In a nutshell

-An expanded-CPP, let’s call it expanded-CPP Plus, may in fact be a good framework for Canada’s pension reform.  If one expands options beyond the dimensions (maximum pensionable earnings and percent benefits) currently under consideration, and one changes some of the other attributes of an expanded-CPP relative to the current CPP, profound changes to Canada’s retirement income system could result. The attribute changes required include:

• level of compulsion to save: a mixture of higher mandatory savings and additional voluntary contributions  not limited to employment-based income
• who pays: employee and/or employer
• investment vehicles beyond the CPPIB portfolio for the new/incremental extended-CPP contributions primarily based on low-cost index-based investment vehicles
• annuity only option extended to include pure longevity insurance on current CPP, and other decumulation strategies including pure longevity insurance on the new extended contributions
• new/incremental benefits  pre-funded rather than funded on a pay-as-you-go basis

The details

The current CPP offers minimal flexibility points: contributions are fixed and paid for by employer/employee on a 50/50 basis, benefits are capped at 25% of median income and must be taken as a lifetime income stream (annuity), investments are (actively) managed by CPPIB, and it is a pay-as-you-go target benefit plan.

At the Meech Lake gathering mid-December 2012, the an expanded-CPP proposal discussed by the finance ministers was the 10-10-10 plan that increased pensionable earnings by $10,000 from current $50,000 to $60,000, increased benefit levels by 10% from 25% to 35%, and to be phased-in over 10 years. So the current proposal on the table only attempts to “extend” CPP in the dimensions of maximum pensionable earnings and percent of benefits without changing the nature of the contribution and benefit formulas.

Andrew Coyne in the Financial Post’s “Beyond expanding the CPP, the challenge of population aging presents an opportunity to reform it”  argues that since today’s demographics have precluded pay-as-you-go and DB plans for private sector employees “More of the burden will have to be borne by pre-funding, that is out of beneficiaries’ own savings” yet Canadians still haven’t got the message.” He further argues that, despite protestations to the contrary, the CPP while actuarially sound in the short-to-medium term is $800B underfunded, and there are too many eggs in the one CPP basket exposing all Canadians to the same risk factors (market, government, etc). To solve two obvious problems of (1) inadequate savings and (2) the 2-3% “waste” associated with mutual fund investments, he proposes: (1) a compulsory increase of CPP premiums but “instead of going into the regular CPP (investment) pot, the funds would accumulate in the contributor’s own personal fund” and (2) “To avoid wasting money on management fees, funds would be invested strictly passively” with age-dependent asset allocations (like target-date funds).

But why should we limit an expanded-CPP to just: higher compulsory contributions flowing into individual accounts with low-cost index fund based age-dependent glide-path as default investment vehicles? Why not build an “”expanded-CPP Plus with increased flexibility by also adding:

• not just higher compulsory employee and employer contributions, but also voluntary individual (employee or not) and/or employer contributions. We know that current CPP compulsory contributions do not deliver the retirement income expected/desired by Canadians above the lowest income quartile. Furthermore, the current/accumulated voluntary contribution/asset levels in RRSPs/TFSAs and taxable retirement accounts in general are insufficient to meet expected and desired retirement income levels. A combination of increased levels of compulsory savings are necessary(e.g. the proposed 10-10-10 for expanded CPP), as well as default auto-enrolment (e.g. starting at 3% of income) with automatic increase of contributions  (e.g. by 1%/yr until 12%) are required to be able to achieve the fully pre-funded retirement income levels expected/desired (default auto-enrolment may be overidden by employee).  Separating and limiting the compulsory incremental employer contribution should address concerns that an increase of employer contributions would be perceived as a tax on business which would slow down employment growth. Allowing non-employment related individual contributions would also address current lack of pensions for stay-at-home parents and family care-givers that fulfill these valuable societal roles, should they so choose. Permitting voluntary individual contributions would also address the need for an appropriate investment vehicle for commuted values of stranded DB pension plan assets in case of multiple employers or in case of the bankruptcy of employer with underfunded pension plan.
• not just a default age-dependent glide-path based investment vehicle to-retirement, but also some fixed (low/medium/high) risk-tolerance -based low-cost index-based through-retirement asset allocation choices. This would address the varying levels of individual risk tolerance, differences in planned age of retirement, the need/desire to annuitize at retirement or the preparation for a more flexible decumulation plan. Individual accounts not invested in the standard CPPIB investment vehicle would also alleviate concerns that Canadians have “too many eggs in the CPP basket” thus not exposing all Canadians to the same CPP portfolio (market, dirigist government, etc) risk
• not just decumulation strategies limited to a CPI-like target benefit plan aiming to deliver a CPI indexed immediate annuity-like payout at age 65 (with some flexibility to start up to 5 years earlier or later), but also a low-cost pure longevity insurance option for both the current and/or the expanded-CPP. Such a pure longevity insurance option would typically offer a dramatically higher lifetime income stream starting at age 85 compared to the one starting at age 65 for each premium dollar paid at 65. This would not only address longevity risk at much lower cost and requiring annuitization of a smaller fraction of one’s assets, but allow people to execute superior decumulation strategies with better outcomes between 65 and 85 knowing that a much higher lifetime income kicks in at age 85. This longevity insurance option should be available in both the existing pay-as-you-go CPP and the fully pre-funded expanded CPP. In addition, systematic withdrawal options should be made available from the individual un-annuitized accounts, including variable withdrawals to meet individual needs/desires, perhaps subject to certain age-dependent floor and/or ceiling (as in RRIFs/LIFs).
• instead of a pay-as-you-go plan, fully pre-funded CPP extensions would not require phase-in period as every dollar of added future benefit would be paid for up front
• CPP administrative infrastructure, irrespective of whether you’re in the camp of those who believe it is low-cost or not, could support an expanded-CPP at relatively low incremental cost thus meeting the low administrative cost hurdle of even the most frugal advocates
• not only offer low-cost index-based investment vehicle for the incremental expanded-CPP contributions, but also offer access to shares in the CPPIB investment portfolio. This would address the needs/desires of those who believe that active investment management can/may deliver superior returns at some given risk level. The CPP investment management fees (whether you believe the CPP fees to be low or not) are significantly lower (typically by a factor of 3-7) than the average mutual fund fees in Canada. This would also address the concerns of those who fear that the use of index investment vehicles will reduce the required governance/oversight/due-diligence typical exercised by investors over the management of corporations they invest in
• current 9.9% CPP premium rate (increased in the 90s from about 6%) up to 25% of maximum pensionable earnings (joint employer and employee) contribution only buys approximately the benefits corresponding to about 6% contribution, in order to make up for benefits received in excess of contributions by the first generation of CPP recipients and the current demographic realities associated with a pay-as-you-go pension system. Any incremental expanded-CPP benefits should be paid for individually on a pre-funded basis.  This should address any concerns/objections relating to further aggravating cross-generational subsidies associated with a pay-as-you-go plan.

Bottom line

The “expanded-CPP Plus” described above, can meet the first 3 of the at least four necessary dimensions that must be addressed for meaningful private sector pension reform in Canada:

1. adequate savings (more compulsion to contributions or at least auto-enrolment wit auto increases)
2. low-cost (accumulation/decumulation) investment vehicles
3. low-cost pure longevity insurance
4. protection of already earned DB pensions in case employer/sponsor seeks bankruptcy protection with an underfunded pension plan (i.e. priority at least over unsecured creditors)

Such an “expanded-CPP Plus” could be readily be done incrementally and on a fully pre-funded basis.