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People are living longer and—even more importantly—yields on investments suitable for retirement saving are very low. These changes have raised the cost of obtaining a given level of retirement income.

November 7, 2017 - Ottawa should raise contribution limits for savers in RRSPs and defined-contribution pension plans, says a new C.D. Howe Institute report. In “Rethinking Limits on Tax-Deferred Retirement Savings in Canada,” author William Robson finds current limits are outdated, unfair, and put savers in RRSPs and defined-contribution plans at a major disadvantage.

“People are living longer and—even more importantly—yields on investments suitable for retirement saving are very low.  These changes have raised the cost of obtaining a given level of retirement income.” says Robson.

The core of the problem is the Factor of Nine, a little-known, outdated “equivalency test” for savings in various retirement saving plans. First adopted in 1990, the Factor of Nine uses a hypothetical defined-benefit pension plan in which saving 9 percent of annual earnings will let a person buy a retirement annuity equal to 1 percent of pre-retirement income. The Income Tax Act lets a member of a defined-benefit pension plan accrue a maximum annuity of 2 percent of final earnings tax-free in the year of accrual - which, over 35 years, would yield a pension equal to 70 percent of pre-retirement earnings. The Factor of Nine limits holders of RRSPs or defined-contribution plans to contributions worth up to 18 percent of their earnings a year (9 x 2 percent).

While intended to let them achieve an equivalent outcome, this limit badly damages their hopes of achieving retirement security like that of members of defined-benefit pension plans common in Canada's public sector.

For one thing, the hypothetical plan underlying the Factor is less comprehensive than most actual defined-benefit plans. Worse, a quarter-century after its adoption, the Factor of Nine is badly outdated. Ongoing improvements in life expectancy and lower yields on retirement-appropriate assets mean that people must save at least twice as much to replace pre-retirement earnings than the Factor of Nine presumes. Moreover, savers in defined-contribution pensions and RRSPs typically incur higher risks and higher costs than defined-benefit plan savers. RRSPs and defined-contribution plan cannot pool longevity risk across cohorts like direct-benefit plan participants can.  

Market downturns are also more harmful to defined-contribution plans since savers cannot contribute extra funds to cover past capital losses: indeed, capital losses incurred by a defined-benefit plan must be offset by plan sponsors. All these considerations would justify more generous tax treatment of retirement saving in these plans - not the less generous treatment dictated by the Factor of Nine.

The author recommends three types of reforms which could alleviate problems associated with the Factor of Nine:

  • Updating the Factor of Nine’s underlying assumptions to reflect current economic and demographic realities; specifically, allowing a higher tax-deferred saving limit, raising the threshold from 18 percent to 30 percent or more.
  • Levelling the playing field for savers catching up on contributions later in life, or for savers with differences in pension plan design.
  • Replacing the current annual saving limits with flexible tax-deferral regimes: either index unused contribution room for inflation or, more transformatively, establish an inflation-indexed lifetime tax-deferred savings limit.

“Defined-contribution plan participants and RRSP savers should enjoy the same opportunity for pension wealth as their defined-benefit plan and public-sector plan counterparts,” says Robson. "All Canadians should have the ability to accumulate sufficient savings for retirement, and unfair tax-treatment should not stand in their way," he concludes.

Click here for the full report.

The C.D. Howe Institute is an independent not-for-profit research institute whose mission is to raise living standards by fostering economically sound public policies. Widely considered to be Canada's most influential think tank, the Institute is a trusted source of essential policy intelligence, distinguished by research that is nonpartisan, evidence-based and subject to definitive expert review.

For more information contact: William Robson, President and CEO of the C.D. Howe Institute or Alexandre Laurin, Director of Research, C.D. Howe Institute. Phone: 416-865-9935; email: lbouchard@cdhowe.org