Rethinking Limits on Tax-Deferred Retirement Savings in Canada

Abstract

Tax rules limiting the amount of tax deferral available to Canadians in various retirement saving vehicles need some measure of equivalency among them. Since 1990 this measure has been the Factor of Nine, based on the proposition that saving 9 percent of annual earnings will let a person buy a retirement annuity equal to 1 percent of pre-retirement income. A quarter century later, the flaws in the Factor of Nine are glaring and the case for change is compelling. The Factor of Nine is the result of calculations based on one particular type of defined-benefit pension plan operating under one specific set of demographic and economic circumstances. It is a crude measure. It neglects features that can make wealth accruals under different defined-benefit plans larger or smaller. It affects people of different ages differently. And it is badly out of date. People are living longer and – even more important – yields on investments suitable for retirement saving are very low. These changes have raised the cost of obtaining a given level of retirement income. The unchanged factor specifying equivalency puts people saving in money-purchase arrangements such as defined-contribution pension plans and RRSPs at a major disadvantage relative to people in defined benefit plans. Three types of reforms could alleviate problems with the Factor of Nine: • Update the assumptions underlying the Factor of Nine to reflect current economic and demographic realities; doing that would raise the current annual tax-deferred savings limit from its current 18 percent to a number around or even exceeding 30 percent. • Level the playing field for tax-deferred saving by refining the factors so that they escalate with age and/or reflect differences in pension plan design. • Replace the current annual tax-deferred saving limits for defined-contribution pension plan participants and RRSP savers with more generous regimes: either index unused contribution room for inflation or, more farsightedly, establish an inflation-indexed lifetime tax-deferred savings limit that will permit all savers to achieve pension wealth equal to that of participants in relatively comprehensive defined-benefit plans. Inaction over another quarter century would be unconscionable. Canadians continue to live longer. Slower world growth and high saving will likely depress real returns for decades. Taxes deferred when people save for retirement get paid once people are retired. Canadians who do not participate in public-sector pension plans should have more opportunities to save, and unfair tax treatment should not stand in their way.