An outdated policy continues to disadvantage holders of RRSPs or defined-contribution plans, expert argues
In a memo addressed to Finance Minister Bill Morneau, the president and CEO of the C.D. Howe Institute reiterated a previous call to allow higher contribution limits for RRSP savers and defined-contribution pension plan members.
“[C]urrent limits are outdated, unfair, and put savers in RRSPs and defined-contribution plans at a major disadvantage,” maintained William B.P. Robson in an intelligence memo titled The “Factor of Nine” Crushes Retirement Saving Opportunities – Let’s Pension it Off.
As Canadians live longer and investments suitable for retirement saving provide low yields, Robson argued, the cost of obtaining a given level of retirement income has risen. However, RRSP limits remain tethered to an equivalency test, the Factor of Nine, which determines how much should be saved in various retirement savings plans.
The Factor of Nine is based on a hypothetical defined-benefit pension plan that affords someone a retirement annuity equal to 1% of their pre-retirement income for every 9% of annual earnings they set aside during their working years. Under the Income Tax Act, a member of a defined-benefit pension plan can accrue a maximum annuity of 2% of final earnings tax-free in the year of accrual; over 35 years, it would yield a pension equal to 70% of pre-retirement earnings.
The Factor of Nine rule limits RRSP holders or defined-contribution plan members to contributions worth up to 18% of their earnings in a year (9 x 2%), ostensibly to let them achieve an equivalent outcome to defined-benefit pension plan members.
But according to Robson, the hypothetical plan on which the factor is based offer less generous benefits compared to the plans one sees in Canada’s defined-benefit pension landscape, making it a poor benchmark. He added that because of rising life expectancies and lower yields on retirement-suited assets, people need to save at least twice as much as the Factor of Nine recommends in order to replace their pre-retirement earnings.
“Moreover, savers in defined-contribution pensions and RRSPs typically incur higher risks and higher costs than defined-benefit plan savers,” he continued. The inability to pool longevity risk across cohorts — along with the fact that defined-contribution plan savers can’t contribute extra funds to cover past capital losses — makes the case for more generous tax treatment than what the Factor of Nine recommends.
Robson repeated the three types of reforms that the original C.D. Howe paper urged:
- Allowing a higher tax-deferred saving limit to raise the threshold from 18% to 30% or more, a measure that some have suggested could backfire;
- Levelling the playing field for late-stage contributors who need to catch up, or savers facing differences in pension-plan design; and
- Replace annual saving limits with flexible tax-deferral regimes, with unused contribution room indexed to inflation or lifetime tax-deferred savings limits being indexed to inflation.
