Individual Pension Plans (IPPs): the Benefits and the Drawbacks
By Julie King | May 31, 2007
Individual Pension Plans (IPPs), formally known as designated plans, offer business owners and incorporated business professionals a way to greatly increase their retirement savings. They enable you to invest annual contributions that go well beyond what you can put into an RRSP.
Peter Merrick, the author of The Essential Individual Pension Plan Handbook, spoke to us about how IPPs work as well as the pros, cons and pitfalls of IPP investments.
The nuts & bolts of IPPs
IPPs are very complex, so you really need to look at them on an individual basis to determine if one is right for you or your company. Here are some interesting points about IPPs:
- You don't need to pay the same investment every year, but you must make sure that there is enough money in the plan so that the promised benefit is available to the recipient.
- The cost of the IPP is a direct, tax-deductible expense for the business.
- When you set-up an IPP you often have the ability to fund it back for many years, which lets you start by putting in substantially more money than your normal annual contribution amount.
- There is no minimum to get an IPP started.
- IPPs costs, on average are $3500 to set-up.
Major benefits of IPPs
An IPP is not as flexible as an RRSP, as you cannot draw the money out at any time and are expected to ensure that enough money is in the plan to pay out the pension benefits when plan members retire.
Nonetheless, IPPs have many advantages for people who are at least 40 years old with a reasonably amount of substantial income.
The greatest benefit is money.
IPPs will help some people make substantially greater contributions than they might otherwise do. More contributions means they will have more money compounding - tax deferred - until they retire. For some people the difference at retirement could be millions.
IPPs have non-financial benefits as well.
They are creditor protected, meaning your retirement is covered even if you or your business goes into bankruptcy. IPPs can also be used to attract high level employees who would normally feel that they can't leave their current job because of their pension plan. Expenses associated with the IPP are fully tax deductible to your company, while the benefit to the employee is not taxable.
In addition to your regular contribution amounts, it is also possible to make voluntary contributions.
Merrick uses the example of a dentist who is only able to put $25,000 into her IPP because she had just incorporated. However, the dentist had $1 million sitting in an RRSP.
Normally the benefit of spending $3500 to set-up the IPP would be minimal because the deposit amount is so low. However, the dentist is able to make an additional voluntary contribution and transfer the $1 million from her RRSP into the IPP.
The funds are still treated like an RRSP and can be taken out at any time. However, they are now creditor protected on top of that you can write-off the 2 % management fees as a business expense.
With the benefits come serious risks
IPPs also come with great risk, as one teacher who Merrick tried to help learned the hard way.
“Someone came up to this teacher and said you know you could get your money out of the teacher's pension if we create a corporation and we transfer the assets over to an IPP,” explained Merrick.
The teacher did this and at the same time he took retirement. Even worse, he listened to the advisor and invested all of the money in his IPP in tech funds in the late 1990s. When the stock market dropped, his $800,000 pension sunk to $250,000.
As Merrick explains in Chapter 2 of his book, for a plan to remain registered it must at all time satisfy four criteria:
- It must comply with all laws and regulations governing Registered Pension Plans and all filings must be up to date.
- The company that sponsors the plan must - prior to the creation of the plan - have existed for a reason other than to simply set-up an IPP.
- There must be a bona fide employment relationship between the plan member and the company.
- When assets from another defined benefit plan are transferred to an IPP the member of the plan must expect that his earnings at the new company will be similar to the earnings from his previous employment.
If you don't meet these four criteria you run the risk of having your IPP deregulated.
In the case of the teacher, the incorporated company that sponsored the plan had been set-up so that the teacher could realize a financial benefit.
"Under Revenue Canada's GAR rule, if Revenue Canada deems that you did something for the purpose of just saving tax they can basically disallow it. With Revenue Canada you are guilty before you can prove yourself innocent, unlike anything else in our system," said Merrick.
Revenue Canada de-regulated the teacher's plan and said they wanted $400,000 cash. With the funds invested down to $250,000 the teacher simply did not have the money to pay Revenue Canada.
"With Revenue Canada you can't go bankrupt, because they still have rights even if you declare bankruptcy," said Merrick.
Unfortunately Merrick was unable to help the teacher. The IPP was not set-up in accordance with Revenue Canada's guidelines and the money was deemed to be owed.
Many IPPs don't meet Revenue Canada's guidelines
The story of the teacher is not an unusual case. Merrick explained that most of the plans that he has looked at are "off-side", which means that they are not invested properly. Most often they are not in funds that meet the IPP investment criteria.
“The criteria for what you are allowed to invest in an IPP are a lot different from what you can do in an RRSP," said Merrick. "It's got lots of restrictions on it.”
“Most advisors selling these things do not – they just say â€˜hey, an IPP' and they throw it off to someone. They don't know whether it's approved, like whether these investments meet the criteria or not.”
To make things worse, while Revenue Canada used to scrutinize IPPs before they were started, they now plan to do more audits instead.
This means that for many companies, they will have an advisor set-up their IPP and may proceed for several years under the assumption that it was done properly. Should Revenue Canada audit the plan several years later and find problems, there could be serious financial consequences.
“In essence, if Revenue Canada was to do an audit and found that they were off-side there are huge penalties and that's something that I see all the time," said Merrick. "Most of my business comes from fixing these things â€¦ that's where it becomes very costly for them. It becomes painful.”
As with many things, the first step is to protect yourself is to become knowledgeable. In that regard Merrick's book is an excellent starting point.
Once you have armed yourself with a basic understanding of how IPPs work, look for someone who specializes in benefits, and who is not just an investment advisor.