Opening up the pension wallet

Some employers are upping the ante by offering additional pension credit for top executives

Top executives at Canadian organizations are getting extra pension credits for years of service as an additional perk, despite rules that limit such practices.

Registered pension plans (RPPs) provide pension benefits to members after retirement, subject to the provisions of the Income Tax Act (ITA) and supporting regulations. These provisions limit pensionable service credits to one year for each year of employment with an employer. In addition, the ITA limits the amount of pension a member can accrue for each year of pensionable service under a RPP.

So how can additional pensionable service credits be provided to certain executives? The answer: Supplemental employee/executive retirement plans (SERPs).

Historically, SERPs have been integrated with an underlying RPP provided by the employer and are not designed as stand-alone plans. The SERP typically tops up the RPP to provide additional benefits that may simply be those that would otherwise be provided by the RPP but cannot be due to ITA limits.

Alternatively, a SERP may include some or all of the following features:

• a benefit formula different from the underlying RPP’s benefit formula;

• higher or no benefit maximums on the total pension benefit provided by the RPP plus SERP;

• for a SERP providing defined benefits (DB), more generous ancillary benefits such as early retirement provisions and a richer form of pension than available under a RPP;

• benefits that vest over a long period of service (for example, after 10 years of SERP membership) or only upon retirement directly from the company;

• no lump-sum payout or transfer option — benefits payable only in the form of a lifetime retirement income, contingent on the member or surviving spouse receiving a lifetime pension from the company’s underlying RPP;

• benefit accrual may be linked to corporate profitability; and

• continuing benefits may be contingent on the honouring of a non-compete provision.

Defined benefit SERPs may also include additional pensionable service credits for certain executives to recognize:

• when an individual has been promoted from a non-executive position;

• years of employment with the company prior to becoming a SERP member; or

• an individual hired externally in mid-to-late career stage, to provide pension benefits that may have been forfeited under the prior employer’s retirement arrangement.

The additional pensionable service credits may be a pre-determined number of years of service or a multiple for each year of future service. For example, an effective method for providing additional years to an employee with 10 years of employment with an employer, who is then promoted to a position that makes her eligible for a SERP benefit, is to award two years of pensionable service credits for each future year of membership in the SERP, with a cap of 10 additional pensionable service years.

Typically, the provision of additional pensionable service credits are detailed in the executive’s individual employment agreement rather than the SERP documents since individual circumstances often differ.

Attraction and retention

From the perspective of attracting top executive talent, a competitive pension plan, including a SERP, will undoubtedly be one of the factors considered by a candidate. The priority placed on the pension arrangements will vary depending on a candidate’s values and other factors, including the total compensation package, opportunities and challenges.

From a retention perspective, certain features of the SERP may make it difficult for an executive to depart without forfeiting a benefit having significant value, both in terms of the pension benefit accrued and future pension benefit accruals, other than those provided under the RPP.

Tax issues and the CRA

While, in general, taxation on SERP benefit accruals, whether funded or not, are deferred until benefits are paid to the member (lump sum or periodic pension benefits), a recent position put forth by Canada Revenue Agency (CRA) may jeopardize such tax-deferral status.

At issue is whether a SERP is a “superannuation or pension benefit” or a salary deferral arrangement (SDA) under the ITA, which calls for deferred annual taxation of the salary or wages. The ITA expressly excludes RPPs from the application of the SDA rules but does not exclude non-registered pension plans such as SERPs.

CRA’s position is if the SERP provides “reasonable” superannuation or pension benefits, the SERP benefits will not be subject to the SDA rules. The SDA rules will not apply if the SERP provides benefits determined in the same manner as the company’s underlying RPP, but without the defined benefit limits, less the benefits provided by the RPP. What is less clear is CRA’s view on “reasonable” superannuation or pension benefits, which will be resolved by the CRA on a case-by-case basis, taking into account the terms of the arrangement and other factors, including:

• the reasonableness of the benefits provided under the SERP in comparison to the provisions of the RPP that apply to particular employees;

• the history of the employer in providing pension benefits to employees and executives;

• the comparability of the benefits provided to other employees or related employers under the arrangements; and

• the history of the employee’s remuneration and any variations in that income as a consequence of the establishment of the arrangement.

As a result of CRA’s current position, new and existing SERPs that provide benefits greater than those provided by the company’s underlying RPP, but without the limits of the ITA, may be subject to the SDA rules under the ITA.

Existing SERPs may be able to pass the reasonableness test of the CRA. However, it is anticipated new SERPs will bear closer scrutiny. Companies with SERPs or considering setting one up where benefits are not similar to those provided by the company’s underlying RPP may wish to seek legal advice or an advanced tax ruling.

Kent Lum is vice-president of retirement practice at Aon Consulting in Toronto. He can be reached at [email protected].

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