the employee’s earnings, length of service or such other equitable formula as may be adopted. Member accounts will receive both contributions and any profits and/or capital gains or losses of the trust.

The employees must pay tax on all amounts allocated to their accounts each year, including the company’s contribution and investment income of the trust. As a result, payments out of the plan will not be included in the employee’s taxable income.

Question 17

Explain how vesting provisions apply to EPSPs and the possible inequity associated with certain vesting schedules.

Answer 17

Vesting provisions vary from plan to plan, ranging from immediate vesting to deferred vesting that does not occur until the plan member dies, terminates employment or retires. As taxes are immediate, inequities can arise if an employee is taxed on amounts contingently allocated to them that are never received. Relief is provided by the Income Tax Act, in that any employee who ceases to be a beneficiary under an EPSP is allowed to deduct an amount equal to the amounts on which they paid tax but cannot receive, less certain adjustments.

Question 18

Describe the key characteristics of a tax-free savings account (TFSA).

Answer 18

A TFSA allows Canadian residents age 18 and older to contribute up to the applicable TFSA contribution limit for the year. TFSA contribution limits are fixed dollar amounts and are related to earnings.

Other key characteristics of TFSAs include:

(a) Contributions are not tax-deductible, and withdrawals are not subject to tax

(b) Unused TFSA contribution room accumulates

(c) Investment income earned on TFSA deposits is not subject to tax

(d) TFSAs can exist until the death of the owner; there is no set maturity date

(e) Withdrawals are not considered to be income in respect of federal income-tested benefits like Old Age Security, Guaranteed Income Supplement, Employment Insurance benefits

(f) Withdrawals are added to the next year’s TFSA contribution room

(g) Funds can be provided to a spouse or common-law partner and to adult children over age 18 to invest in their own TFSA accounts

(h) There are no attribution rules on contributions made to a spouse’s TFSA, nor do spousal contribution affect an individual’s TFSA contribution room

(i) TFSA assets can generally be transferred to the TFSA of a spouse or common-law partner upon death

(j) TFSA assets may be used to secure a loan without being withdrawn from the plan.

Individual TFSA accounts can be opened with various financial institutions including insurance companies, banks, trust companies and credit unions. The provider of the TFSA account takes care of registering the account with the Canada Revenue Agency (CRA).

Question 19

Describe a group TFSA.

Answer 19

A group TFSA is a collection of individual TFSAs for which the routine administrative functions are centralized. The employer deducts contributions from the employees’ incomes and contributes the amounts, usually monthly, to their individual TFSA accounts. The plan sponsor decides what investment options will be made available to plan members. Group TFSAs offering more than one investment option fall under the Guidelines for Capital Accumulation Plans (CAP Guidelines).

Question 20

Outline the advantages of employer-sponsored group TFSAs.

Answer 20

Employer-sponsored group TFSAs offer access to another tax-sheltered savings vehicle for retirement contributions that currently cannot be tax sheltered through registered plans where, typically, any excess now goes to taxable savings plans. In addition, they offer the opportunity to:

(a) Encourage further employee savings through supplemental contributions in a group program, allowing employees access to institutional money managers who may not sell in retail markets

(b) Benefit from their employer’s oversight of the investment fund managers and plan administrators

(c) Benefit from automatic inclusion of TFSA balances in any retirement income modeling tools provided by the plan administrator

(d) By combining group TFSAs with existing employer-sponsored savings vehicles, administrative and management fees are reduced compared to individual TFSAs offered by outside parties (banks or other retailers) and obtained individually by employees on their own

(e) Tax-shelter investment earnings on an employee stock ownership plan, provided employees have unused TFSA contribution room

(f) Conveniently save through payroll deduction

(g) Use the TFSA as a temporary holding account for subsequent transfers to other registered plans (e.g., RRSP) as a way to maximize their tax benefit.

Question 21

Explain the main difference between a TFSA and an RRSP.

Answer 21

The main difference between a TFSA and an RRSP is that contributions to a TFSA are made with after-tax dollars and no tax is imposed on withdrawals—even on investment income or capital gains. Contributions to RRSPs are tax-deductible when made, but withdrawals are taxed as income whether due to return of contributions, investment income or capital gains.

Question 22

Indicate situations in which an individual would favour a TFSA over an RRSP.

Answer 22

Situations where a TSFA would be more favourable include:

(a) Canadians age 71 or older who wish to save and earn tax-free investment income

(b) Lower-income Canadians who depend on income-tested government pension programs—Monies withdrawn from a TFSA do not impact the income test

(c) Canadians who expect to be in a higher tax bracket after retirement.

Question 23

Identify basic characteristics of two types of retirement savings plans designed to target the self-employed and businesses that have no employer-sponsored plan.

Answer 23

Pooled Registered Pension Plans (PRPPs), available in all provinces except PEI and Newfoundland and Labrador, and Québec’s Voluntary Retirement Savings Plans (VRSPs) were designed to target these two groups of workers. They are intended to be low-cost defined contribution plans that are administered by regulated financial institutions instead of by employers. Participating employers may make tax-deductible contributions directly to a PRPP for their employees, and employees can also make tax-deductible contributions, subject to certain limits.

Unlike RPPs, PRPPs do not require employer contributions. PRPPs must be administered by regulated financial institutions that hold a fiduciary duty to plan members.

VSRPs are very similar to PRPPs and are mandatory in Québec for certain employers that do not offer other types of registered retirement plans. Employers are not required to contribute to a VSRP, and the employee contribution rate must be no less than a prescribed minimum amount.

Question 24

Describe the key characteristics of employee savings plans.

Answer 24

The key characteristics of employee savings plans are:

(a) They are developed to address various savings objectives, e.g., to cover exceptional expenditures or emergencies such as periods of reduced income

(b) They may provide the employee with immediate entitlement to a company contribution or entitlement, which may depend on vesting requirements

(c) They may offer a variety of investments

(d) They may include an employer contribution that matches some portion of the employee’s contribution

(e) Generally, cash withdrawals are permitted at any time up to the amount vested in the employee’s account

(f) They may provide for automatic payouts of both employer and employee contributions and investment earnings after a fixed time period

(g) Tax treatment of nonregistered savings plans is unfavourable when compared to Group RRSPs, Group TFSAs or deferred profit-sharing plans.

Question 25

Indicate types of stock plans companies offer to employees.

Answer 25

Share purchase plans: Designed to encourage employees to invest in their employer’s stock, often through convenient payroll deduction

Stock option plans: Designed as incentives for employees to increase profits or to retain and attract key employees

Share appreciation rights: Allow employees the right to receive a cash amount representing the appreciation in the value of company shares

Phantom share plans: Designed as bonus, or incentive plans that are tied to the value of company stock

Restricted and performance share unit plans: Involve granting employees notional shares that mirror the market value of the company’s shares, typically the common shares

Deferred share unit plans: Similar to restricted share unit plans but which prescribe payment only after the employee’s retirement, termination of employment or death

Restricted share/performance share plans: Depend upon the issuance of restricted shares by the corporation sponsoring the plan.

Question 26

Explain how funds are held in a savings or thrift plan if the plan is designed to acquire shares of company stock.

Answer 26

If the savings or thrift plan is designed to acquire shares of company stock, typically the service provider will be an investment broker who will set up individual accounts for each plan member. If the plan is allowed to invest in other assets, the funds are held in individual accounts by any institution that can handle the tax reporting (i.e., reporting taxable interest, dividends and distributions).

Question 27

Describe the key characteristics of a stock option plan.

Answer 27

Under a stock option plan, eligible employees are given options to buy specified amounts of the capital stock of a company (or an affiliated company) at a price fixed on the day the option is granted. The employee is usually given a period of up to ten years during which the option may be exercised.

Specific approval of the company’s shareholders may be required to implement a stock option plan.