Optimal Compensation Saving and Consumption with Braden Warwick | E107

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 in episode on IPPs, one on the fundamentals of, 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 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 described well and is kind of, it's gonna be our book of reference moving forward when clients have sophisticated questions regarding these topics. And then the second piece was the case study, which we wanted to really try to capture as realistic problem as we could, starting from 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 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 great, 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 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 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 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 individual prefers and what they want out of it.

Jason Pereira: Rightly so; you accommodated for preference, right? Which is a 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, starting with no salary at all. 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 minimized, then it'll take salary based on that. So what that looks like in practice for 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 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 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 said, you basically targeted a certain income, tried those kinda three methodologies and, but I would say, though, let's keep something clear here. So if you're taking a dividend or you're taking the 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 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 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 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 tested, well, we wanted to test the trade-off between a corporation and personal accounts, but then also the IPP, which was the big differentiator. Should we, if we, depending 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 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 the IPP contribution is based on different actuarial calculations 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 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 sweet spot to the IPP. It's really, like the main benefit is taking assets that would be located in a corporation typically 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 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, TFSA, or any of the number, you start doing, start exponentially calculating how many different variables there were. This is enormous. So, like, one of the things that I commented on was when I saw how many data points you were working with, I'm like, okay, I respect your ability to basically beat yourself down over this, 'cause that's a lot of work. So let's give some people idea of the scale of the problem. How big was the scale of this actual report or the study?

Braden Warwick: Yeah, for sure. So the final paper investigated over 7 million financial-planning outcomes.

Jason Pereira: I love that.

Braden Warwick: And the funny thing is 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 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's the scale that we're working at. So 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 million financial-planning studies in approximately 20 minutes of compute time.

Jason Pereira: Well, I mean given the compute power these days, 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 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 surprising to me. And 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 bigger things that I think jumped out. And I think you can open up for anything else you think was another key finding. 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 Ontario and New Brunswick, they both have 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 a non-eligible dividend to be converted into an eligible dividend so it's much more tax efficient when it's paid out 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 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 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 in interest, the next dollar of interest takes away access to $5 of that small business tax rate. And that, the entire small business tax rate disappears at $150,000 of passive income, and that means that your rate goes from 12.2 percent to 12.65 percent. Now that's a big leap, but keep in mind that 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 that there's this period of transition of $150,000 of passive income. And Ontario and New Brunswick decided not to follow the federal guidelines on this when they basically brought them 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 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 is not a qualified dividend. So long story short is you got this interesting 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 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 kind of this nice little sweet spot where we end up with the highest net personal cash once all of those variables are considered.

Jason Pereira: Yeah, so I mean just to give people an idea of it. When you look at what gets paid out when you pay out money at the small business rate corporately, so you earn $100,000, you take out money as a dividend, and you basically pay personal tax corporately. You found 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 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 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, the over 50,000 of adjusted annual adjusted investment income. 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, there is some pensions or IPPs 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 make a 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 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 contribute the full RRSP contribution room. But the problem is that there's added actuarial costs associated with setting up the IPP. So all else equal, 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 purchasing past service. So all of the years that you've previously worked, you can purchase those 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 way of 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 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 that CDA room being available always to you to take out cash free. But the problem is when you start thinking through the lens of real dollars, we notice that 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 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 money personally versus corporately in today's dollars is more valuable because, hey, you may say $100,000 in the corp or $100,000 personally is the same. Well, no, because there's a deferred tax liability in that 100 grand, right? And what you're basically saying is that that $100,000 you're owed from the company never goes up over time. So the $100,000 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 you need the money, just book it as a loan to the shareholder and draw it down as fast as possible because that, or as soon as you need it, because frankly, hey, it's literally tax-free money at this point. Like that portion of it, right? So makes a lot of sense. So the moral of the story there 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 highest diminished returns, and that's because, ultimately, you're taking a tax-free dividend, and then you'd have to convert that into a non-eligible dividend which would be taxed much higher. And it kind of, the other accounts kind of generated similar, a similar story in terms of the ERDTOH account generating the second highest diminished return because, just because of the tax benefits of the eligible dividends. And just for some more context around ERDTOH, it's if you take it in the same year 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, 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, for the non-eligible RDTOH is not quite as beneficial to pass it through immediately just because there is some tax that's getting lost no matter what. And then the fourth worst would be the GRIP 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 tax rates that 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 that actually, great takeaway from that one. So basically, you ran 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, they sell the business or they're getting out of business or they're closing it down. Right, they have a couple of options. They can either keep the account as is and just continue to basically draw money 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 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, a sizable one, typically a six-figure taxable portion. So there's been a lot of aversion to the commuted value option with IPPs. But you had a finding 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. So what that implies is 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 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 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 investment returns are bad and the size of the portfolio is small because of that, there actually is no tax impact when we're converting the IPP to the RRSP. Because that calculation, again, is an actuarial calculation, but it's based on different annuity factors and things like that. So when we do that calculation, you know, typically 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 minimums.

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 yeah, so I can, with the RRSP, I can take out RIF minimum or any amount thereof. So that inherent flexibility 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 fund consumption with capital dividend tax free because now we're not obligated to take out that higher IPP benefit that 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 cost. Okay, so there's cases where you don't hit the target and you don't hit the presumed value, in which case, yeah, there's no cost to doing it. But then there is times where pensions can be up to 30 percent overfunded or 25 percent overfunded before they have to take a holiday. So there's also a possibility that you end up with more than can go into an RRSP. 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 take the commuted value and toss it into an RRSP. But if there was a taxable liability owed, then it would just continue maintaining the IPP and then paying out 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 big deal. If I'm overfunded, then that's a pretty substantial tax hit.

Braden Warwick: Well, exactly. And then 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.

Jason Pereira: Yeah, there's no universal outcome here, but there is I think 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.

Braden Warwick: Exactly.

Jason Pereira: Excellent. All right, so let's talk about the end 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 this research actually looked quite in favor of the IPP overall, but I do wanna preface that this is one case study. And there's just a ton of variables here that I'm 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 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 certain level of consumption and maximize the multi-generational 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 generated the highest level 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. And the reason for that is because when you're spending a lower amount, the account levels of the assets inside the corporation 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 max salary case.

Jason Pereira: Yeah, so I think it was a very interesting finding in that regard. And the way you laid it out was different retirement ages, different monthly spending targets, and yeah, as you said, the lower spending levels were dynamic salary and IPP. And that's, but the thing I find 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 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 generated high salary in the beginning, and it took a few years, almost a decade really, for that break-even point to come in where notional account balances are now high enough that we can fund consumption with dividends.

Jason Pereira: So in a starting-from-zero scenario then basically no one has 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're saying salary for a decade – but not only salary. You start taking the notional account value slowly over time.

Braden Warwick: Yeah.

Jason Pereira: But the reality is you have this chart that showed salary decreasing, dynamic income increasing. So really 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, possibly because of the pension allowing you to top up during bad market years. Was that a factor?

Braden Warwick: Yes, absolutely. So all of that still continued. Obviously, when you're no longer taking salary, then you're not gonna generate additional contribution room on a yearly basis due to the salary, but you would still have the opportunity to top up because the IPP growth is indexed to a prescribed rate that's defined by the Income Tax Act. So in bad years, or bad market years, you still have those opportunities to top up the IPP 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 scream and fist bump in the air by hearing that one now. But then the other piece was, okay, where salary made sense was kind of along, it's interesting you could draw a line along a relationship between age and spending level, right? And it was the later you retire, higher spending levels favored salary. Whereas the earlier 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 8. Salary made sense at the 10 and 12 for people retiring at 45 and then 12,000 for 55. And then 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 spending need, the more likely salary makes sense.

Braden Warwick: Yeah, exactly. And I think the reason for that that I took away was that at low spending levels, you're gonna end up with high amount of assets in the corporation, which would generate high notional account balances, which would prefer the flexibility of taking those dividends to fund consumption, as opposed to strictly the salary, which ended up being the 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 the salary, you know, the more you need now, the more 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 would sustain your retirement to a greater degree, reducing the need to take the notional accounts over time and dynamic salary. So it was this very interesting interplay that all three things were heavily correlated based off of what is it you actually want to take out every year to live off of, right?

Braden Warwick: Yeah.

Jason Pereira: Like it changed one thing; it changed all three simultaneously.

Braden Warwick: Yeah, exactly.

Jason Pereira: This is why no one's done it before. Okay. I mean not everybody's willing to put themselves through the self-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 a great way to torture yourself. All right, so I think those were the bigger takeaways for me. What, were there any other takeaways for you that you found surprising or novel?

Braden Warwick: Yeah, so the other interesting piece that I found, and it alludes to what we just talked about previously with the IPP being indexed to a prescribed growth rate, is we actually analyzed two different asset allocation profiles. We investigated an individual that has a low risk tolerance and a high risk tolerance. So we had someone in 100 percent equity profile and then someone in 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 the 100 percent equity case, the IPP was still the optimal outcome, like we just discussed. But in the 50 percent, the 50-50 investor, the IPP was more beneficial than it was for 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-risk investor because the expected return of that profile is lower, meaning that you would expect the IPP, the realized growth rate of the IPP to lag more than you would 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 sense when you know how IPPs work to some degree, right? Like 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 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 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 pension on your behalf and benefit from the tax deduction and deferral than if you were in a higher-return portfolio. So, to me, yeah, that's one of the things I've heard is that this makes sense. But you actually tested it and proved that, empirically, it absolutely does have a better long-term outcome. The more conservative you are, the better off you are with an IPP.

Braden Warwick: That's right. And one last caveat. It's still more beneficial to be a 100 percent equity investor, though the outcome, the final net worth was still twice as high.

Jason Pereira: Wow.

Braden Warwick: 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, again, risk tolerance has to be taken into consideration as a constraint. But I also think the other piece of interesting feedback on that, too, or the other piece we didn't discuss is that the more conservative you are, the more the different 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 interest and dividend based, then you're generating more RDTOH in general. So the reality 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 makes sense that taking some of that off the table, that less-efficient dynamic income taxed at a higher rate and putting that into an IPP and getting the deduction played out favorably. So 5,000-foot view looking at this, you sit back and say, okay, this all makes a lot of intuitive sense.

Braden Warwick: Yeah, exactly. Everything is interrelated.

Jason Pereira: Yeah, and that's what I really appreciate about your paper. For all the suffering you put yourself through for it, the reality is that everything I thought, every time I said, huh, to a result. 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. But 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 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 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.