Beyond Locked-In RRSPs

— a Moneysaver Article by H.Michael Wise

Canadian Moneysaver readers are well aware of the features of RRSPs and RRIFs. There is much less information available about another retirement plan which is, unfortunately, becoming much more common today. I say unfortunately, because locked-in Registered Retirement Savings Plans too often come about as a result of "unplanned departure" from a company. Despite the similarity of their names, the RRSP and locked-in RRSP are two different animals. Before describing the locked-in RRSP, and what can be done with it, let's look at some pension concepts.

Types of Pension Plan

There are two basic types of company pension plan: the defined benefit plan and the defined contribution plan. The Group RRSP and Deferred Profit Sharing Plans are other forms of savings plans, but they are not pension plans, and I won't cover them in this article.

The defined benefit plan is the more traditional pension type. The company agrees to pay a retiree a monthly sum for the rest of their life after retirement. The sum is usually based on the person's earnings for the past 5 years, multiplied by a factor related to years of service with the company. By federal law, the pension factor cannot be more than 2%, unless you are a Member of Parliament. The factor for MPs is 6%.

The monthly sum, which is essentially an annuity, can be payable in any of four ways:

  • for the life of the retiree;
  • at a rate of 100% as long as the retiree lives, and at 60% thereafter for the surviving spouse;
  • at an even rate throughout the life of the longest-living spouse;
  • at one rate until the retiree reaches 65, then lowered by the amount of the CPP payment.

Not all of these choices may be available to an individual. The Declaration of Trust which established the pension may restrict choice; pensions are often a negotiated part of union contracts; provincial law may restrict choice. For example, Alberta requires that a pension payable to a married retiree must continue for the surviving spouse.

The company assumes a risk when it offers a defined benefit plan. The plan must contain sufficient assets to be able to fund annuities for all possible retirees. If investment returns have been satisfactory, and the plan has more than sufficient assets, the plan has a surplus and the company does not have to contribute any money to fund the plan. If it does not, the company must pay sufficient money into the plan to bring it back to a fully-funded condition.

Defined benefit plans provide a secure worry-free retirement to long-time employees. They work less well for employees who leave the company, either voluntarily or involuntarily, prior to retirement.

If leaving a company early, the employee usually has a choice of leaving the pension with the company. This option will provide an annuity starting at age 65, with the payments depending upon years of service, etc. The other option is to take a lump sum buyout of the annuity obligation. The size of the lump sum is equal to the present value of the annuity obligation. A young employee would qualify for a much smaller lump sum buyout than would an older employee, even if salary and years of service were identical. The lump sum would be placed in a locked-in RRSP.

In a defined contribution plan (often called a money purchase plan), the company and possibly the employee make regular payments into the plan. When the employee leaves the company, the sum of company and employee contributions, plus any investment returns, become the property of the employee as a single lump sum. The lump sum would be placed in a locked-in RRSP.

The employee assumes all risk with a defined contribution plan. The size of the lump sum depends upon the investment returns achieved by the pension fund manager. There is an additional risk if the employee wants to use the money to fund an annuity. The income received from an annuity depends upon interest rates at the time the annuity is purchased. If the employee is retiring at a time of low interest rates, the monthly income will be a lot lower than if the annuity had been purchased at a time of high interest rates.

The Registered Retirement Savings Plan is a federal creation. Federal rules govern RRSPs. Pension legislation is a provincial responsibility. Provincial rules govern defined benefit and defined contribution pension plans. The laws of the province in which the pension was registered govern what can be done with funds which were formerly held within pension plans.

Despite its name, the locked-in RRSP comes under provincial law. All of the provincial pension regulators consider that the money is to provide a continuing retirement income. Once this is taken into account, the various restrictions make sense.

Locked-In RRSP Options

You have a locked-in RRSP. What can you do with it?

Until you retire, a locked-in RRSP is just like an ordinary RRSP. You can use it to buy GICs; you can buy mutual funds; you can have a self-directed plan, in which you can hold a wide variety of investments. There are only 2 restrictions: you cannot add more money to the locked-in RRSP, and you cannot withdraw any funds.

Once you choose to retire, you need to get money out of the locked-in RRSP. To do this, you must convert it into another form.

If you hold a regular RRSP, you might convert it to an annuity. More commonly, you would convert your RRSP to a Registered Retirement Income Fund (RRIF). The RRIF option is not available to holders of a locked-in RRSP. The reason is simple: the RRIF has a minimum withdrawal schedule (see Table 1), but no maximum limit. It is possible to remove all the assets from a RRIF in a single year. This would defeat the underlying principle of the locked-in RRSP, and therefore it is not allowed. If you hold a locked-in RRSP, the allowable conversion depends upon the province. Former federal government employees have special rules which restrict conversion of their locked-in RRSPs.

Annuities

All provinces permit conversion of the locked-in RRSP to an annuity. Many provinces require that, if married, the annuity be a joint and survivor annuity. It is possible to get a waiver for the joint survivor restriction, but this is seldom to the advantage of the spouse. As a financial advisor, I would need a very good reason before dealing with someone who insisted on waiving the joint survivor clause. One such reason would be if the spouse were terminally ill. The increased payment available from a single life annuity would not be an acceptable reason. (I don't even recommend the 60% survivor option.)

The annuity is best suited for those who prefer security over all aspects of retirement income. Annuities are offered by life insurance companies. In exchange for a lump sum, the life insurance company contracts to provide you and your spouse a fixed, continuing, monthly income for the rest of your life. The money received from an annuity depends upon interest rates at the time the annuity is purchased. If you are retiring at a time of low interest rates, your monthly income will be a lot lower than if you purchased it at a time of high interest rates. The monthly payout will vary considerably between insurance companies, so it really pays to shop around. You are also relying on the insurance company to honour its contract, so credit quality of the company is important. The income stream from an annuity purchased from a locked-in RRSP is fully taxable as pension income, and qualifies for the pension tax credit.

There are all kinds of options available with annuities, including inflation indexing. Virtually every option which increases your flexibility also reduces your monthly income stream.

Once purchased, the funds invested become the property of the insurance company. Unless you have a term certain annuity (another option), no money will pass to your heirs. It is also rare to find an annuity which allows you a conversion or buyout of the contract.

Annuities are a good business for life insurance companies. They are big winners if you and your spouse both die prematurely. They also win even if you live to a ripe old age. The monthly annuity payment seldom exceeds the interest you would get had you purchased a long term, high quality bond. When you buy an annuity, the insurance company can buy the bond with the lump sum you have provided, pass the interest to you, and wait patiently until you die before pocketing the entire bond principal! (No wonder the banks want to get into the insurance business.)

Life Income Funds

Life Income Funds are a relatively recent development. They combine the features of a life annuity and a RRIF. They are not available in all provinces, and there are significant differences in rules between provinces. The LIF is suitable for those who want to have control over their retirement assets.

The LIF comes in two parts.

The first part extends from when you start the LIF until the end of the year when you reach 80. Over this period of time, the LIF acts just like a RRIF, and all the flexibility and rules concerning RRIFs apply. Just like the RRIF, the LIF can hold GICs, mutual funds, stocks, bonds, and mortgages. The 20% foreign content rule applies. Table 1 shows the RRIF rules which govern the minimum annual payment. The provinces impose maximum annual payouts during the RRIF stage of a LIF. The income from a LIF is fully taxed as pension income. There is no withholding tax if the level of income is at the RRIF minimum payment level.

Should you die during the RRIF stage, your spouse assumes ownership of the plan. In most provinces, the locked-in restrictions do not apply to the spouse. If there is no surviving spouse, the funds are paid to a named beneficiary, or to your estate.

At age 80 (or before if you so wish), the remaining assets in the LIF must be converted to a life annuity. All the features of an annuity described in the previous section apply.

Life Retirement Income Fund

Alberta and Saskatchewan have the most flexible conversion option - the Life Retirement Income Fund (LRIF). This option became available in 1993, and is most suitable for those who want to have complete control over their retirement assets, and who wish to leave an estate to their heirs.

Those who choose an LRIF will most commonly desire a fully self-directed plan, which can hold GICs, mutual funds, stocks, bonds, and mortgages. Non arms-length mortgages are OK in Saskatchewan, but are not acceptable in Alberta. The 20% foreign content limit applies.

The LRIF is similar to the LIF with one key exception: there is no requirement to convert the LRIF to a life annuity. As with the LIF, there is both a minimum annual payment and maximum payment. You can choose any payment level in between the minimum and maximum.

The minimum payment matches the RRIF minimum payment, and is determined by either your age, or that of your spouse. The current RRIF minimum payment schedule is shown in Table 1.

For those 70 or younger, the minimum payout formula is 1/(90-age at 1 Jan). The percentages shown above relate to the value of the LRIF at 1 January each year.

The maximum payout from an LRIF is a little tricky. For the first year of your LRIF, the maximum payout is limited to 0.5% of the initial value of the LRIF per month. In the second year, the annual maximum is limited to the greater of 6% of the 1 January value, or the total investment income earned the previous year (including dividends, interest and capital gains). In subsequent years, it is limited to the greater of the earnings of the fund in the previous year, or the net earnings (earnings minus all payments) since the LRIF was established.

If the minimum required payment is greater than the maximum allowable payment, the minimum applies. The trustee of the plan generally computes the minimum and maximum allowable payments, and around the end of each year asks you to choose the income you wish to have for the next year. As always, LRIF payments are fully taxable as pension income, and are eligible for the pension tax credit. Withholding tax applies only on the portion of the LRIF payment in excess of the minimum.

If administration of the LRIF becomes too onerous, it is always possible to collapse the LRIF and purchase an annuity.

Conclusions

In summary, locked-in RRSPs are a provincial responsibility. Provincial pension regulators consider them as savings designed to fund a continuing retirement income. The locked-in RRSP can be converted to an annuity, a Life Income Fund in some provinces, or a Life Retirement Income Fund in Alberta and Saskatchewan. The annuity is most suitable for those who want a secure income source with no investment control. The LRIF is most suitable for those who want maximum control, and who want to leave an estate to their heirs.

One major word of warning to Alberta or Saskatchewan residents who are about to leave their company pension plan. Many company pension plans are managed by eastern-based financial institutions. Your human resources department will ask you to fill out their standard "locking-in agreement" which may not include a clause permitting conversion of your locked-in RRSP to an LRIF. Refuse to sign such an agreement! If you are an Alberta resident, contact me and I'll send you a copy of an Alberta locking-in agreement which includes the LRIF clause.

Table 1
RRIF/LIF/LRIF Minimum Payment Schedule

Age on 1 Jan RRIF Started Before
1/1/93
RRIF Started After
1/1/93
65 4.0% 4.0%
66 4.17% 4.17%
67 4.35% 4.35%
68 4.55% 4.55%
69 4.76% 4.76%
70 5.00% 5.00%
71 5.26% 7.38%
72 5.56% 7.48%
73 5.88% 7.59%
74 6.25% 7.71%
75 6.67% 7.85%
76 7.14% 7.99%
77 7.69% 8.15%
78 8.33% 8.33%
79 8.53% 8.53%
80 8.75% 8.75%
81 8.99% 8.99%
82 9.27% 9.27%
83 9.58% 9.58%
84 9.93% 9.93%
85 10.33% 10.33%
86 10.79% 10.79%
87 11.33% 11.33%
88 11.96% 11.96%
89 12.71% 12.71%
90 13.62% 13.62%
91 14.73% 14.73%
92 16.12% 16.12%
93 17.92% 17.92%
94+ 20.00% 20.00%

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