Growing need for SERPs to top up retirement income

Canadian organizations are apt to find themselves under increasing pressure to introduce supplemental employee retirement plans (SERPs) as more employees are negatively impacted by government limits on registered pension plans as wages increase.

Two recent surveys of Canadian employers found that one of every six employees is already impacted in this way and that number is expected to increase to one in four by the year 2005 when the limits are scheduled to be increased.

“Basically it’s the government’s fault we have SERPs,” said Lyle Teichman, a principal in Towers Perrin’s retirement practice. The federal government sets limits on the benefits that can be provided through a registered plan and so employers have to look to other vehicles to provide benefits to employees who exceed those limits, he said. Typically employees making $86,111 and participating in a two per cent defined benefit plan reach the point where pension benefits as a percentage of total pay begins to diminish.

What this means is that as more employees receive higher incomes and find themselves bumping up against government limits — which have remained essentially unchanged since 1976 — they will look for employers who top-up their pensions to at least provide them with the benefits they would receive if the limits didn’t exist. In other words, it’s likely to become yet one more factor for employers to consider as they try to offer an attractive employment contract for scarce talent.

“Twenty years ago they were for the executive suite only, but now we’re seeing them being set up in many cases for all employees effected by the tax limits,” said Teichman.

This is an issue that encompasses employees at all levels, agreed Patrick Longhurst a senior consulting actuary at Watson Wyatt Canada. “Even employees earning $65,000 today may find their pensions affected by the time they retire,” he said.

In 1976, a senior executive making $50,000 could have received a pension that replaced 70 per cent of income after 35 years of service but in the current context an employee at the same level and making $200,000 would only receive about 30 per cent of total income. A study by Watson Wyatt found that just 52 per cent of Canadian firms provide some form of SERP and of those only 37 per cent make them available to all employees.

SERPs are still more common among large companies who have the resources to establish such a program, as well as a large enough number of interested employees. Smaller organizations tend to lack the requisite level of pension expertise to offer a SERP and senior decision-makers often can’t be convinced of the need, added Longhurst. However, over time it seems very likely more employers will be looking to set up some form of supplemental plan since it could become an important attraction retention tool.

According to the Watson Wyatt survey, of those companies that don’t offer a SERP 28 per cent said it was because they didn’t know they could or else they were uncertain how to implement one.

Often employers want to take it to the board before they decide they can offer a supplemental plan for employees because they are worried about the appearance of offering executives a perk, while in fact providing supplemental retirement plans for employees is not a special treat at all since those employees are not receiving the same share of their contributions as other workers.

A Towers Perrin study found 75 per cent of respondents have a SERP in place however most respondents had revenues exceeding $100 million, while the Watson Wyatt study looked at organizations of all sizes.

The most common reason employers are offering SERPs is that they want to restore benefits limited by the Income Tax Act, said Teichman, adding employers want to provide employees with the pension they would have received if the limits hadn’t existed.

More than half of the respondents to the Towers Perrin survey provide employees with two per cent of earnings above the yearly maximum pensionable earnings, effectively eliminating the government imposed limits.

As has always been the case with SERPs, the biggest issues are around funding since plan sponsors continue to search for a tax-effective way to fund supplemental arrangements.

Of the respondents to the Towers Perrin survey, 67 per cent take no steps to fund or secure the SERP. Employers that make contributions to fund a SERP through a retirement compensation arrangement (RCA), have to match contributions dollar for dollar to a refundable tax account with the Canada Customs and Revenue Agency which is only refunded when benefits are paid out. Employers would rather hold on to the money and invest it in other ways, choosing instead to rely on providing the benefits on a pay-as-you-go basis from general revenues.

While SERPs may remain a viable tool for larger firms, small employers that may not be able to support a supplemental program are making the switch to defined contribution plans since they mask the problem to a certain extent, said David Vincent, a pension expert with the law firm Fasken Martineau DuMoulin. “If you have a DC pension plan it works the same as a RRSP where there are limits to the contributions but the value of the payout is essentially unlimited.”

However, he added that some investment advisors are now suggesting that with the recent government changes to capital gains tax, investments in registered plans aren’t as attractive as they once were. The tax deduction on contributions up front remains appealing in registered plans but the income at the other end continues to be fully taxed as income. An employer could offer employees a standard registered plan and then set something up outside the registered plan where the employee and employer co-invest and enjoy a greater share of the gain in value.

A theory echoed by Teichman. “Now that corporate and capital-gains tax rates are falling, the use of funded RCAs may now decline in favour of other, more tax-effective funding strategies,” he said.

True, said Longhurst of Watson Wyatt, the pension landscape could start to change if capital gains taxes continue to decrease, making after-tax vehicles more attractive but he believes it is unlikely to have much of an impact on employers anytime soon since the concept is unlikely to replace the comfort level they feel with registered plans.

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