Ottawa increased pension limits, but top-ups for top earners still needed

There was speculation early in 2003 about a meaningful increase to the maximum pension allowed under defined benefit registered pension plans. And while the federal government increased limits in its budget at the beginning of the year, HR professionals who may have wondered if they still need compensation schemes to supplement retirement plans for top earners will find little has changed. Reviewing pension top-ups is likely in order, with federal changes taken into account.

Pension limits and a Supplementary Employee Retirement Program (SERP)

Often referred to as the “maximum $60,000 annual pension,” this limitation on how much an individual can accumulate in a pension plan has been in place since 1976, essentially without change.

There’s good reason to consider increasing this limit.

First, the limit has eroded significantly from 27 years of inflation. In 1976, it tended to affect just top executives. Today, many middle management, professional and technical employees are affected. In real terms, the limit has shrunk since 1976 by more than two-thirds of its value.

Second, significantly higher limits are available in other countries with similar pension systems, notably the United States and the United Kingdom. Canadian employers are at a competitive disadvantage.

In this situation, supplementary pension arrangements have become prevalent as a way for employers to deliver the benefit that was intended, notwithstanding the pension tax limit. In fact, the term “SERP,” which initially meant Supplementary Executive Retirement Program, has evolved to mean Supplementary Employee Retirement Program.

Need for SERPs to remain high

The federal government’s February 2003 budget presented an opportunity to catch up. Indeed, some change in the limit did emerge and has since been passed into law.

With changes in the budget, the limit will increase to a $70,000 maximum pension for an employee who retires during 2005 with 25 years of service. For retirements after 2005, this limit on the initial pension amount will be adjusted to reflect future wage inflation.

While the increase in the limit is desirable, the budget changes fall far short of compensating for the effects inflation has had on pension limits. Nor will the changes achieve parity with the limits legislated by Canada’s main economic partners.

Studies show that more than 85 per cent of large employers currently have supplemental pension arrangements. This will remain the case even with the modestly higher pension limits now available.

Nevertheless, this change in rules should trigger organizations to review existing pension arrangements to ensure that the registered and supplemental elements remain properly co-ordinated, and that the higher registered plan limit now available is in fact exercised (presuming this is consistent with program objectives).

Although protection against the pension limit is the main reason why employers sponsor SERP arrangements, it is not the sole reason. Considerations include:

Mid-career hires: For someone in mid-to-late career, pension benefits assume greater importance in deciding between alternative job opportunities. And, by leaving a current employer, an individual might be foregoing pay-related increases to a benefit already earned for many years of prior service. A SERP offered by a new employer can offset some or all of this loss and greatly assist in recruiting mid-career talent. On the flip side, lack of a SERP might increase the risk of losing star talent.

Tax-effective compensation: An employer might be contemplating two reward packages — one having higher cash compensation with lower pension, the other having lower compensation with higher pension. In such a situation, an executive who does not need additional cash for current consumption might look favourably upon the higher pension option (due to the tax deferral achieved by a properly-structured arrangement).

Team re-alignment: As organizations change ownership or direction, the executive team is often subject to “adjustment.” SERP arrangements can assist by having early retirement features that facilitate such a change.

Heightened focus on SERP security

Most SERPs are “pay as you go” arrangements where the employer pays benefits from its current cash flows as they become due. In the absence of any special security arrangement, this approach leaves covered individuals at risk; the SERP recipient is an unsecured creditor.

Additionally, as organizations change and as leadership teams change, differences can emerge between the employer’s and the individual’s understandings of the supplementary pension promise. From the individual’s perspective, there is a “change of heart” risk in addition to the “ability to pay” risk. Scenarios such as a merger or change of ownership can trigger a review of compensation schemes, and potentially, a “change of heart” in the organization’s desire to honour a SERP promise.

Consider these risk exposures in light of both the pace of change in today’s business world and the increased size of SERP entitlements due to historically eroding tax limits. It is not surprising, then, that securing the SERP promise is assuming much greater importance. Achieving security involves two main elements — documentation and “financial backstops.”

Documentation of the promise should ensure a common understanding of the deal. What is the amount of benefit, and when will it be paid? Are there criteria (such as vesting) that must be fulfilled as a condition for receiving benefits? These issues must be addressed. Indeed, clearly articulated benefit terms in tandem with properly executed documentation are critical to achieving SERP security as they enable SERP members to demonstrate their claims, should this prove necessary.

Financial backstops can be categorized into three main types.

Funding: Assets can be set aside, outside the reach of the employer’s creditors, where SERP members can look to these assets for satisfaction of their benefits. A funded Retirement Compensation Arrangement (RCA) is an example of such an approach. Provided the necessary level of assets is regularly assessed and additional contributions made as warranted, members can be reasonably assured that their accrued SERP benefits will be provided — even if the employer itself encounters financial difficulty.

Transfer the obligation: The SERP obligation might be assumed by a party other than the employer. For example, consider an approach where annuities are purchased from an insurance company as members retire. Since the annuity would be owned by the SERP member, it would not be within the reach of the employer’s creditors. Hence, once the purchase had taken place, the member would be assured of receiving the benefit. In a similar vein, the SERP obligation could be settled by having the employer make a lump sum payment to the member.

Provide access to employer’s credit facility: A more complicated approach, this involves creation of a special trust. The trust holds a letter of credit that would be called in certain circumstances, beyond which SERP benefits would be paid to members from the trust assets. Until that time the employer would pay SERP benefits to members, and would also be obliged to periodically renew the letter of credit, assess its sufficiency and ensure that the trust had assets sufficient to cover the letter of credit stand-by fees.

Each of these approaches involves tax issues that are complex and financially significant. And, to varying degrees, the approaches each reduce the employer’s cash resources (either by withdrawing funds or utilizing its credit line) in advance of when SERP benefits are payable to members. Since the after-tax return on these withdrawals tends to be less than what the employer could have achieved internally within its own operations, there is a cost associated with the financial backstop arrangements (that is, relative to the pay-as-you-go approach). The amount of this cost is highly sensitive to the approach used and to how the funds would otherwise have been deployed had they remained in the employer’s operations. In some cases, this cost is relatively large.

Many organizations are currently assessing their supplementary retirement benefit programs. In some cases the matter had been on hold pending a likely change in registered pension rules. For others, economic volatility and the realization that supplemental benefits will continue to be a large portion of some members’ overall pension promise is prompting a review of security approaches. Organizations should review both benefit design and financing arrangements to ensure alignment with program objectives.

Gerry Schnurr is a principal in the Toronto office of Towers Perrin. He specializes in pension design and financial matters, and can be reached at [email protected] or (416) 960-2709.

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