Impact Of The New Income Tax Act Limits On SERPs
By: Diana M. Woodhead
The 2003 federal budget proposed increases to the Income Tax Act limits for tax-assisted retirement savings (the ITA Limits) for registered pension plans (RPPs), registered retirement savings plans, and deferred profit sharing plans. The increased ITA Limits subsequently became law with the enactment of Bill 28. Employers who sponsor supplementary employee retirement plans (SERPs) that are designed to top-up the benefits that can be provided under an RPP should be aware that the increased ITA Limits may have an unintended impact on these supplemental arrangements.
So let’s examine the potential impact of the increased ITA Limits on SERPs.
Changes In The ITA Limits
Under Bill C-28, the ITA Limits increase as follows:
• Money Purchase Limits
The money purchase limit has been increased from $14,500 to $15,500 for 2003; $16,500 for 2004; and $18,000 for 2005. For 2006 and subsequent years, the money purchase limit will be increased by increases in the Average Industrial Wage. This will permit increased contributions to money purchase pension plans starting in 2003, provided the plans in question permit the higher contributions.
• Defined Benefit Limits
The defined benefit limit will continue to be the greater of $1,722.22 and 1/9 of the money purchase limit. This means that the defined benefit limit will be $1,722.22 for 2003; $1,833.33 for 2004; $2,000 for 2005; and 1/9 of the money purchase limit for subsequent years.
Types Of SERPs
Most SERPs are designed to top-up benefits that cannot be provided under RPPs due to the operation of the ITA Limits. SERPs can provide top-up benefits in a variety of ways. The most common format for a SERP is to mirror the benefits that are provided under the RPP but without regard to the ITA Limits, with an offset for the benefits that can be provided by the underlying RPP. Alternatively, a SERP could guarantee the replacement of a specified percentage of salary – for example, 70 per cent – without regard to the ITALimits, and with an offset for the benefits that are provided by the underlying RPP.
Another possibility would see the SERP providing for a higher accrual rate than is permitted by the ITA Limits – such as 21⁄2 per cent rather than the two per cent that is currently permissible under the ITA – with an offset for the benefits that are provided by the underlying RPP.
In these scenarios, it is usual for SERP members to be members of the underlying RPP, as most organizations prefer to take maximum advantage of the tax assistance that is provided under the ITA.
Therefore, as can be seen from the examples above, the typical SERP is structured with an offset for benefits that are provided under the RPP.
SERP Funding Arrangements
SERPs can be fully or partially funded arrangements and, if so, are normally ‘retirement compensation arrangements’ (RCAs) under the ITA, that are subject to a 50 per cent refundable tax on contributions to the SERP and earnings thereon.
Alternatively, the SERP promise can be secured by an irrevocable letter of credit, with partial or full funding triggered by certain ‘events of default’ on the part of the sponsoring organization.1 Secured SERP arrangements are also typically RCAs, as the cost of the letter of credit is considered to be a contribution to an RCA.
Then, again, the SERP can be a completely unfunded arrangement, with a promise to pay benefits upon retirement or termination.
Impact Of ITA Limits
The impact of the new ITA Limits depends on the design of the RPP and the SERP. In this article, the focus is on SERPs that are top-up arrangements providing benefits based on the same formula as the underlying RPP, with an offset for the benefits paid or payable under the RPP. These are the SERPs that will potentially be impacted by the increased ITALimits. Typically, such a SERP tops up benefits provided under a defined benefit RPP, but, increasingly, you will find these SERP arrangements topping up benefits provided under an underlying defined contribution RPP.
The actual impact of the new ITA Limits on a top-up SERP depends upon how the ITAprovisions are drafted in the underlying RPP. For example, if the maximum pension limits in a defined benefit RPP are indexed to the ITALimits, (the RPP limit is stated as “$1,722.22 per year of service or such greater limit as may be permitted under the ITA”), then commencing in 2004, a greater benefit will automatically be provided under the RPP on a tax sheltered basis. This means that the cost of the RPP will increase because of the additional funding requirement. If the SERP is an unfunded arrangement, there would be no impact on SERP funding. However, the benefits obligations under the SERP will be correspondingly reduced.2 If the SERP is a partially or fully funded arrangement or is secured by a letter of credit, the costs of the SERP (or of the letter of credit required to secure the SERP obligations) may decrease as a result of increased benefits being provided under the RPP.
If, on the other hand, the maximum pension limits under the RPP are stated as a fixed dollar amount (the RPP limit is stated as “$1,722.22 per year of service”), then the benefits that can be provided on a tax-sheltered basis under the RPP will not change as a result of the new ITA Limits and SERP obligations will not be reduced. In order for both the RPP and the SERP to take advantage of the additional tax sheltering provided by the new ITA Limits in this latter case, the RPP would have to be amended.
In the case of a SERP that tops up a defined contribution RPP, under which contributions are made, for example, based on a percentage of salary and are limited by the ITA Limits to the lesser of 18 per cent of compensation and the money purchase limit, contributions to the RPP would normally be constrained by the dollar money purchase limit. The SERP would typically provide for contributions (or notional contributions in an unfunded SERP) in excess of the money purchase limit.3 If the limits on contributions under the RPP are indexed to increases in the ITA Limits, (for example, the maximum contributions limits are stated as “the lesser of 18 per cent of compensation and the money purchase limit”4), then more contributions can automatically be made to the RPP commencing in 2003 on a tax sheltered basis. This will increase the cost of the RPP, and will result in a corresponding decrease in SERP obligations.
However, if the ITA limit referred to under the RPP is a specific dollar limit – for example, “the lesser of 18 per cent of compensation and $13,500” – then contributions under the RPP (and the cost of the RPP) will not change as a result of the new ITA Limits and SERP obligations will also remain the same, unless the RPP is amended to reflect the new ITA Limits.
Impact On Compliance With Provincial Minimum Standards
SERPs that provide benefits exclusively above the ITA Limits, such as the arrangements described in the previous paragraphs, are normally exempted from the requirement to comply with provincial minimum standards legislation.5 This is often a desirable feature for plan sponsors who have more flexibility with respect to the terms of the plan dealing with issues such as funding, eligibility, vesting, and locking-in and the form of benefits provided on termination or retirement than they would if the plan were governed by minimum standards legislation. Care needs to be taken to ensure that these types of SERP arrangements do not accidentally fall within the ambit of the minimum standards legislation, so as to be characterized as “pension plans” for purposes of the provincial minimum standards legislation.
For example, consider a SERP that tops up an RPP providing a two per cent final average earnings defined benefit per year of credited service, subject to an ITA limit of $1,722.22 per year of credited service, with an offset for the benefits payable under the RPP.
Prior to introduction of the new ITALimits, the SERP would only have been providing the portion of the benefit that is in excess of the $1,722.22 limit and would have met the conditions to be exempt from most provincial minimum standards legislation.
Under the new ITALimits, however, for years after 2003, when the ITAlimit is higher than $1,722.22 per year of service, a portion of the benefit provided under the SERP would be below the ITALimits. In that event, the SERP will no longer meet most provincial exemption requirements and would become subject to provincial compliance requirements unless the RPP is amended.
Other Funding Implications
As indicated previously, if the SERP is fully/partially funded or secured by a letter of credit (LOC), the costs of the SERP may decrease as a result of increased benefits being provided under the RPP. Such a decrease in costs gives rise to a number of potential issues for SERP plan sponsors. Can over-contributions be refunded or used to offset future funding requirements or can SERP funding be decreased on an on-going basis to reflect the reduction in on-going SERP costs? The answers to these questions will require an examination of the SERP plan text and the trust or other funding agreement(s) constituting the plan to determine whether a refund of over-contributions or payment of surplus to the employer is permitted, whether surplus may be used to offset future contribution obligations, or whether funding can be reduced on an ongoing basis. The documents should also be examined to determine the conditions, if any, under which these provisions can be exercised. For example, is an actuarial valuation required in support of the refund, use of surplus to offset future contribution obligations, or reduction in future funding, what are the timing requirements/restrictions of the actuarial valuation, is notice to the participants required or must participants’ consents be obtained?
If the SERPdocuments do not provide for refunds or use of surplus to offset contribution obligations, can they be amended or will such an amendment trigger an “event of default,” requiring full funding of the SERP? If so, can the documents constituting the SERPbe amended to remove the amendment from the ‘event of default’ criteria and what conditions (such as notices and consents) are attached to making the amendment?
Similar questions arise in connection with a SERP whose benefit promise is secured by a LOC. Can the amount of the LOC be decreased to reflect a change in the cost of the SERP or will a change in the amount of the LOC trigger an “event of default.” LOCs are normally irrevocable for the year for which they have been obtained and a decrease in the amount of the LOC could constitute a revocation unless the SERP documents specifically provide for this. If a decrease in the LOC amount would constitute an “event of default,” the documents must be examined to determine whether, and under what conditions, an amendment can be made to remove this condition from the “event of default” criteria. If the SERP documents permit the LOC to be adjusted to reflect a change/decrease in on-going obligations, are there any conditions under which such a change in the LOC would be permitted (such as actuarial valuation in support, notice to participants, participants’consents).
These examples illustrate the point that plan sponsors should examine carefully the wording contained in their current RPP and SERP documents to assess the impact of the new ITA Limits on their SERP arrangements and whether amendments are required to the RPP, the SERP, or both, in order that these plans can continue to operate together to provide the intended benefits, without resulting in adverse tax or other unintentional consequences.
Diana M. Woodhead is with Blake, Cassels & Graydon LLP.
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