In a nutshell
Expanded CPP is back on the table again with federal and provincial finance ministers all agreeing that it has merit. In the context of this newly emerged consensus around some form of CPP expansion, though not about its timing, it is useful to look at the pros/cons of an expanded CPP.
Given that any expanded benefits will have to be prefunded (and without any cross-generational transfers) the full benefits of the expansion will likely be phased in over 20-40 years. While this is beneficial to people under age 45 who have still time to build/prefund the offered benefits, people who are within <10 years of retirement and of course those who are already retired will see little and no benefit, respectively. While little or nothing can be done about additional savings by those near/in retirement, there are opportunities even for this group within an expanded CPP framework if they could: (1) purchase a (deferred) CPP income stream with a lump sum payment and/or with excess CPP contributions (without employer matching), (2) defer a portion of the CPP benefits to be taken in the form of pure longevity insurance (i.e. deferring a portion of the benefit to be payable as a much larger income stream starting at age 85), and/or (3) get access to low-cost professionally managed/governed (e.g. Teachers/OMERS/CPPIB-like constructs) asset accumulation and systematic withdrawal funds with the option but not the obligation to annuitize at retirement.
Similar options are needed for caregivers/homemakers who are effectively excluded from the current CPP.
An finally, given the extent of consensus and the level of commitment to an expanded CPP, with the timing of the incremental “payroll tax” on employers as the only concern, then the expanded CPP could be started immediately with only the employee portion of the contribution, to be followed by the employer match when a pre-specified economic trigger is reached.
Credit to PEI and Ontario which by their actions, in preparation for the December 2013 federal/provincial premiers/ministers’ get-together, reignited some energy behind pension reform with fresh ideas related to the expanded CPP. After years of studies, consultations and recommendations, followed in the past few years by federal/provincial finance ministers’ discussions/debates, we still have no meaningful pension reform within or outside of the CPP framework. Even the federal finance minister indicated that that he sees the value of an expanded CPP, but calls CPP a payroll tax and argues that the timing is not right now. (Ontario indicated that, if necessary, it is prepared to go it alone to address retirement income system shortfalls. (If Ontario does act alone or together with other provinces, they should consider the recent UK proposals succinctly described in Kevin Wesbroom’s Financial Times article entitled “CDC: A road map to better pension provision” which describes a Collective Defined Contribution plan which offers: cross-cohort risk sharing, quality governance, professional management, economies of scale and do not force annuitization at retirement. )
How difficult is pension reform anyways?
Do we know what’s wrong with Canada’s “retirement income system” that used to be called “pension system” before everyone realized that real (DB) pensions are history (except in the public sector)?
As to what’s wrong is quite simple:
-not saving enough for retirement,
-savings are invested in high cost funds (e.g. Canadian mutual funds) which year after year appropriate about 30-50% of the returns on accumulated assets and which after 30-40 working/saving years can generate as little as 50% less retirement income than if they used a low cost investment alternative
-no low cost decumulation and longevity insurance mechanisms are available (as described in the earlier Pure longevity insurance payout option in CPP would reduce retirees’ longevity risk blog post), so people continue to suffer the same corrosive effects of high fees over the 20-40 years in retirement as they did while they accumulated those assets (e.g. annuities, GMWBs, principal protected products, not to speak of the financial repression under way for the past 5 years with nominal interest rates still in the 1-3% range, leaving reduced annual purchasing power for the remaining assets.)
-private sector pension plan members continue to be exposed to slashed pensions if employer chooses bankruptcy (often to shirk pension obligations)
And the solution is?
Well, the solution is simple:
- Increase retirement savings during working years. At least default to auto-enrolment save-more-tomorrow commitment, though I am increasingly coming around to agree with those who want to make contributions mandatory. Set minimum savings at 15% within 3 years of starting work.
- Provide access to low-cost default investment options during working years. The all-in-cost (admin, investment management, transactions, etc) target should be 0.3% per year and certainly no more than 0.5% easily achieved with a passive implementation of balanced portfolio with periodic rebalancing designed to sell some of the appreciated asset classes and invest in relatively cheaper asset classes. (This is readily achievable using large pension plan management entities modeled on the likes of Teachers/OMERS/CPPIB)
- Provide access to low-cost decumulation strategies such a systematic withdrawal plans with the same cost parameters as suggested for the accumulation phase, with optional low-cost annuitization and/or pure longevity insurance options
- Increase priority of trust funded private sector pension plans in case of employer bankruptcy
Expanded CPP: Some pros and cons:
Expanded CPP proposals are a step in the right direction, as they contribute (at least on an incremental basis) toward points 1, 2 and 3 above:
- Current CPP contributions of 9.9% delivers about the benefit of 6% contributions (the excess contributions are apparently necessary in part to make up for accumulated plan deficits due to benefits paid to those who became eligible at the start of the CPP but had insufficient opportunity to contribute to it) Therefore since we are getting about 6% worth of benefits we would have to raise contribution to about 19% in total to receive about the expected benefits the 15% suggested in the 1st solution point above.
- Assuming that there are no incremental administrative costs using the CPP admin infrastructure, the CPP investment management (only) costs appear to meet the <0.5% maximum criterion in point 2 above at least incrementally; this is a massive improvement over the currently prevailing mutual fund fees paid on most retirement savings in Canada
- Annuitization is the only available decumulation option with the CPP at this time, which would works fine at the current low level of benefits and might even be acceptable for young workers who get to participate in the CPP expansion, but may not be optimal for many beneficiaries
Expanded CPP as articulated so far, does not address retirees’ and boomers’ retirement income crisis: The most important shortfall of expanded CPP proposals is that, given the reasonable expectation that all new individual benefits will have to be on a fully funded basis and without cross-generational transfers/subsidies, they either do not address at all or substantially the real issues faced by the existing retirees or those who will be retiring over the next 10-20 years, i.e. most of the boomer generation. This is because the new benefits proposed are to be phased in over 20-40 years as they become fully funded. To address the needs of those who are in retirement or are approaching retirement, the expanded CPP must permit the lump-sum purchase of a (deferred) CPP income stream and/or excess catch-up contributions over and above the normal CPP contributions to: access low cost incremental annuity-like CPP benefits, or access low-cost accumulation and systematic withdrawal strategies or to receive CPP benefits in form of a pure longevity insurance. The only other alternative would be that an expanded CPP would not provide any or sufficient relief to those near/in retirement, without an unacceptable cross-generational transfer/subsidy whereby our children and grandchildren would be paying for our retirement. By the way, so far there has been no mention of addressing the retirement needs of temporary or permanent caregivers/homemakers who would also benefit mechanisms to access CPP in other than an employer/employee payroll deduction/contribution.
Asset concentration: While building on the existing CPP administrative infrastructure is desirable (likely even necessary to minimize administrative cost of a parallel infrastructure), it is less desirable to continue the growing concentration of retirement assets (all eggs in one basket) with the CPPIB. There is no obvious reason why, while managed by the same administrative infrastructure, the additional assets from the “expansion” of the CPP could not be managed by Teachers or OMERS or similar independent constructs.
Unrelated to the CPP expansion discussion, protection of pensions in employer bankruptcy is an important element of reform. Pension reform must address protection of private sector pensions in case of employer bankruptcy with an underfunded trust fund, by increasing priority of pensions among creditor claims, at least above other unsecured creditors. (I am aware that the current federal government refuses to act on this, but it is an essential step in protecting employees’ deferred wages; it is the right thing to do.)
The expanded CPP addresses neither the needs of much of the Boomer generation nor the needs of already retired Canadians. Some of this can be addressed by options to allow a purchase of a deferred CPP income stream with a lump sum or excess CPP contributions (without employer match), pure longevity insurance payout option in CPP and other systematic withdrawal payout options.
And of course, if there is real commitment to the expanded CPP, but the only concern is the timing of the incremental “payroll tax” on employers, then start immediately with the employee portion of the contribution and specify the economic trigger which will enable the employer match.