I often hear physicians and other incorporated professionals lament that they don’t have a pension. Sometimes, that is tainted by a dose of pension envy. Unfortunately, that envy is leveraged by companies selling pension products. Products have benefits, but they come with costs and trade-offs. Self-employed Canadians actually have multiple options to plan for their retirement. Including pension products. Learn the basics of how pensions work and the options available to self-employed business owners. That way, you can make an informed logical decision guided by your goals rather than one based on envy or FOMO.
Pensions Are Part of Employee Compensation
The Pension Shell-Game
The first step to taking a logical look at pension options is to set pension envy aside. A pension is part of an employee’s compensation package. If an employer is paying money into a pension as part of the cost allocated to paying for their worker, then that is also money that could have been paid directly to the worker instead. Usually, the employee is also forced to contribute from their pay to participate.
It is all a shell game because all of the money comes from the employer. Whether part appears on the employee’s paystub or not. Still, that does have better optics, a feeling of ownership for the employee, and can be a retention incentive. The forced-saving and arms-length investment management may also foster behavioral advantages.
Self-employed business owners have no pension illusions. They have options.
For the self-employed, there are no illusions. We make money in our business and decide how to compensate ourselves.
For incorporated business owners, that usually means a mix of salary and dividends.
Paying dividends leaves more partially-taxed money in the corporation to grow and access later. Kind of like a pension except that the investment income is taxable and it is not 100% tax-deferral.
Paying a salary takes more money out of the corporation now, but allows you to contribute to fully tax-deferred and tax-sheltered pensions or pension-like registered accounts.
For unincorporated business owners, there is no choice. The profits of their business are taxed as personal income, they pay into the Canada Pension Plan (CPP) or Quebec Pension Plan (QPP). They also get room to fund their Registered Retirement Savings Plan (RRSP).
Basic Pension Terminology
Before getting into the options for pensions, you must understand some of the terminology that goes with them.
Defined Benefit Pensions
For a defined benefit (DB) pension, the employer/employee contributes to the pension plan. The money is invested, managed, and funded to target a defined benefit. For example, 2% of your salary per year of service. This means that there are actuarial calculations to define how much funding and performance is needed to meet that target. If you were to access the pension early, the annual income is reduced to reflect the shorter investment period and longer projected retirement drawdown period.
The employer assumes the majority of the risk. If the pension investments are underperforming relative to the predicted pension liability, then they must contribute more to keep the pension adequately funded. This is why this type of pension is hard to find anymore outside of the public service. Self-employed private corporation owners can use that liability to transfer more funds from their company to their pension plan. More on that later.
Defined Contribution Pensions
With a defined contribution pension, the employer may contribute a defined amount to the pension each year or it may match contributions by the employee up to a maximum. The eventual pay-out depends on how well the investments held in the pension do. It is very similar to an RRSP, except that the employer often has a limited selection of funds that you could choose from.
Just like with other investments, the risk and returns depend on what the pension holds. The largest impacts are usually from the asset allocation (stocks:bonds) and the drag caused by the fees. Higher management fees are generally associated with worse performance. Unfortunately, the investment fund selection may be limited due to whatever arrangement the employer has with the pension provider. If there is employer matching, then that may offset the fees. However, if not, then perhaps a self-directed RRSP with low-cost asset allocation ETFs instead may be a better option.
Commuting a Pension
If you leave an employer or The Terminator gets you, then there is an option to commute your pension. That means the pension is valued and the money moved out. For a DB pension, that involves an actuarial assessment and there are rules to value the pension based on how much it would cost to provide the benefit entitlement. A DC pension is more straightforward since it is just an account value.
The pension can be commuted to a new pension or Locked-In Retirement Arrangement (LIRA). For DB pensions, usually, only a portion can be commuted to a sheltered account. An additional lump sum cash payment could also be paid out. It would be taxable as income if you don’t have extra RRSP contribution room to shelter it in. For DC pensions, the involuntary contributions go to a LIRA. If there were excess voluntary contributions, then they could be transferred to an RRSP.
RRSP, RRIF, LIRA, & LIF
An RRSP is a registered account that is meant to be used to save for retirement. At retirement, or by age 71, an RRSP is converted to a registered retirement income fund (RRIF). There are then minimal required annual withdrawals.
A LIRA is an account that a pension was commuted to and the money is “locked in” the account until at least age 55. Some provinces allow the unlocking of a LIRA into an RRSP or RRIF. At retirement, the LIRA can be converted to a Life Income Fund (LIF) and possibly an RRIF.
Independent Pension Plan & Personal Pension Plan
There are a few different flavors of registered pension plans (RPP). An RPP is governed by a specific set of rules. They are similar to the RRSP rules in some ways, like tax treatment. However, they have some differences in the investing rules, ownership, and creditor protection. We’ll explore that in the next section, but first the different flavors. For self-employed private corporation owners, the two main pension options are an IPP and the proprietary PPP variant.
An independent pension plan is a pension that is owned by a Canadian Controlled Private Company. It is usually for an individual but can be for a family employee/shareholder also. They are usually DB pensions but can be DC.
A personal pension plan (PPP) is a trademarked proprietary version of IPPs. It has a defined benefit IPP, a defined contribution IPP, and a voluntary additional contributions account. A PPP is a packaged product by Integris that comes with the actuarial, tax lawyer, and pension expert support to use the different PPP accounts as conditions warrant.
For an IPP or PPP, you need an actuarial to help with the required RPP filings, a brokerage that holds the IPP accounts, and investments held within those accounts.
Group Pension Plan & Multi-Employer Pension Plan
A group pension plan (GPP) is an employer-sponsored RPP. This is your classic defined benefit pension plan, like the teacher’s pensions or public servant pensions. Everything is held in trust by the pension and managed by the pension managers.
A multi-employer pension plan (MEPP) is a type of GPP that has multiple companies paying into it. The new Medicus Pension Plan from Scotia Bank is an example of this. It is vital to understand that this is NOT a type of IPP or PPP. The characteristics of this type of plan are very different from the IPP/PPP option. Or the RRSP option. You should park any pension envy that you have and logically compare this product to your other self-employed pension options.
Pension Taxes Investments & Dispositions
Pension & RRSP/LIRA Tax Treatment
All pension options have pretty similar tax treatment. The contributions are made with pre-tax dollars. Contributions to an employer-sponsored pension (IPP/PPP/GPP) are a business expense and also not income for the employee. With an RRSP, the contribution is deductible against income. So, it is not taxed.
The amount that you can contribute is also global. For example, contributing to a pension reduces how much RRSP room you have due to a pension adjustment. You could have a personal plus a spousal RRSP, but the contribution limits are shared by the contributor.
Investments within the pension grow tax-free and there is no tax on dividends or interest. There could be some foreign withholding taxes for dividends from funds or stocks domiciled in a country without pensions as part of their tax treaties with Canada. The biggest market is the US. Fortunately, RRSPs and pensions are exempt from US foreign withholding taxes.
When income is paid out of the pension, it is then taxed as regular income. So, pensions and RRSPs are basically tax deferral vehicles, with tax-sheltered growth along the way.
With an RRSP, LIRA, or IPP/PPP you have options for investment management. An RRSP and LIRA can easily be managed as self-directed accounts. Alternatively, you could use a good financial advisor to manage it, using your input. An IPP can also be self-directed for investment management in theory. However, it also requires actuarial assessments and annual filings. So, IPPs are most commonly used in conjunction with a financial advisor to help stick-handle some of those administrative tasks.
Employer-sponsored plans limit your investment management options. For a DC plan, there is usually a limited selection of mutual funds to choose from. For a DB plan, you have no choice. The investments are managed by pension managers.
Pension managers take a different approach to risk management than we do as individuals. They are building a portfolio to match the liabilities of the pension over an ultra-long time frame. In contrast, as individuals, we try to maximize the investment risk required to meet our goals. Balanced by enough stability to tolerate that risk and have our basic needs protected. We also do that over a time frame that matches our retirement and lifespan.
All pension types (IPP/PPP/GPP) have some differences in the investments allowed. They cannot have more than 10% in a single security. Importantly, a well-diversified mutual fund or ETF does not count as a single security – it holds many.
Pensions can also hold private equity. That is usually touted as a strength. However, the returns of private equity are more complex than promoted. They may not be superior when you account for the pricing issues and leverage. Alternatively, if you really want to, you could hold those assets elsewhere.
A large pension plan may hold some private investments directly, classically infrastructure, due to efficiencies of scale for managing that. However, remember that pension managers are looking at risk and return differently and that does not directly translate into what you experience as the return. The main benefit of good performance is that your pension income stream is safer. You may also have some cost of living adjustments if the investments consistently do much better than anticipated, net of fees.
Creditors & Ex-spouses
In the event of bankruptcy, pensions, Life Income Funds (LIF), and Locked-in Retirement Accounts (LIRAs) are protected from creditors in all provinces. Registered Retirement Income Funds (RRIFs) that have been converted from an RRSP have full protection in some provinces. Notably, in some provinces, an RRSP does not have full creditor protection unless it is holding insurance products with a designated beneficiary. Further, RRSP contributions within 12 months of declaring bankruptcy may not be protected.
In the event of a divorce, pensions or RRSPs accrued during the marriage are valued and form part of the assets that get divided between the splitting couple. For a self-employed professional, this includes a pension held by their private corporation. In practice, that usually means an equalization payment is made from the overall assets (not directly from the pension or RRSP).
‘Till Death Do You Part
What happens to the income stream and assets of a pension when the primary pensioner dies varies. Some pensions may have survivor benefits. In that case, the surviving spouse may receive a portion of the original pension income stream. It could be the full pension or it could be much less. Some pensions will value the pension and it can be commuted if the spouse dies before their earliest possible retirement age.
In the case of an RRSP, the full RRSP can be transferred to the surviving spouse. It could even be transferred to a qualifying survivor such as a dependent child or grandchild. It is important to have the spouse named as beneficiary (instead of the estate). Plus, file the terminal tax return and some additional paperwork properly. Overall, the net effect is continued tax deferral and sheltering.
The Final End-Game
When the pensioner dies without a surviving spouse, or the surviving spouse dies, the income stream of a pension ends. What happens to the residual assets that were providing that income depends on the type of pension it was.
For an IPP/PPP owned by a private corporation, the assets form part of the corporation. If the corporation is wound down due to the death of the self-employed corporation shareholders, then the pension value goes back to the corporation. There would be taxes and possibly probate depending on your corporate estate planning. Family businesses that are continuing, can simply have the pension continue within the corporation for the benefit of the next generation.
If it was a multi-employer pension plan (MEPP) or an employer-run group pension plan (GPP), then the assets simply stay in the plan to support the other members. Read that sentence again, if you are considering a MEPP.
An RRSP/RRIF would be considered part of the deceased estate. The residual, after-taxes plus probate, would be dispersed according to the will.
Pensions Available To Everyone
Mandatory Canadian Public Pensions
When you collect T4 or T4A income, there are mandatory pension contributions to Canada Pension Plan (CCP) or Quebec Pension Plan (QPP). They are sometimes called payroll taxes. However, the CPP or QPP contributions are actually mandatory pension contributions.
Self-employed individuals pay both the employee and employer halves of the required contribution. So, there is no compensation shell game. The important concept is that you get a relatively safe, predictable income stream proportional to what you contributed. It is indexed to inflation with some survivor benefits. Overall, it is a decent risk-adjusted return and a defined benefit pension. However, the pension is small compared to what most self-employed professionals will need.
Registered Retirement Savings Plan
Collecting T4 or T4A income also generates RRSP room. The RRSP is functionally similar to a defined contribution pension. You get 18% of your income, up to an annual maximum as contribution room. For example, it was $30780 for 2022 – corresponding to an income of $171K. The maximum contribution increases with inflation each year. It will be $31.5K for $175K salary in 2023. Unused contribution room accumulates. Contributions are 100% tax deductible and unused deductions can be carried forward to a higher income year.
It is important to understand that an RRSP is an account type. A container. Like defined contribution pensions, you can hold a wide variety of investments within an RRSP which will ultimately determine its value at retirement time. You may choose to DIY invest to minimize the drag of fees on performance or use an advisor if you feel they will provide good value for the cost.
Self-Employed Pension Options
As mentioned above, income that you take as personally earned income opens the door to pensions. The earned income from a non-incorporated business is captured as the income that appears on your T4 or T4A slip. The graphic below summarizes some of the big major options to get oriented to. Then, take a deeper dive into the text below.
Using an Independent Pension Plan For Incorporated Business Owners
A self-employed incorporated business owner generates years of service for pension purposes when they pay themselves a salary. The main advantages of an IPP don’t really come into play until you are in your early 40s due to the balance between the actuarial calculations and costs. So, most private corporation owners would use their RRSP before then. The years of service and RRSP balance can be used to buy back years of service when opening the IPP. That usually means the transfer of some of the RRSP into the IPP and a lump sum contribution by the corporation.
The corporation makes direct contributions to the IPP each year as a deductible business expense. The amount it can contribute is usually more than an RRSP. For example, roughly the same as an RRSP in the late 30s and growing to perhaps $50K at age 65. This is due to the actuarial calculation of the cost to provide the targeted benefit. So, it will vary based on many factors.
Because it is targeted to a benefit, the corporation may be able to contribute extra when investments underperform a 7.5%/yr benchmark or be forced to take contribution holidays when the investments exceed that. So, the type of investments you hold and their expected return influence the utility of an IPP.
You can technically DIY invest an IPP. However, with the administrative complexity, most use an advisor. Those advisor fees will drag on the return a bit. However, if already using an advisor, then an IPP at least has other advantages and you are paying anyway. Ben Felix and Braden Warwick recently did a very in-depth analysis of the potential benefit of IPPs that assumes the same fees whether using an RRSP or IPP.
When could a PPP offer advantages?
A PPP has most of the exact same features as an IPP. An IPP could also be contorted to emulate a PPP. However, Integris does streamline the processes considerably. The CEO of Integris explains IPPs on the Beyond MD Podcast. After giving it some critical thought, I can see some potential advantages to using a PPP instead of an IPP.
The PPP service provides tax lawyers, pension experts, and actuaries all in one stop. The IPP is a complex instrument. So, that is an advantage for implementation. The PPP can also more smoothly shift contributions to use defined benefit mode when markets are lagging and DC mode when they are smoking hot. You could even potentially hold your bonds in the DB account and equities in the DC account. Those strategies should translate into more money shifted from the corporation into the pension.
The main benefit of the third “overflow” voluntary account is if you have a family business with young members that you want to participate in the pension. The actuarial calculation does not favor those under the age of 37 relative to an RRSP. However, they could park some of that contribution shortfall within the pension management structure this way.
Naturally, that PPP packaging comes with an extra cost. Whether that is worth it relative to using another actuarial firm and a financial advisor experienced with IPPs depends heavily on your circumstances and preferences.
Multi-Employer Pension Plans (eg. Medicus)
The Medicus Pension Plan(TM) is a MEPP that is targeted at self-employed incorporated physicians by MD Financial and Scotiabank. I hope from reading the sections on pension terminology and pension characteristics that you already understand this is completely different from an RRSP or an IPP.
A MEPP is a packaged product. There are other MEPP products that corporations can buy for their employees, but I am going to use Medicus as my example. I am neither for nor against Medicus and I cannot give specific details about it. That is the nature of opaque financial products. So, is the fact that they are made to be sold and generate income for the selling institution. What you need to consider is what the high-level pros and cons are. Consider how they align with your approach. Plus, how they compare to your alternatives.
Potential Multi-Employer Pension Plan Benefits
One big advantage of pooling investments with a group is that members would be drawing from the plan at different times. So, that spreads out the risk of retiring and starting to draw money during a market downturn causing investments to miss the ride back up. This sequence of returns risk (SORR) decreases a portfolio’s survivability and a group plan mitigates that. If on your own, you could mitigate SORR with asset allocation strategies, or flexible cash flow options.
Similarly, the investment horizon for a MEPP spans multiple lifetimes. In contrast, a self-employed individual typically has a horizon in the 25-50 year range for their pension. It shortens as you age, but the uncertainty of outliving your money also decreases with age. I am not sure how much of a practical difference this makes despite being touted as a benefit. I want to see my investments paying off in less than a 100-year time horizon.
The management model may be a benefit or a pitfall depending on your preferences. If you want to just give your money and have someone manage it with no decision-making required of you – then it is perfect. A pension manager will manage it. There are also some economies of scale. However, the fees are unknown and certainly vastly higher than a passive management strategy. An advisor has more transparent costs and you have input into the investment strategy.
A MEPP permits holding some assets that an RRSP isn’t allowed to. As previously mentioned, IPPs or PPPs have the same options. Perhaps, the one difference may be the direct management of private equity assets and infrastructure investments. Either way, you pay for the management and have manager execution risk.
Potential Multi-Employer Pension Plan Pitfalls
For Medicus, the initial contribution looks to be the same as an RRSP. It is a defined benefit plan. So, there will be actuarial calculations. However, it is a group that is being used. So, you will not benefit from the rapidly escalating contributions that an IPP/PPP is likely to have as you get closer to age 65.
The assets in a MEPP that support the target income stream are owned by the group. You can get a spousal survivor benefit. However, once the second death of a couple occurs the residual assets stay in the group plan to support other members. In contrast, an RRSP would be passed on to beneficiaries. Same with an IPP or PPP – either within your family corporation or as your corporation is dispensed to beneficiaries.
If the pension is overfunded, there could be cost of living adjustments. Within regulated guard rails. Conversely, if the MEPP is underfunded, benefits could be reduced. The product is sold as a reliable income stream. It likely is, with control of contributions and investments matched to the projected pension liability. However, there is some downside risk and a cap on upside potential too.
What if you have second thoughts? You can withdraw from a MEPP. That results in valuing your share of the pension and commuting it. Just like other DB pensions. There are rules about how to value it, but there is some potential for loss. For a MEPP, the commuted value may be reduced based on the funded value of the plan at the time you are leaving it. In contrast, with an IPP or PPP, all of the money gets back to you. Regardless of valuation rules and timing.
How I Would Weigh The Pension Options?
I have summarized the different pension options for self-employed incorporated professionals in the table below. These are just my personal thoughts. Feel free to put your own in the comments section. Also, pensions are a complex tangled mess across the country. So, if I have gotten something wrong, please call that out in the comments – along with a reliable reference. I plan to update the post accordingly.
If I use a highly competent advisor already
If I were using an advisor and paying them fees to handle paperwork and investment management, then I think an IPP or PPP would be a serious consideration for me in my 40s. Particularly, if I had a significant conservative part of my portfolio (like bonds) to hide in there and a large corporation. That way I could shift more corporate money into a tax shelter. In my younger years, I would just use my RRSP. At retirement, I would likely put a terminal lump sum into the pension from the corporation and then commute it to avoid ongoing excess costs.
If I am DIY investing
If using low-cost DIY investing, then I think it is a tougher decision. The advantages of an IPP may not be offset by the increased cost of investing using an advisor. Trying to DIY the IPP has execution risks if you miss filings or don’t handle some nuance properly. If I could make this really simple and turn-key, then I would consider it – but I am also a finance nerd. Further, the incremental benefit of an IPP over an RRSP depends on the returns. If I have an all-equity RRSP then I very well may exceed the 7.5% return frequently. Muting the benefit of an IPP.
If I am extremely hands-off & have pension envy
If I just want to give someone my money, not be involved, and I trust them to deliver the promised income stream, then a MEPP could be a good option. It may be even better if I have a very expensive advisor/fund cost model and the MEPP comparatively lowers costs through economies of scale. That would be impossible to know because the fees are opaque. It may leave less money for my heirs, but I could flex that “I have a DB group pension just like the civil servants, it has professional pension managers and owns infrastructure”. While quietly forgetting the fact that I still paid the bill for all of that. There are no free lunches, but it does help force some consumption.