The New Canada Pension Plan"

— a Moneysaver Article by H.Michael Wise

In the first half of this century, seniors were the poorest group in Canada. That has changed. The social safety net now includes Old Age Security, the Guaranteed Income Supplement, the Canada Pension Plan, and provincial medical plans. The effect has been that, according to Statistics Canada, seniors are now the 2nd wealthiest group of citizens in the country, second only to the 50+ demographic group.

The group which now has the unenviable distinction of being "poorest" are those between 20 and 35 years of age. Statistics Canada reports that real (after inflation) earnings for the under-34 age group have declined over the past 30 years, while those older than 45 have had real earnings gains of around 25%.

The revisions to the Canada Pension Plan which are now before Parliament represent the biggest tax increase ever levied on Canadians. Under the current proposal, the burden to pay this tax will fall mainly upon our youth, while the benefits accrue to older Canadians.

A Little History

CPP (and the Quebec Pension Plan) was established in 1966. It was designed to ensure that all members of the paid labour force in Canada, and their families, had at least a small pension. CPP is not designed to redistribute income. CPP also provides coverage in case of disability, and has a small death benefit. The plan covers all employed and self-employed persons between the ages of 18 and 70 who have earnings greater than $3500 annually.

The Plan was established on a "pay as you go" basis. Funds collected from those employed go to pay the pension of those who have retired. Unlike a private pension plan, there is no investment fund allocated to each potential retiree. The proposed revision to the Canada Pension Plan does not address this fundamental weakness.

When the plan was first established, there were many workers for each retiree, and so premiums could be kept low. In fact, even with low premiums the Plan took in more money than it paid out, and the Plan developed a healthy surplus. This surplus was loaned to the provincial governments at an interest rate lower than market interest rates. In the intervening 30 years the birth rate has dropped, and life expectancy has increased. The ratio between workers and retired persons has changed dramatically. The accumulated surplus is now equivalent to two years of retirement payments, and is dropping rapidly. Even larger changes are coming up. The leading cohorts of the Baby Boom generation are now in their 50's, and will be retiring in a little over 10 years.

The difficulties resulting from these demographic changes have been exacerbated by increases in disability payments over the past decade. The number of CPP disability beneficiaries has increased by 93% in the decade, while the workforce increased by only 12%. The QPP has not seen this increase, despite a similar definition of disability under both CPP and QPP. Mismanagement of the Canada Pension Plan has clearly contributed to the problems which we now face.

The contribution rate in 1997 is 5.85% of earnings between $3,500 and $35,800. Existing legislation provides for this to rise gradually to 10.1% of earnings by 2016. However, even this increase is not enough. The Chief Actuary of the Canada Pension Plan has advised that the surplus would be exhausted by 2015, and stated that contribution rates would have to increase to 14.2% of earnings by 2030 for the Plan to remain viable. Clearly something had to be done. In 1996, the federal and 8 of 10 provincial governments agreed on the changes which are now under review by Parliament.

Proposed Changes

Table 1 indicates the proposed schedule of CPP/QPP contribution rates. Along with other proposed changes, the Canada Pension Plan should (perhaps) be stable once the 9.9% contribution rate is achieved in 2003. The other changes are designed to broaden the contribution base, redefine the investment mandate of the Plan, and modify benefits.

Table 1
Proposed CPP Contribution Schedule

Year Contribution Rate Maximum Annual Contribution*
1997 6.0% $1,938
1998 6.4% $2,070
1999 7.0% $2,280
2000 7.8% $2,550
2001 8.6% $2,820
2002 9.4% $3,100
2003 9.9% $3,270
* in 1997 dollars; includes effect of "frozen" minimum

A person has to contribute to CPP if her earnings are between $3,500 and $35,800.

The lower limit will no longer be inflation-adjusted, but the upper contribution limit will be. Over time, this will bring more low-income earners into the Plan, plus force contributions over a wider income range. For example, for 1997 a taxpayer would pay into CPP at a rate of 6.0% on the difference between $35,800 and $3,500, or $1,938. Suppose inflation over the next 10 years is 2% annually. In 2007, then, our taxpayer will be paying into CPP at a rate of 9.9% on the difference between $43,640 and $3,500, or $3,974 (in 2007 dollars; $3260 in 1997 dollars).

The provinces will no longer be able to borrow from CPP at favoured rates. They will have to pay interest in accordance with their credit ratings. The Plan will also be allowed to invest in corporate securities, with a similar investment mandate to other Canadian pension plans. The Plan will be managed independently, and investment returns will be made public. The goal will be to achieve a real (after inflation) return on assets of 3.8%.

Benefits

Any proposed changes to benefits do not affect those currently collecting a CPP retirement payment. Someone who is collecting a CPP disability payment, but has not yet reached age 65, could be affected by the proposed changes.

The Canada Pension Plan has four types of benefit: term life insurance; a survivor's benefit; disability insurance; retirement income. We'll discuss each of these.

The CPP death benefit will be restricted to the lesser of 6 months of pension payments, or $2,500. This will be indexed to inflation.

The survivor's benefit has a flat-rate portion as well as a variable portion which is earnings-related. The maximum spouse's benefit is $413 per month if the spouse is under 65; $451 if the spouse is over 65. The maximum survivor's benefit for dependent children is $170. It is possible to be eligible for either the CPP retirement benefit or disability benefit and the CPP survivor's benefit if the deceased spouse had contributed to CPP. The proposed maximum payment when combining the survivor's benefit with a CPP retirement pension will be equivalent to the maximum CPP retirement benefit. The rules for combining the survivor's benefit with a CPP disability benefit will also be changed; the proposed ceiling will be equivalent to the maximum disability benefit.

A person can be eligible for the CPP disability pension if their physical or mental illness is "severe and prolonged". Under the proposed changes, a person must have worked enough to have contributed to CPP in at least 4 of the past 6 years in order to be eligible for a CPP disability pension. The disability benefit consists of a flat-rate amount plus a variable sum which is related to level of earnings and time in the workforce. For 1997, the maximum disability pension is approximately $890 per month. There is also a children's benefit of approximately $170 per month for each child. These sums are indexed to inflation.

Upon reaching 65, a disability pension is converted to a retirement pension. The proposal changes the rules for this conversion, reducing the benefit somewhat.

The retirement income benefit is based upon an individual's level of earnings and length of time in the workforce. The benefit will be based upon the average of the "pensionable earnings" for the previous 5 years, rather than the previous 3 years as is currently used. Assuming a person had made the maximum CPP contribution over the past 5 years, and had a long work history, under the proposed rules the 1997 CPP retirement benefit would be $724 per month. The CPP pension is fully indexed to inflation.

Winners and Losers

Those currently retired are the big winners from the proposed changes to CPP and the Senior's Benefit. None of the CPP changes apply to them, and they can choose to remain on the "old" OAS/GIS or switch to the new Senior's Benefit. For most seniors who are currently collecting a CPP cheque, the amount being received over their retirement years greatly exceeds the amounts paid in, even without assuming any investment returns.

The big losers are young people. Let's look at how the proposed CPP changes affect them.

Joe Average is 25 and married, with 2 young children. Life is a struggle; there's never quite enough money to make ends meet, and he's never sure whether he'll have his job next month. He is earning $36,000 per year, and is therefore paying the maximum CPP contribution.

Joe will be paying $3,197.70 per year (we'll quote everything in 1997 dollars) into CPP once the contribution rate reaches 9.9%. CPP is more than just a retirement plan. The disability coverage, in particular, is valuable. If he became disabled, CPP would pay Joe and his children $1,230 per month. Equivalent long term disability protection, purchased through a commercial group disability insurance plan, would cost $245.62 per year. The death benefit and survivor's benefits are not worth much, but let's be generous and say that equivalent protection, if purchased commercially, would cost $120 per year. After subtracting the cost of disability and life insurance, Joe is, in effect, paying $2,832.08 per year into "his" CPP retirement plan. Joe will be paying this amount into CPP for 40 years, until he finally reaches 65.

Once he retires, Joe can finally collect on all those contributions. He will be eligible for the maximum pension of $8,688 per year. CPP statistics show that, on average, he can expect to collect his pension for 19 years.

It is easy to calculate the rate of return achieved by 40 payments of $2,832, followed by receipt of 19 cheques of $8,688. It works out to a real return of 1.26% on his "investment", around the return from Treasury Bills or money market funds. Suppose Joe had put the same money into an RRSP-eligible balanced mutual fund which gave him a 3.8% real return. In this case, his RRSP would generate an annual return of more than $19,000 per year — more than twice what CPP is able to give him!

CPP is a Tax

As far as Joe is concerned, CPP provides him with 3 things of value: disability protection, life insurance (term insurance plus survivor's annuity), and a defined benefit pension plan. Assuming he can get a 3.8% real return in a retirement savings plan, this package is worth $1,645.70 per year. But he is paying $3,197.70. The difference of $1,552 is a tax, paid by Joe to support the wealthiest members of Canadian society.

Joe's example shows that CPP is a terrible "investment" for someone aged 25. At what age does it become a reasonable investment? Once again, we'll use the government's target return of 3.8% annually as our measuring stick. It turns out that everyone currently under the age of 42 will be paying more into CPP than they could ever hope to get out. Conversely, those 42 and over will be the net beneficiaries of the CPP revisions.

The Canada Pension Plan is a regressive tax. Those who are paying the tax are not the recipients of any commensurate government service. Furthermore, the tax will be paid disproportionately by the poorest members of society, and the benefits will flow to the wealthiest groups in Canada.

In addition, there is no assurance that the assumptions which the Government has made are going to be accurate. It is possible that, with changes in lifestyle, longevity or inflation, a contribution rate of 9.9% will not be adequate to ensure the stability of the Canada Pension Plan. Poor Joe might never receive his pension!

Is There An Alternative?

The Canada Pension Plan was established to ensure that all Canadians have at least a modest pension. This was, and is, a worthwhile goal. At the time it was created, many elderly Canadians lived in utter poverty. CPP is part of the social safety net which, with the proposed Senior's Benefit and RRSPs, have allowed seniors to dramatically improve their living standards.

CPP may have outlived its usefulness. There may be other ways of meeting this worthwhile public policy.

The method of funding CPP was chosen as a politically expedient option. Who would not support a plan for which others (in the future) would be paying for one's retirement?

The need for changes was recognized more than 20 years ago, but political expediency once again delayed action until it was too late. Political expediency has driven the proposed reforms: seniors vote and young people do not. Perhaps it is time to look for solutions which do not encourage inter-generational warfare. Unfortunately, there appears to be only one political party in Canada which is interested in finding a solution which does not pit one generation against another.

If CPP is going to survive as a "fair" public pension plan, it must be changed from a "pay as you go" defined benefit plan into a fully-funded defined contribution plan. This can't happen overnight, and it can't be painless. I envision that changes can be implemented in 3 steps:

  • Those presently 60 and over should be guaranteed their current pension, with funding from the current CPP surplus, supplanted by general tax revenues when this becomes necessary. It may be necessary to remove inflation indexing from the pension payments.
  • Those presently 40 and under should make mandatory contributions to locked-in RRSPs at levels equivalent to the CPP contribution rate. Any shortfalls in contributions should be taxed away, with the revenues going into a government-managed retirement account held on behalf of the taxpayer.
  • Those between 40 and 60 should pay into CPP at higher contribution rates than younger people, while benefits should be lower than those granted to today's seniors. The precise levels of contributions and payouts should be determined by the Chief Actuary, using the government's 3.8% investment return assumption. It may be necessary to supplant these contributions with funds from general tax revenues.

Conclusions

Canadian tax policy has always been progressive. An important principle of taxation in this country has been the redistribution of wealth from those who have more to those in need. The Canada Pension Plan does exactly the opposite. It takes money from the poorest generations of Canadians, and pays those funds to the wealthiest generations.

The goal that all Canadians should have at least a modest pension is worthwhile public policy. If CPP is to survive as an agent for achieving this goal, it must change from "pay as you go" funding to a fully-funded defined contribution pension plan.


Portfolio Strategies