Why it's time to rethink the 'outdated, unfair' RRSP contribution limit

National Post


If you diligently maximize your RRSP contributions each and every year but have this nagging feeling that you may end up worse off in retirement than your neighbour, who is fortunate enough to belong to a well-funded defined benefit pension plan, you’re probably correct.

While the amount we’re able to accumulate for retirement on tax-free basis in an RRSP is supposed to be equivalent to the amount of pension benefits that can be accrued under a defined benefit pension plan, the reality is that the “majority of Canadians who save for retirement in (RRSPs are) at a major disadvantage,” says a new report out this week from the C.D. Howe Institute.

In the report, authored by the Institute’s president and CEO, William Robson and titled “Rethinking Limits on Tax-Deferred Retirement Savings in Canada,” Mr. Robson calls the current limits “outdated, unfair, and put savers in RRSPs and defined-contribution plans at a major disadvantage.”

RRSPs, along with TFSAs, are very popular savings vehicles for Canadians. Indeed, recent census data shows that Canadians are embracing our various retirement savings accounts with nearly two-thirds of Canada’s 14 million households making some form of retirement contribution in 2015. About 40 per cent of households contributed to a TFSA, 35 per cent to an RRSP and 30 per cent to a registered pension plan. In 2015, out of 26.2 million tax-filers, six million contributed to an RRSP for a total of $39.2 billion worth of collective contributions.

But Canadians should be able to contribute more to their RRSPs, should they wish to do so. According to the report, the problem with the current RRSP system has its roots with increases in longevity and low interest rates. “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 Mr. Robson. As a result, Mr. Robson is calling on Ottawa to raise contribution limits for savers in RRSPs and defined-contribution pension plans.

Under the current rules, which have been around since 1990, the amount you can contribute to your RRSP on an annual basis is limited to 18 per cent of your previous year’s (i.e. 2016) “earned income,” up to a yearly maximum of $26,010 for 2017, less any pension adjustment. Earned income typically includes employment income, self-employment income and rental income and excludes investment or pension income.

But, have you ever wondered where the 18 per cent contribution limit percentage came from?

It has to do with something called the “Factor of Nine,” a “little-known, outdated ‘equivalency test’ for savings in various retirement saving plans.” The Factor of Nine uses a hypothetical defined-benefit pension plan in which saving nine per cent of an employee’s annual earnings will let an individual buy a retirement annuity equal to one per cent of pre-retirement income.

The Tax Act lets a member of a defined-benefit pension plan accrue a maximum annuity of 2 per cent of final earnings tax-free in the year of accrual, which, over a 35-year working career, would provide a pension equal to 70 per cent of pre-retirement earnings. The Factor of Nine therefore limits RRSP or defined-contribution pension plan contributors to making contributions worth up to 18 per cent of their earnings a year (9 x 2 per cent).

While the Factor of Nine was designed to let RRSP retirement savers achieve an equivalent outcome as defined benefit plan members, the current limit “badly damages their hopes of achieving retirement security like that of members of defined-benefit pension plans common in Canada’s public sector,” Mr. Robson contends.

There are various reasons for this. First of all, the hypothetical defined benefit plan under which the Factor of Nine was based is less comprehensive than most actual defined-benefit plans. Worse still, however, is that in the 27 years since its adoption, the Factor itself has become “badly outdated.” Ongoing improvements in life expectancy combined with lower yields on “retirement-appropriate” assets mean that Canadians must save at least twice as much to replace pre-retirement earnings than the Factor of Nine assumes.

Furthermore, RRSP savers and defined-contribution plan members cannot pool longevity risk across other retirement savers like defined benefit plan participants can and often incur both higher risks and higher costs than defined-benefit plan members.

In the event of a market correction or downturn, RRSP and defined-contribution plan savers aren’t able to contribute any extra funds to cover market losses. Contrast this with defined-benefit plans in which losses must be offset by their plan sponsors. These factors alone would justify more generous tax treatment of retirement saving in these plan, well beyond the outdated Factor of Nine.

To improve Canada’s retirement system, Mr. Robson recommends some fundamental reforms which could help alleviate problems associated with the Factor of Nine.

Firstly, he recommends updating the Factor of Nine’s underlying assumptions to reflect both the current economic climate and updated demographic realities. Specifically, he would recommend the government introduce a higher tax-deferred saving limit, raising the threshold percentage for RRSP contributions from 18 per cent to 30 per cent (or more.)

He also advocates levelling the playing field for savers who wish to catch up on contributions later in life. To this end, he suggests that the government consider replacing the current annual saving limits with more flexible tax-deferral regimes, such as indexing your unused RRSP contribution room for inflation or, in a more fundamental reform proposal, establish an inflation-indexed lifetime, as opposed to annual, 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 Mr. Robson. “All Canadians should have the ability to accumulate sufficient savings for retirement, and unfair tax-treatment should not stand in their way.”