Optimal Compensation Saving and Consumption with Braden Warwick | E107
Considering income type, savings vehicles, and client preference all at the same time.
On today's episode, Jason Pereira is going to talk to Braden Warwick, research associate at PWL Capital. Braden has recently composed a study on optimal compensation savings and consumption for business owners of private corporations. Braden has recently composed a study on optimal compensation savings and consumption for business owners of private corporations. Braden's study was a deep dive at a lot of things that started by looking specifically at compensation, structures, and methodologies and had several interesting findings.
Episode Highlights:
01:38: Braden shares how he switched his field and how he joined PWL Capital where he was tasked to answer complex problems that the firm is having.
02:29: As per Braden the problem faced by business owners ultimately boils down to problems typically composed in 3 different fields.
03:42: The numbers for an individual doing dividends or income make sense. Answer is different on different for different people and different provinces.
04:56: Jason and Braden are talking about IPs or individual pension plans for the concepts of emotional accounts.
06:06 Braden shares why they needed to consult with actuaries and accountants. He used to gather knowledge about how calculations are made so that they could capture that in their own financial planning model.
07:16: Braden defines the problem while he does all the research, he explains to people everything which is foundational.
07:46: The first objective is to maximize spending with the constraint of a 90% Monte Carlo success rate and then basically just explain people, when we test this randomly against the universe of possible returns, 9 out of 10 times it is 100, well 90% of the time there is no deviation from the spending level, says Braden.
08:06: The second objective is just maximizing final net worth and because it's a multi objective problem there may be some individuals with a preference more towards one end or the other.
08:56: Jason and Braden talk about the different approaches to income as a starting point.
09:33: Capital dividends get passed tax-free from the corporation to the individual, and there is also RDTA of accounts, which is basically a tax refund.
11:17: If you are taking a dividend or taking their dynamic type of income, that sort of income doesn't attract CPP contributions or RSP room. There is a tradeoff there that people need to be aware of.
12:24: There is a different pathway that involves taking a salary alongside an IP, which is an entirely different structure, but ultimately the benefits of the IP are larger contribution room because it somewhat equivalent to a defined benefit pension in the way that the calculations are made.
14:00: Braden talks about the three different forms of income, one which is dynamic, that's changing every year depending on what the results of the returns are in the corporation.
14:43: The final paper investigated over 7,000,000 financial planning outcomes, says Braden.
16:10: In Ontario and New Brunswick, they both have a similar corporate tax structure where there is a transition rate that Jason alluded to, which is kind of in between the small business rates and the general federal rate.
16:57: When you are over $50,000 of passive income or aggregate adjusted investment income is the actual term for it. But think of it as a return that you've earned.
17:15: The small business tax rate, for example in Ontario is 12.2% in the first half million. But if you make more than $50,000 of interest, the next dollar it takes away access to $5.00 of that small business tax rate, and that the entire small business tax rate disappears at $150,000 of passive income.
18:15: Payout grip tells you how much money you can pay out as a qualified dividend, which basically means that you are paying less than a normal small business dividend which is not a qualified dividend.
19:47: Planning should be around keeping the passive income below 150, because that's when the general corporate kicks in and then you are still in that sweet spot of the transition zone for Ontario and New Brunswick residents.
20:49: When the calculation comes up the IP contribution would be less than the equivalent RSP contribution, they can choose to contribute the full RRSP contribution room.
21:31: You can basically transfer your RSP assets into the IP and then if any additional corporate funding is required to purchase that service, then that opens up an additional contribution room from the corporation into the IP.
22:31: When you start thinking through the lens of real dollars, we notice that account value is staying constant in nominal terms. But when we look through the real lens, we see that it's decreasing.
24:04: The CDA, the capital dividend absolutely has the highest diminished returns and that's because ultimately you are taking a tax-free dividend and you would have to convert that into a non-eligible dividend which would be taxed much higher and it kind of generated a similar story.
27:06: In-order to maximize consumption subject to that constraint, the main driver of that performance is the worst 10% of outcomes. So, if we are thinking in terms of a return from a portfolio, if stock markets do poorly, that obviously would generate a poor outcome.
29:47: Depending on the taxable liability that occurs at the point in time where IP benefits start there would be a decision, and if there is no taxable benefit then it would choose the path to take the commuted value and tossed into an RSP. But if there is a taxable liability owed then it would just continue maintaining the IP and then paying out the benefit.
31:31: The IPO looked quite favorable and the main findings again it comes down to preference of what the individual prefers in terms of do they want to get every last cent of consumption out of the financial plan or would they prefer to be content with a certain level of consumption and maximize the multi-generational wealth or final request.
34:16: When you are no longer taking salary, then you are not going to generate additional contribution room on a yearly basis due to the salary, but you would still have the opportunity to top up because the IP growth rate is indexed to a prescribed rate that's defined by the Income Tax Act.
37:21: With the IP being indexed to a prescribed growth rate, Braden analyzed two different asset allocation profiles.
40:05: If you are primarily an equity investor, you are generating more capital gains, which is more CDA credit, which is tax free.
3 Key Points:
Braden explains how he is trying to solve the key issues around compensation and retirement savings because dividends versus income are one thing versus notional account-type distributions.
Braden shares how the net personal cash is higher in the transition zone than it is with either the small business rate or the general corporate.
The longer the CDA sits in there, or the longer those tax refunds sit in those notional accounts, the lower the purchasing power becomes over time.
Tweetable Quotes:
"For me being relatively new to the world of finance was not a trivial task, because especially with things like IP's, you can't just Google that that information is not readily available." - Braden
"The problem, as we could starting from the very high level of an individual would come to us with the question of how much can I sustainably spend over the course of my lifetime and then how much net worth will I be left with on average at the end of the day and what's the best plan to get me there and to maximize those." - Braden
"RRSP contribution room is a simple calculation of 18% of your salary to a maximum, but the IP contribution is based on different actuarial calculations, and the big piece is that it changes on a year-by-year basis." – Braden
"We had to the other challenge, the other side of the coin was we have to make this analysis computationally efficient enough that this is feasible and we're actually able to do those 7,000,000 financial planning studies." – Braden
"For those folks that want to maximize consumption, we found that the IP with the maximum salary was the best route." – Braden
"The lower return than the pension also resulted in a lower return within the core, but also less efficient dynamic income." - Jason
Resources Mentioned:
Full Trancript:
Producer: Welcome to the Financial Planning for Canadian Business Owners Podcast. You will hear about industry insights with award-winning financial planner and entrepreneur, Jason Pereira. Through the interviews with different experts with their stories and avi, you will learn how you can navigate the challenges of being an entrepreneur, plan for success, and make the most of your business and life. And now, your host, Jason Pereira.
Jason Pereira: Hello, and welcome. Today on the show, I have Braden Warwick, research associate at PWL Capital. Braden has recently composed a study on optimal compensation savings and consumption for business owners of private corporations. Now this actually was a pretty extensive deep dive in a lot of things that started by looking at I think IPP specifically but looked at compensation structures and methodologies and answered, and had a number of interesting findings. So they had asked me to kind of give them a peer review on the paper, and when that happened, I said, hey, you should come on the podcast and talk about the implications of this because it touches upon a lot of things. So with that introduction, here's my interview with Braden. Braden, thank you for taking the time today.
Braden Warwick: Hey, Jason. Thanks for having me. Happy to be here.
Jason Pereira: Well, my pleasure. So Braden Warwick, uh, PWL. Uh, tell us about yourself and what it is you do.
Braden Warwick: Yeah, for sure. So, like you mentioned, I'm a research associate at PWL Capital. I've been with them for a few years now, primarily investigating complicated questions like this. And, well, my background's in engineering actually, so I did a, a bachelor's degree and a PhD at Queen's University, and then I kind of, kind of left that field, switched over to PWL Capital where I've been just tasked with, with answering complex problems that they were having in the firm. One of them being this financial planning for owners of corporations, uh, which kind of ties into this research paper. And just to, to kinda give a, a sense of the business problem that we're having. So these, the owners of corporations kind of, uh, pose a complicated problem, but also, it's not necessarily as niche of a, a problem as it, you may think because this sort of, this individual may be a small business owner but also a physician, a dentist, a lawyer. So there's, there's tons of potential clients for our firm that are facing these types of problems, and quite frankly, we weren't satisfied with the level of financial planning advice that we could give to them with off-the-shelf software that we were using. And the, the reason for that is it ultimately boils down to these problems typically compose three different fields, in a sense. The individual with a corporation goes to a financial planner to ask them what's the optimal financial plan for me. How do I compensate myself out of my corporation? Do I pay myself a salary? Do I pay myself a dividend? What does that look like? And the financial planner, using the tools that they have available, can kinda piecemeal together a plan for them, but then the, which may or may not be satisfactory. But then the, the individual might go to their accountant, and then the accountant is telling them about different estate-planning strategies or different notional account balances and different compensation of dividend packages that they can distribute involving capital dividends which are tax free and all of these different pieces of the puzzle, which the financial planner can't, doesn't necessarily have the tools to be able to incorporate all of those details into the financial plan. And then the, the other piece –
Jason Pereira: Just to interject there, I mean I think you're, like I think what you're getting at and what you're right about is that, you know, a lot of times these questions are dealt with in isolation in silos. Right, like is an IPP work? Well, the answer is it depends. Let's look at, right, for you look at numbers for an individuals. Do dividends or, or, or, um, income make sense? Well, the answer is different on different, for different people and different provinces. And then the notional account stuff, like it also, like these are all factors that are typically looked at in isolation, right, and I think trying to bring those in and harmonize them, you know, we do that in financial plans and try to get to the best optimal one, but no one's really kinda done what you've done here, which is kinda like bring all these things into one study and look at optimization across everything.
Braden Warwick: Well, and that's, that's exactly it, Jason. And then to add the third piece of that puzzle, it's the IPPs, which it's a similar silo where –
Jason Pereira: Mm hmm.
Braden Warwick: – uh, the individual might go to an actuary, and the actuary can give them a calculation of how much more contributions that they can make to an IPP in comparison to an RRSP. But, again, that doesn't answer the question about that the client, or that the individual would have is: How much money can I actually spend sustainably, and what will be optimal in terms of my final net worth that I can leave to my future generations or charity or, or what have you?
Jason Pereira: Yeah, and that's, that's it exactly. It's, again, it's the entire, you know, you get that quote and it says, oh, 30 percent more. Well, that looks great, but what about everything? That's in isolation. It's not optimal for the individual, which takes into consideration many other factors. And, and just, uh, for people listening who wanna know more about what we're talking about in terms of IPPs, or individual pension plans, or the concepts of notional accounts, these were all on previous episodes. You'll find them **** episode on IPPs, one on the fundamentals of, of bookkee, of accounting and finance for business owners. So if you're interested in learning more about those, please go back and listen to those episodes. We'll post the numbers in the show notes. So, okay, you're trying to solve for kinda like, I'm not gonna call it the everything study, but you're trying to solve for the key issues around compensation and, really, retirement savings. 'Cause dividends versus income is one thing, versus notional-account-type distributions, right? And then, at the same time, you've got all these vehicles for ret, for retirement savings. You've got the corporation, the RRSP, the TFSA, the IPP. How does this all play out? So what was your approach to how you started tackling this question?
Braden Warwick: Yeah, that's a good point, so the first step, honestly, was understand what all these different vehicles are and, and how to calculate. And that's, for me anyways, being relatively new to the world of finance, was not a trivial task because, especially with things like IPPs, you can't just Google that. That information's just not readily available. So, for us, it was about reaching out to, to subject-matter experts in that area. We needed to consult with actuaries. We needed to consult with accountants to kinda give us the details in the weeds of how these, how these calculations are made so that we could, we could capture that in, in our own financial planning model. So that was Step 1. And then in terms of the paper, that's kind of the first half of the paper is really explaining all that we've learned and all of the different pieces of the puzzle, estate-planning strategies, IPPs. All of that fun stuff is, uh, is described well and is, is kind of, it's gonna be our book of reference moving forward when, when clients have sophisticated questions regarding these topics. And then the second piece was, was the case study, which we wanted to really try to capture as realistic problem as we could, uh, starting from the, a very high level. An individual would come to us with a question of how much can I sustainably spend over the course of my lifetime, and then how much net worth will I be left with on average at the end of the day, and what's the best plan to get me there and to, and to maximize those value.
Jason Pereira: So, all right, so you, you start off by defining the problem well. You do all the research. Explain to people everything which is fundamental. Absolutely. I mean also gre, if it's your, if it's a guiding document for the company, great. You know, you have a wonderful training tool because everybody can get explained as to what happened there. So in terms of your methodology, once you had that laid out, how did you attack, basically, comparing these options?
Braden Warwick: Yeah, for sure. So fundamentally, it's, we approached it as a, a multi-objective optimization problem.
Jason Pereira: Mm hmm.
Braden Warwick: And with two objectives. The first objective is to maximize spending with the constraint of a 90 percent Monte Carlo success rate. And then –
Jason Pereira: So basically, just to explain for laypeople, when we test this randomly against a universe of possible returns, 9 out of 10 times, it is a hundred – well, 90 percent of the time, there is no deviation from that spending level.
Braden Warwick: Yeah, yeah, exactly. So that was the first objective. And then the second objective is just maximizing final net worth. And because it's a multi-objective problem like that, there may be some individuals with a preference more towards one end or the other. There might be individuals that have a preference for maximizing every last cent of consumption that they can, that they can squeeze out of a plan. But there might also be clients that are content with spending a lower amount if they want to maximize that multi-generational wealth or a bequest, a charitable donation, something like that. So, so that leaves, so because we approached it in that way, it leaves, there's not a clear-cut optimal solution across the board. It really depends on what the, what the individual prefers and what they want out of it.
Jason Pereira: Rightly so; you accommodated for preference, right? Which is –
Braden Warwick: Yeah.
Jason Pereira: – something **** vital component. Okay, so you did that. And let's talk about the different approaches to income as a starting point. Let's go through the options that you tested there.
Braden Warwick: For sure. So we tested a whole bunch of different salary levels, um, starting with no salary at all. Um, so just compensating with only dividends from the corporation, all the way up to what we call the maximum salary, which is the salary that generates maximum RRSP contribution room moving forward. And we also had a separate strategy which I call the dynamic salary strategy. And what that did was it prioritized minimizing notional accounts within the corporation. So examples are capital dividend account so capital dividends get passed tax free from the corporation to the individual. And there's also RDTOH accounts which are basically a tax refund.
Jason Pereira: Mm hmm.
Braden Warwick: So we wanted to, with the dynamic salary strategy, it prioritized taking those first, getting our tax-free capital dividend, getting that tax refund from the corp into the hands of the individual so that they could use that for consumption. And then once those accounts are, are minimized, then, then it'll take salary based on that. So what that looks like in practice for, say, a younger individual that's just starting out, has lower values in their corporation and lower notional account values, what that looks like is at the start, they'll take a higher amount of salary. They'll generate that RRSP contribution room. And then as the corporation builds up assets, they'll also build up notional account values, and then that's, there'll be a switch at some point where the notional accounts get so big that consumption is primarily driven by dividends, and then salary falls off. But you've already built up a big nest of RRSP room and RRSP account value on the personal side.
Jason Pereira: Yeah, and just for the layperson to go back up and listen to the previous episodes. You know, these are, these are the returns that are generated by investment within the corporation not from operations. And they produce the ability to draw down money in a very tax-efficient manner that's more tax efficient than the normal income or dividend options. And therefore, they are, again, it makes sense. If you're trying to maximize wealth, why wouldn't you take income in the most tax-effective format possible? So, okay, so that, that said, so you, you basically targeted a certain income, tried those kinda three methodologies and, uh, but I would say, though, let's keep something clear here. So if you're taking a dividend or you're taking, you know, the dynamic pa, dynamic type of income, that sort of income doesn't attract CPP contributions or RRSP room, right? So there is a trade-off there that people need to be aware of.
Braden Warwick: Yeah, exactly. And that's part of what we wanted to capture is that whole, that whole effect of when you take salary, that generates RRSP contribution room in the future, and then also, like you mentioned, Jason, with the CPP, we also scaled CPP benefits and retirement down in the case of, of the dividend strategy, because you wouldn't be contributing as much as you would be otherwise if you're taking that full salary.
Jason Pereira: Yeah, so I mean, and this is I think that people listening are getting a sense for why this is a complicated questions. Look how many variables we just identified on the income side alone. Right? We haven't even started talking about where to put the money. Right, so –
Braden Warwick: ****, yeah.
Jason Pereira: – that's a separate piece. Okay, so you have those options for income, so you're gonna test all of those. And then you're gonna simultaneously test the optimal allocation to different account types. So how'd you do that?
Braden Warwick: Right, so yeah, so we, we tested, well, we wanted to test the, the trade-off between a corporation and, and personal accounts, but then also the IPP, which was the big differentiator. Should we, if we, depending on, on this income distribution, there's also a different pathway that involves taking a salary and, alongside an IPP, which is an entirely different structure, but ultimately, the benefits of the IPP are, uh, larger contribution room because it's somewhat equivalent to a defined benefit pension in the way that the calculations are made. So they're not, like RRSP contribution is a simple calculation of 18 percent of your salary up to a maximum but, but the IPP contribution is, is based on, um, different actuarial calculations and it, and the big piece is that it changes on a year-by-year basis. So for younger individuals, the IPP contribution actually might be less. The calculation would come out to be less than the equivalent RRSP contribution. But then as the, once the individual is in their 40s, then it kinda switches where IPP contributions become significantly larger than the RRSP. So the idea, though, is there is a bit of a, a sweet spot to, to the IPP. It's really, like the main benefit is taking assets that would be located into, uh, in a corporation typically and, and putting them into an IPP because it's a tax-deferred vehicle. So if you don't have the assets in the IPP, well, it doesn't make a whole lot of sense to, to go ahead and set one up, but if you do, then it possibly might make sense, and that's really what we wanted to look at.
Jason Pereira: Good. So considered all of those and now let's go through. So you got three different forms of income, one of which is dynamic, right, so that's changing every year depending on what the results of the returns are in the corporation.
Braden Warwick: Correct.
Jason Pereira: And then you also, simultaneously, then tested for all these, money being put into all these different accounts, so corporate, IPP, RRSP, uh, TFSA, or any of the number, you know, you start doing, start, you start, start exponentially, uh, you know, calculating how many different variables there were. This is enormous. So, like, one of the things that I, I commented on was when I saw how many data points you were working with, I'm like, okay, I, I respect your ability to, to basically, to basically beat yourself down over this, 'cause that's a lot of work. So, you know, let's, let's give some people idea of the scale of the problem. How big was the, the sc, the scale of this actual report or the, the study?
Braden Warwick: Yeah, for sure. So the, the final paper, uh, investigated over 7 million financial-planning outcomes.
Jason Pereira: I love that.
Braden Warwick: Um, and, and, and the funny thing is that's, that's a much scaled-down version than what we had previously. We actually initially investigated a whole ton more, but it was just so huge that, uh, it was **** –
Jason Pereira: Oh, no, 7 million was not ridiculous enough. You had to go for the –
Braden Warwick: Yeah, no, yeah, exactly right. So but yeah, that, that's the scale that we're working at. So we had to, the, the other challenge, the other side of the coin was we have to make this analysis computationally efficient enough that this is feasible and we're actually able to do those 7 million financial-planning studies in approximately 20 minutes of compute time.
Jason Pereira: Well, I mean given the compute power these days, that's, uh, that's still a lot of time. All right.
Braden Warwick: Yeah.
Jason Pereira: So the, so reading through this, there was, I will say, a number of things that were, that jumped out. One or two, like certain interesting factoids that people aren't aware of if they're not in the space. So, for example, the transition rate on, on corporate taxation, which we'll get to in a second. And then there were other things that I thought were pretty intuitive results. And then there were other ones that were really spiriting to me. And when, when you think back to that logic, looking back at it, you say okay, that makes sense. So I kinda wanna go through some of the, some of the, the bigger things that I think jumped out. And I think you can open up for anything else you think was a, another key findings. But, as I alluded to, the first piece is the transition rate. So let's talk about what that is and why that's a unique planning opportunity in two different provinces.
Braden Warwick: Right, yeah, it's so interesting. So in, in Ontario and New Brunswick, they both have, um, a similar corporate tax structure where there's this transition rate that Jason alluded to, which is kind of in between the small business rate and the general federal rate. And it exists because those two provinces decided not to adopt the general federal rate on certain levels of income.
Jason Pereira: Yeah.
Braden Warwick: So once you're, but the interesting part, though, is when you're, because they chose not to, even though they chose not to adopt that general federal rate, that income range still generates GRIP, which ultimately allows the, a non-eligible dividend to be converted into an eligible dividend so it's much more tax efficient –
Jason Pereira: Hmm.
Braden Warwick: – when it's paid out on, to the individual.
Jason Pereira: So let's go over some fundamentals here to make sure people have context. So what happens is, is that when you're over $50,000.00 of passive income, or aggregate adjusted investment income is the actual term for it, but think of it as return that you've earned that's from investments. What happens is, is that every dollar after that, the feds start reducing your access to the small business tax rate. The small business tax rate, for example, in Ontario is 12.2 percent on the first half million. But if you make more than $50,000.00 in, say, interest, the next dollar of interest takes away access to $5.00 of that, of that small business tax rate. And that, the entire small business tax rate disappears at $150,000.00 of passive income, and that means that your rate goes from 12.2, uh, percent to 12.65 percent. Now that's a big, that's a big leap, but keep in mind that it's, it, it's technically, it technically doesn't increase your taxes. It temporarily increases your taxes 'cause if you pay that money out personally, it all equals the same thing as if you earned it personally under integration, which we covered before. So, but the key here is, is that there's this period of transition of $150,000.00 of passive income. And Ontario and New Brunswick decided not to follow the federal guidelines on this when they basically brought 'em into, into bear. So instead of having two rates that exist in Ontario and New Brunswick, there's actually three rates for corporations but only if you're generating passive income. And as you said, GRIP, so GRIP is one of these notional accounts which basically allows you to pay out. GRIP is the, tells you how much money you can pay out as a qualified dividend, which basically means that you're paying less than a normal small business dividend, which isn't, which is not a qualified dividend. So long story short is you got this interesting little thing, little area where you're paying more than 12.2. You're paying, in Ontario, 18.2, which is still less than 26.5, so you got, you got a gap. But then you also have the ability to take out at a lower rate, which creates, like I said, an interesting planning opportunity. So can you tell me what happens when that money gets paid out?
Braden Warwick: Yeah, so the interesting finding that we saw in the paper was that the net personal cash is actually higher in the transition zone than it is with either the small business rate or the general corp rate. So it's, it's kind of this nice little sweet spot where we end up with the, the highest net personal cash once all of those variables are considered.
Jason Pereira: Yeah, so I mean just to give people an ide, idea, sorry, idea of it. When you look at what we got, gets paid out when you pay out money at the small business rate corporately, so you earn $100,000.00, you take out money as a dividend, and you basically pay person risk corporately. You found a, I think it was Ontario was 54.12 roughly, which is not far from 55, 53.53, which is the normal personal rate. The general rate was 55.41, but the transition zone was 50.38, which means that you're actually paying less on that passive income if you distribute it than you would have. And it's funny because, why I think it's funny is because there's a lot of planning around avoiding making more than $50,000.00 in the corp to keep access to it. But really, that's almost counter intuitive if you wanna take that money out now, right? Because it's actually a slight tax benefit.
Braden Warwick: That's exactly it. So, really, the planning should be around keeping the passive income below 150, because that's when the general corp rate kicks in and, and then you're still in that sweet spot of the transition zone for Ontario and New Brunswick residents.
Jason Pereira: Yeah, so unique planning opportunity for two provinces, and I think the key takeaway is don't look at the $150,000.00, the, the over 50,000 of adjusted, annual adjusted investment income, uh, whatever the acronym actually works out to be. And don't look at that solely as a negative. That's actually a planning opportunity if you're smart about it.
Braden Warwick: Exactly.
Jason Pereira: Yeah. One key takeaway which I have to dig at 'cause it comes up from time to time was, um, there is some pensions or IPPs or p, or other branded IPPs that go by other names that are made up, that offer this option for a hybrid. So basically, I can either do the defined benefit contribution, or I can do a, uh, I can make a defined benef, uh, sorry, defined contribution plan, which is basically like an RRSP contribution limit. I think you had one line there that summed it up. It was really of no tangible benefit to the study, was it, that option?
Braden Warwick: Not really. Where it kicks into place is for, like I alluded to previously, for those younger individuals where the calculation actually comes up that the IPP contribution would be less than the equivalent RRSP contribution. They can choose to, to contribute the full RRSP contribution room. But the, the problem is, is that there's added actuarial costs associated with setting up the IPP. So all else equal, if, if room is equal on both sides, then it pretty much becomes null. And you might as well wait until you're the age where the IPP actually started showing benefits and showing added contribution room because you can, with the IPP, there's this concept of, of purchasing past service. So all of the years that you've previously worked, you can, you can purchase those and, and basically transfer your RRSP assets into the IPP. And then if any additional corporate funding is required to purchase that service, then that opens up an additional contribution room from the corporation into the IPP.
Jason Pereira: Excellent. So long **** saying it, but thank you for reaffirming it. The next kind of key interesting takeaway, I think, and I'm just going through the ones kind of in order that I saw, was how you addressed the diminishing long-term value of the CDA accounts. So the CDA is I had a capital gain in the corporation. Half of that gets booked as a capital dividend account credit, which is a portion, which is the non-taxable portion of the capital gain that I can, as a business owner, draw at any time tax free. But you made a point on how the real value of this diminishes over time. Can you expand on that?
Braden Warwick: That's exactly it. So, typically, we think in terms of notional dollars, and you wouldn't really put much thought into, into that CDA room being available always to you to, to take out cash free. But the problem is, is when you start thinking through the lens of real dollars, we notice that, that val, that account value is staying constant in nominal terms, but when we look through the real lens, we see that it's actually decreasing. So that's part of the reason why I decided on investigating that dynamic salary strategy because the longer that CDA sits in there or the longer those tax refunds sit in those notional accounts, the lower the purchasing power becomes over time, and especially if we're, we're talking years later, it could be a pretty substantial difference.
Jason Pereira: Yeah, and I think one of the key things to remember here is that having may personally versus corporately in today's dollars is more valuable because, hey, you may say $100,000.00 in the corp or $100,000.00 personally is the same may. Well, no, because there's a deferred tax liability in that 100 grand, right? And what you're basically saying is that, hey, that, that $100,000.00 you're owed from the company never goes up over time. So the $100,000.00 tomorrow in the future is not worth the same thing as today. So I mean this kind of always goes into, this kinda played into my normal best practice, which is as soon as the CDA is available, and you confirmed it, just, you know, if **** the money, just book it as a loan to the shareholder and draw it down as fast as possible because that, or as, as soon as you need it, because frankly, hey, it's literally tax-free money at this point. Like that, that portion of it, right? So –
Braden Warwick: Exactly.
Jason Pereira: – makes a lot of sense. So the, the moral of the story there is, is better to take that sooner than later, otherwise the real value of it diminishes over time. Now you found the same thing for the other notional accounts but not to the same degree. So how did the various forms of RDTOH and GRIP basically play out in this scenario?
Braden Warwick: Yeah, for sure. So CDA, the capital dividend, absolutely has the, the highest diminished returns, and that's because, ultimately, you're, you're taking a tax-free dividend, and then you'd have to, you'd have to convert that into a non-eligible dividend which would be taxed much higher. Um, and, and it kind of, the other accounts kind of, uh, generated similar, a similar story in terms of the ERDTOH account, um, generating the second, the second highest diminished return because, just because of the tax benefits of the eligible dividends. And, and just for some more context around ERDTOH, it's if you take it in the same year that, that that is generated, so meaning if your corporation earns an eligible dividend on their investment portfolio and then you pay out an eligible dividend to the individual and then capture that tax refund, uh, you'll, you'll be able to recover the full amount. But for the non-eligible RDTOH, there is some tax that gets lost, so it's not a full one-to-one pass through. So, again, having that, the, for the end, RDTOH is not quite as beneficial to, to pass it through immediately just because there is some tax that's getting lost no matter what. And then the third, or sorry, the fourth worst would be the GRIP because, because really, you're just converting a non-eligible dividend to an eligible dividend on the personal account. So it really depends on the difference in, in, uh, tax rates that you're, you're trading between; leading from the capital dividend account generating the highest diminished return over time and the GRIP having the lowest diminished return over time.
Jason Pereira: Fair enough. So definitely found a way to prioritize what order those should be coming in, which is a question that comes up all the time. Should I pull this? Should I pull that? And you're basically looking at it not just from the lens of taxation but from the lens of actual time value of money so –
Braden Warwick: Yeah.
Jason Pereira: – that actually, great takeaway from that one. So basically, you ran all these, all these different options. Now one of the things that also came up was basically what happens when the person hits retirement and they have an option for what they're gonna do with their pension. Right, so assuming they're not continuing at like, they sell the business or they're getting out of business or they're closing it down, whatever it is. Right, they have a couple of options. They can either keep the account as is and just continue to basically draw money from, down from it. They can buy an annuity. Or they can wind it down, which basically means transferring a portion, a large portion of it to a locked-in RSP equivalent. Like so any time you take money out, like when you do a commuted value of a pension normally. And then the rest of it, there's gonna be a taxable portion so, and a sizable one, typically a six-figure taxable portion. So there's been a lot of aversion to, I think, the commuted value option with, with IPPs. But you had a finding on, on which of those actually plays out the best in the long run that I found surprising at first but then intuitive afterwards. Care to share?
Braden Warwick: Yeah, for sure. So, first, before I get into the result, let's go back to the objective of the analysis, which was one of them being the sustainable spending. So you wanna maximize your sustainable spending, with the constraint that it's successful nine times out of ten, like Jason explained. So what that implies, though, is that that, in order to maximize consumption subject to that constraint, the main driver of that performance is actually the worst 10 percent of outcomes. So if we're thinking in terms of a return from a portfolio, if, if stock markets do poorly, that obviously would generate a poor outcome. So in the outcomes where stocks do poorly over the lifetime of the simulation, obviously has a big impact on –
Jason Pereira: Mm hmm.
Braden Warwick: – on which strategy is optimal if we're trying to push sustainable spending as high as it can go. So with that said, if we're thinking about the three pathways for the IPP that Jason described, if, if investment returns are bad and the size of the portfolio is, is small because of that, there actually is a, is no tax impact –
Jason Pereira: Mm.
Braden Warwick: – when we're converting the IPP to the RRSP. Because that calculation, again, is an actuarial calculation, but it's, it's based on different annuity factors and things like that. So when we, when we do that calculation, you know, typically in, in good times, there would be a taxable liability, like Jason alluded to. But in bad times, there wouldn't be, so you might as well convert it to the RRSP. You have more flexibility in the benefit that you wanna pay out because you're only constrained to RIF minimizes.
Jason Pereira: Whereas in the pension, you're obligated to take out the guarantee, the income the pension was targeting in the first place so –
Braden Warwick: Exactly.
Jason Pereira: – yeah, so I can, with the RRSP, I can take out RIF minimum or any amount thereof. So that inherent flexibility is, is valuable.
Braden Warwick: Exactly. And it allows us to prioritize passing through some of those notional accounts that we've just described previously. So we can –
Jason Pereira: Mm hmm.
Braden Warwick: – fund consumption with capital dividend tax free because now we're not obligated to take out that higher IPP benefit that we would, we would be otherwise. And then, of course, there's also the added benefit that we don't have to pay actuarial costs of doing these actuarial evaluations on the IPP every 3 years, which is relatively small but still worth mentioning.
Jason Pereira: Absolutely. Always a friction costs. Okay, so, so yeah, so there's cases where you don't hit the target and, or you don't hit the, the presumed value, in which case, yeah, there's no, there's no cost to doing it. But then there is times where, let's face it, you could be this, pensions can be up to, what is it, 30 percent overfunded or 25 percent overfunded before –
Braden Warwick: Yeah.
Jason Pereira: – they have to take a holiday. So it's, there's also a possibility that you end up with more than can go into an RRSP or ****. What, so that's the taxable portion. Right? In those cases, your findings were?
Braden Warwick: So when there is a taxable hit, it's obviously not as beneficial to commute to the RRSP. And one thing that I want to look into for future work is to actually set up an algorithm so that depending on the taxable liability that occurs at the point in time where IPP benefits start, that we would, there would be a decision. And if there's no taxable benefit, then it would choose the path to, to take, or to take the commuted value and toss it into an RRSP. But if there is was a taxable liability owed, then it would just continue maintaining the IPP and then paying out the, the benefit.
Jason Pereira: But at the end of the day also, it's also gotta be, I think in general, I think your findings said something to the effect of it's relative to the size of that piece, right? 'Cause, hey, having to take 50 grand out and getting rid of the additional overhead cost, no, no big deal. If I'm overfunded, then that's a pretty substantial tax hit.
Braden Warwick: Well, exactly. And then the, the reason why I didn't include that algorithm in this work is because it's not necessarily intuitive to what, where that threshold would take place.
Jason Pereira: Yeah.
Braden Warwick: Like what amount of tax liability is too big?
Jason Pereira: Yeah.
Braden Warwick: That's for a future research question. But, uh –
Jason Pereira: Yeah, there's no, there's no universal outcome here, but there is –
Braden Warwick: Yeah.
Jason Pereira: – I think there, there was a, what you did put together was a compelling reason for why you would want to consider winding it down, at least in certain scenarios. Because, again, that additional flexibility is inherently valuable. So –
Braden Warwick: Exactly.
Jason Pereira: – excellent. All right, so let's talk about kind of like the, the end kinda result of this, which was: Where does it make sense to take a salary versus dividends versus dynamic salary? And when does it make sense to favor an IPP versus traditional savings vehicles?
Braden Warwick: Yeah, for sure. So the outcomes of, of this research actually looked quite in favor of the IPP overall, but I do wanna preface that this is one case study. And, and there's just a ton of variables here –
Jason Pereira: Mm hmm.
Braden Warwick: – that I'm, I'm not, not considering, or that we're not adjusting for. So it's really gonna be, the outcome's really gonna be on a case-by-case basis. But for this case, the IPP looked quite favorable. And actually, the main findings, again, it comes down to preference of, of what the individual prefers in terms of do they wanna get every last cent of consumption out of the financial plan, or would they prefer to be content with a le, certain level of consumption and, and maximize the multi-general wealth or final bequest. So for those folks that wanna maximize consumption, we found that the IPP with the maximum salary was the best route. It, it generated the highest level of, of sustainable spending. But for those individuals that may be content with a lower level of spending, actually, we're better off taking the IPP with the dynamic salary. Uh, and, and the reason for that is because when you're spending a lower amount, the, uh, account contri, or the account levels of the assets inside the corporation are, are higher, relatively speaking, meaning that they're generating more notional account, higher notional account balances. So just that flexibility of being able to take a dividend to fund consumption ended up being a little higher than it would be for the, for the max salary case.
Jason Pereira: Yeah, so I think it was a very interesting finding in that regard. And the way you got, the way you guys laid it out was different retirement ages, different monthly spending targets, and yeah, as you said, the, the lower spending levels were dynamic salary and IPP. And, you know, that's, but I, the thing I find that was interesting there was that is despite the fact that the dynamic salary will not generate IPP room, right, 'cause it's not salary. So but you don't start off, and just to be clear about your study, you don't start off taking dynamic salary; you start off taking normal salary and then slowly ratcheting up the, the income that's coming from the notional accounts based off of the growing pot of money in the corporation generating return. Correct?
Braden Warwick: So that's how it worked out in this case study. And the reason for that was the assumption that initial notional account balances were zero.
Jason Pereira: Fair.
Braden Warwick: So because of that assumption, it gener, it led to high salary in the beginning, and it took a few years, you know, almost a decade really, for that break-even point to come in where notional account balances are now high enough that we can pretty fund consumption –
Jason Pereira: So –
Braden Warwick: – uh, with dividends.
Jason Pereira: – so in a starting-from-zero scenario –
Braden Warwick: Yeah.
Jason Pereira: – then basically no one, no one has a, they don't have a multi-million dollar portfolio in the corporation, they don't have notional account balances. They're just starting to really get to the point where they can do all this. In that case, then yeah, you know, you're saying salary for a decade – but not only salary. You know, you start taking the notional account value slowly over time.
Braden Warwick: Yeah.
Jason Pereira: But the reality is you have this, you have this chart that showed salary decreasing, dynamic income increasing. So really what we're, what you're saying with this is even in that scenario, the pension made more sense because of probably a combination of higher contribution rates during that 10-year period but also, I'm guessing, I'm guessing possibly because of the, uh, the, the pension allows you to top up during, during bad market years. Was that a factor?
Braden Warwick: Yes, absolutely. So all of that still continued. Obviously, when you're t, when you're no longer taking salary, then you're not gonna generate additional contribution room fr, on a yearly basis due to the salary, but you would still have the opportunity to top up because the IPP growth is, it's indexed to a prescribed rate that's defined by the Income Tax Act. So in bad years, or you know, bad market years, you still have those opportunities to, to top up the IPP from, uh, from corporate assets.
Jason Pereira: Yeah. So basically the IPP, almost universally, you'll want it in every scenario for a business owner, which I'm sure all the actuaries are letting out a triumphant, uh, scream and fist bump in the air by hearing that one now. But then the other piece was, okay, where, where salary made sense was kind of along, it's interesting you kinda could draw a line along a relationship between age and spending level, right? And it was the, from what I could see is the later, the later you retire, higher spending levels favored salary. Whereas the earlier reti, you retired, the mid-range spending levels, and let's just say you tested spending of 6, 8, 10, 12, 14, and 16,000 a month. Right?
Braden Warwick: Yeah.
Jason Pereira: So at the lower end of the spectrum, salaries didn't make, never made sense on the 6 and 10, 6 and 8. Salary made sense at the 10 and 12 for people retiring at 45 and, and then at, uh, 10, and then 12,000 for 55. And then the sixt, at 65 was 14 to 16. So it was kind of like the later you retire, the more likely dynamic salary makes sense, but the higher the income, the more likely, or higher the spending need, the more likely salary makes sense.
Braden Warwick: Yeah, exactly. And I think the reason for that from, that I took away from that was that at low spending levels, you're gonna end up with high, high amount of assets in the corporation, which would generate high amounts of high notional account balances, which would prefer the flexibility of taking those dividends to fund consumption, as opposed to strictly, strictly the salary, which ended up being the, uh, optimal solution for those individuals with higher spending levels.
Jason Pereira: Yeah, I mean it's an interesting interplay, right, because what you had was, what you have is, is that the salary, you know, the more you need now, the more like a salary was necessary in a lot of ways, because it was gonna take a long time to get the dynamics up to that level. Right? Which then gave you the ability to put more in the pension, which then the pension then would sustain your retirement to a greater degree, reducing the need to take notional, the notional accounts over time and dynamic salary. So it was this, you know, it's a very interesting interplay that all three things were kinda very heavily correlated based off of what is it you actually want to take out every year to live off of, right? And it –
Braden Warwick: Yeah.
Jason Pereira: – like it, it wasn't the one, it changed one thing; it changed all three simultaneously.
Braden Warwick: Yeah, exactly, so –
Jason Pereira: Yeah.
Braden Warwick: – it's a pretty complicated –
Jason Pereira: It, uh, well, this is why no one's done it before. Okay.
Braden Warwick: Yeah.
Jason Pereira: Uh, I mean not everybody's willing to put them through the, the self, uh, flagellation of basically 7 million variables. But I do commend you for it. I think I actually, when I saw it, I started laughing. I'm like good on ya 'cause that's, that's a great way to torture yourself. All right, so I think those were kinda the bigger takeaways for me. What, what other, were there any other takeaways for, for you that you found surprising or, or kinda novel?
Braden Warwick: Yeah, so the other interesting piece that I found, and it, it alludes to what we just talked about previously, actually, with the IPP being indexed to a prescribed rate –
Jason Pereira: Yeah.
Braden Warwick: – prescribed growth rate, is the play – so we actually analyzed two different asset allocation profiles. We, we investigated an individual that, that has a low risk tolerance and a high risk tolerance. So we had, uh, someone in 100 percent equity profile and then someone in a, a 50-50 balanced profile, 50 percent equity, 50 percent fixed income. And what we actually saw was holding asset allocation fixed, so looking at, looking at the, uh, 100 percent equity case, the IPP was still the optimal outcome, like we, we just discussed. But in the 50 percent, the 50-50 investor, the IPP was more beneficial than it was for the, the 100 percent equity investor. And the reason for that was because of the additional IPP contribution room that would have been generated for the lower, the lower-risk investor because the expected return of that profile is lower, uh, meaning that you would expect the IPP, the realized growth rate of the IPP to, to lag more than you would the, the 100 percent equity investor. So that ultimately generated more contribution room for the 50-50 investor, which made the IPP even more appealing to them.
Jason Pereira: Yeah, so I mean it makes a lot of **** when you know how IPPs work to some degree, right? Like the, they're expected to earn 7.5 percent a year. Now that is a number that's static. It is just in the way these things are calculated. It's not a comment on, on what you should be making; it's completely dependent upon market situations and your risk tolerance, but that is the benchmark they use, right? So if, the more conservative you are, the more likely you are to be under 7.5 percent a year on average, which basically means that the company can contribute more money to the quo, to the, uh, to the pension on your behalf and benefit from the tax deduction and referral than if you were in a higher-return portfolio. So, to me, yeah, I mean I think, that's one of the things I've kinda heard is that like, hey, this makes, this makes sense. But you actually tested it and prove that, empirically, it absolutely does have a better long-term outcome for the purse. The more conservative you are, the better off you are with an IPP.
Braden Warwick: That's right. And, and one last caveat. It's, uh, it's still more beneficial to be 100 equity investor, though the outcome, the final net worth was still twice as high.
Jason Pereira: Wow.
Braden Warwick: But so, so it's not a reason to be more conservative just to generate the added contribution room.
Jason Pereira: No.
Braden Warwick: But if you are, by nature, a more conservative person, then the IPP might be for you.
Jason Pereira: Yeah, and I mean, hey, you comp out at a bigger number, odds are it's gonna be bigger. But the reality is –
Braden Warwick: Yeah.
Jason Pereira: – again, risk tolerance has to be taken into consideration as a constraint. But I also think the other –
Braden Warwick: Yeah.
Jason Pereira: – the other piece of interesting feedback on that, too, or the other piece we didn't dis, discuss is that the more conservative you are, the more the, the different, the different the composition of the notional accounts, right? So if you're primarily an equity investor, you're generating more capital gains, which is more CDA credit which is tax free, which is preferable versus GRIP, right? And if you're more –
Braden Warwick: Yeah.
Jason Pereira: – interest and dividend based, then you're generating more, more RDTOH and, and GRIP – well, not GRIP but RDTOH in general. So the reality is, is that those two things were linked. Right? So the lower return within the pension also resulted in a lower return within the corp, but also less efficient dynamic income. So it make, it makes sense that, hey, taking some of that off the table, that less-efficient dynamic income taxed at a higher rate and putting that into a IPP and getting the deduction played out favorably. So 5,000-foot view looking at this, you sit back and say, okay, this, this all makes a lot of intuitive sense.
Braden Warwick: Yeah, exactly. Everything is interrelated.
Jason Pereira: Yeah, and that's what I think I really appreciate about your paper. You know, for all the suffering you put yourself through for it, the reality is, is that everything I thought, you know, every time I said, huh, to a result. You know, you could sit back, take a look, get the big picture and say you know what? This doesn't just make mathematical sense, it actually makes a lot of intuitive sense when you understand all these things work together. So it's, but it's, but it takes, it takes putting them all in this one big pot and studying them all simultaneously, not just for one unique case that you're testing in a financial plan, but for like all the 7 million calculations you ran, that we need to see it before we can actually see the full landscape. So I commend you for it, and I thank you for it 'cause I think this is a valuable study for the industry in general.
Braden Warwick: Thanks, Jason. Yeah, it was a lot of hard work, but I think it's, uh, it's definitely valuable.
Jason Pereira: Yes, I think I first proofread this about, what, 3 months ago?
Braden Warwick: Yeah.
Jason Pereira: I don't even know how long you were at it before that so –
Braden Warwick: Yeah, probably about a year of work.
Jason Pereira: Excellent. Well, I think it's, uh, like I said, it's a great contribution to the body of knowledge in the industry, so I thank you for that.
Braden Warwick: Yeah, thanks, Jason.
Jason Pereira: All right, Braden, so where can people find you if they wanna learn more?
Braden Warwick: Yeah, so check out the PWL Capital website. That's where the paper's gonna be live probably by the time this, uh, episode gets released. Yeah, and then our firm, PWL Capital, also has a, a podcast, the Rational Reminder Podcast. I'm sure my, my colleague, Ben Felix, is gonna cover the, the results of this paper in –
Jason Pereira: Yeah.
Braden Warwick: – in a lot of detail. He also has a YouTube channel: Common Sense Investing –
Jason Pereira: Yeah.
Braden Warwick: – that you can check out too.
Jason Pereira: No, you got there before I did. I was gonna give a shout out to both of those things. Both required, required listening and viewing, uh, in my opinion. Yes, gentlemen, you both owe me a beer. So, uh, Braden, thank you so much for taking the time today.
Braden Warwick: Of course. Thanks, Jason. It was awesome.
Jason Pereira: So that was, uh, Braden Warwick from PWL Capital. Hope you enjoyed that. I know it may have been hard to follow along at some points, but if you wanna understand more about this, go back and listen to the introduction to corporate, uh, taxation that I did and also the, um, I think I had an entire episode on notional accounts, and the episode on IPPs. This can get a little bit tax heavy. There was a lot to study. But this is incredibly, I'd say, important for business owners because so many key factors are being touched upon here. Income versus dividends. We found that, you know, taking salaries, dividends just didn't make as much sense as, as income or dynamic income. The use of an IPP has been basically demonstrated to be very valuable in most scenarios. And that's, there's a lot of questions that get asked about business owners that got answered in this study. So if you wanna learn, if you wanna take the time to learn more, it's definitely of value, or feel free to reach out. As always, if you enjoyed this podcast, please leave a review on Apple Podcasts, SoundCloud, Stitcher, Spotify, or wherever it is you get your podcasts, and until next time, take care.
Producer: This podcast was brought to you by Wood Gate Financial, an award-winning financial-planning firm catering to high-net-worth individuals, business owners, and their families. To learn more, go to woodgate.com. You could subscribe to this podcast on Apple Podcast, Stitcher, Google Play, and Spotify, or find more episodes at jasonpereira.com. You can even ask Siri, Alexa, or Google Home to subscribe for you.