In a nutshell

The expanded CPP is a key element addressing Canada’s pension crisis. Proposed level of expanded CPP is acceptable, but the 49 year phase-in period makes addressing other problems of Canada’s retirement income system urgent. Needed changes include: higher savings rates, low-cost accumulation/decumulation vehicles, longevity insurance, fiduciary level of care/advice for all retirement savings and claims priority for already earned private sector DB pensions when employer bankruptcy occurs.

The details

An expanded CPP is a long overdue key element of much needed reform of Canada’s pension crisis; given rapid disappearance of pensions in all but the public sector, the pension crisis has more recently been euphemistically renamed retirement income crisis. We’ll look at the good, the bad and the ugly associated with the CPP change.

Pension crisis in Canada is not new. Canada’s three pillar system: (1) OAS/GIS (government revenue funded), (2) CPP/QPP (mandatory employment related public plan) and (3) DB/DC occupational pensions and private retirement/saving plans (RRSP/TFSA). According to a Stats Canada report, report and OSFI report on RPP (Registered Pension Plans), private sector employee coverage has dropped from about 50% during the mid-70s to near 20% today. The OSFI report also indicates that DB (vs. DC) coverage was flat around 93% in the public sector while the private sector DB coverage dropped from 74% (2001) to 51% (2011).

Furthermore, private sector DB benefits are not guaranteed, no insurance to backstop (except a minimal one in Ontario) underfunded plans when employer enters bankruptcy protection and no claim priority for pension deficiency. This is further aggravated by tax-laws preventing RRSP contributions due to presumed/assumed contributions toward DB plans. Many of these private sector pensioners latter discovered that these pension plans turned out to be a house of cards.

The level of CPP benefits have remained unchanged at 25% of one’s  average annual lifetime earnings up to the average Canadian earnings ($54,900 in 2016) since the mid-60s when it was introduced, despite the dramatic erosion of the private sector RPP coverage. The announced changes agreed to in principle increase the replacement rate from 25% to 33% and the maximum pensionable earnings from $54,900 to $82,700 by 2065. The current average Social Security payout is comparable to average CPP+OAS (assuming CAD$=USD$), but the maximum SS payout is 60% higher than the maximum combined CPP+OAS. US Social Security benefits maximum about USD$32,000 (average about USD$15,500) compared to maximum of about CAD$13,000 (average CAD$8,000) plus OAS of about CAD$6,800. The lowest income Canadian retirees are also eligible for GIS payments. The in principle agreed to changes to the CPP will finally get the two public pension systems more aligned by 2065.

A couple of good articles summarize the agreement in principle reached Federal and Provincial Finance ministers in the past couple of days. If you wish to read some of the details three articles provide a good overview’ Kevin Milligan’s Macleans piece Making sense out of CPP expansion, Susan Eng’s Hufffington Post blog entitled Historic CPP expansion agreement is something to celebrate and McFarland and McGugan’s Globe and Mail article A new premium on retirement . The initial very brief announcement came on June 20^th with the signature of 8 of the provinces which can be seen here .

First let’s consider what appears to be on the table is that a 1% increase in contribution rate for both employers and employees will increase income replacement rate from 25% to 33% while simultaneously increasing pensionable earnings cap from $54,900 to $82,700. With the government not having as yet released the cost and benefit specifics, there appears some confusion on this matter in some reports in the papers.

Currently employers and employees are together paying 9.9% for 25% replacement rate on earnings (from $3,500) up to $54,900. But only 6% of the 9.9% annual CPP premium is to fund the specified benefits, and the other 3.9% is to make up for much lower contribution of the early beneficiaries of the CPP who were not required to fully fund their benefits. So in effect each 1% increased contribution rate (by each of employer and employee) over a 40 year working life funds about 1/3 of 25% or 8.33% additional income replacement rate. So 1% increased contribution would raise income replacement rate from 25% to 33.3% up to the maximum of $54,900, but 4% increased contribution rate would be required between $54,900-$82,700 to get to secure income replacement rate to 33.33% in that range, because each 1% contribution only buys only 8.33% replacement rate.

So it appears that what is being proposed is a CPP overlay system in which the incremental benefits are fully prefunded:

-Replacement rate: increase from 25% to 33.33%

-Pensionable earnings cap: increase from $54,900 to $82,700

-Contribution rate increase: 1% up to $54,900 and 4% from $54,900 to $82,700 (by each the  employee and employer)

-Maximum benefits after 40 years contribution: increase from $13,000 (average of about $8000) to a maximum of about $17,500 for those earning $54,900, and $26,400 for those earning >$82,700 if 4% contribution increase is applied over $54,900

-Maximum CPP+OAS benefit (w/o OAS claw-back): $33,400 compared to current $20,000

-Phase-in period for contributions: over 7 years 2019-2025 to 1% (or 4%)

-Phase-n period for full benefits: over 49 years to full 33% replacement (to a max of $82,700)

-Sign-up deadline by provinces: July 15, 2016

 

Good news

-CPP benefits improved to acceptable levels together with the OAS/GIS

-Ontario’s ORPP will be cancelled if overlay CPP gets go-ahead on July 15, 2016 (and Ontario won’t have to set up a duplicate administrative infrastructure to the CPP)

-will help somewhat those now between ages 25-45, help very little those between ages 45-65 (and not at all those aged >65)

-greatest CPP benefit improvement to those in the $54,900-$82,700 income range (2016)

-new CPP overlay premium contributions are tax deductible rather than earn a less beneficial tax credit (see The enhanced CPP comes with a tax change — and that’s a good thing )

-low income earners will benefit from “Expanding the refundable tax credit known as the federal working income tax benefit” and “they could also increase the exempt income to calculate GIS payments”.

Bad news

-zero value to current retirees (age >65),

-very little to nothing done for those aged 45-65

-phase-in too slow even for middle income 25-45 year olds

-49 year phase-in

Ugly

Shortly after the announcement that the June 20-21 finance ministers’ meeting will focus on an expanded CPP, the long knives were out to try to stop the (much needed and long overdue) CPP expansion, some of the arguments valid others not:

-some business groups just can’t get with the program Business groups call CPP enhancements a job killer and CPP deal is ‘devastating move,’ businesses warn

The rhetoric is rich in hyperbole like “job killer” and “devastating” which are just not credible given that the contribution increases are being introduced very gradually starting in 2019 and will only take full effect in 2025; over the next 9 years even the most challenged employers hopefully will be absorb the 1% increase for wages up to $54,000 and the (likely) 4% increase for wages between $54,900-$82,700, even if that means that salary increases would have to be somewhat curtailed until 2025.

-the Globe and mail’s The CPP enhancement is only a half-measure Barry McKenna discusses pension envy (or inequity) of public sector pensions and how lower income workers without a without a pension will be able to save for retirement were left unresolved. ” So while the reform is a step in the right direction, it is also a missed opportunity to resolve some of the broader pension issues facing the country. It is a half-measure that fixes half the problem.”

– in the National Post’s CPP board can’t escape blame for fund’s bloated state Andrew Coyne attacked the departing CEO Mark Wiseman and the board on escalating costs which “…reflects a fundamental shift in the fund’s investment strategy, undertaken with the board’s approval in 2006” and condemns the switch to an active strategy “In pursuit of higher returns, the fund has plunged into an increasingly esoteric, and risky, range of private investments, from shopping malls to drug patents to toll roads.” All this was accompanied by higher compensation individually and in aggregate. He further argues that the fund’s new strategy beat its benchmark in the past 5 of 9 years; but he calls the 65% benchmark “a fraud” because the equity component is 72% and the a lot of it is non-public illiquid securities riskier than public ones.

– Randall Denley in a scathing Ottawa Citizen’s Canada Pension Plan change is far from benign questions whether an extra $4,300 in 2065 (when the overlay CPP will be fully phased-in) will make much of a difference to the lifestyle of the then 65 year olds (now 16 year olds) are ready to retire. (In actual fact the extra $4,300 applies to those earning at current maximum pensionable $54,900 level, and it is more like an extra $13,500 for those earning at the new higher maximum pensionable level of $82,700 today.) I won’t take you through his arguments of why he considers the promised changes “far from benign” or the arguments why other issues facing Canada today being more urgent.

-a couple of Fraser Institute sponsored reports were also highly critical. One argued that pension fund management costs are supposed to drop as the size of the fund increases, but when CPP is compared with a half a dozen other smaller Canadian public plans, the expenses associated with it appear inconsistent with the expected lower cost of larger plans (see CPP more costly than other public sector pensions: report ); however cost has more to do with what investment strategy is taken rather than just the size of the plan. Yes, but the real or perceived high cost of the CPP is not news. The other paper points to the plan members’ expected return on their CPP contributions ranging from >40% for those retiring in the first 5 years or so  after the inception of the CPP, to real 3.6% for those becoming 65 recently to real 2.1% for those retiring in about 25 years or so. This is a result of the early recipients having contributed for very few years and receiving pensions which were only very partially funded by their contributions whereas those who are currently contributing are doing so are rates much higher (9.9%) than required (6%) to deliver the expected benefit in order to cover previous generation of beneficiaries’ under-contributions (not that real 2.1% is that bad given the current environment).

-financial industry interests have been arguing that CPP expansion is unnecessary because there are adequate existing retirement savings vehicles and products already available to serve Canadians retirement needs. With very few exceptions, the financial industry has not been serving the best interest of their clients for decades  and shouldn’t qualify to manage clients’ retirement funds until they commit to deliver advice consistent with fiduciary levels of care as recently mandated in the US by the DOL (i.e. act in the clients’ best interest).

Other concerns

In the Globe and Mail’s For CPPIB, new money raises new questions about investment risk Jacqueline Nelson reports the view of CPPIB chief actuary about the potential need for a new IPS (Investment Policy Statement) for the additional CPP premiums to cover the new overlay benefits which are now required to be 100% prefunded, so there will not be a repeat of the core CPP plan problem when in the late 90s the contribution rate was jacked up from about 6% to 9.9%. (This makes sense in order to make sure that Canadians are not exposed by having too many eggs in one basket.)

In fact, I always wondered how much longer the current 9.9% contribution, now about 20 years old, will continue to be necessary given that it is only delivering a 6% worth of benefits; so when can it be reduced or benefits increased closer to what the 9.9% should deliver? It appears that there no plans to make any changes to the contributions/benefits of the core/existing CPP. This is discussed in the 2007 CPPIB actuarial report No. 6 entitled Optimal funding of the Canada Pension Plan (pp. 5-7) which explains how we have gone from a pay-as-you-go to a partial funding approach called steady-state funding (the third way of funding such schemes is full prefunding which appears to be applied to the new overlay CPP). They also note that “the funding methodology could always be changed or reworked” if assumptions differ drastically about “future demographic and economic conditions” (that’s why I always think of the CPP a target benefit plan where premiums/contributions and benefits can always be changed if deemed necessary).

According to the CPPIB 2016 annual report the active strategies pursued by the CPPIB had a net benefit over 10 years of $17B which they indicate to be equivalent to 80bp incremental return per year. So while an expanded CPP may not be perfect, it is probably the best option for most Canadians to provide a lifetime inflation indexed income stream to help cover part of their fixed expenses. Having praised the CPP, still not everyone is comfortable with the CPPIB strategy. 2016 was a bad year for the CPP by historical standards at 3.4% nominal, but prior performance was also boosted by ‘lucky’ 20/25% drop in CAD/USD exchange rate on a portfolio >70% non-CAD based.

But more disconcerting to some might be that according to the latest CPPIB 2016 annual report (March 31, 2016), about 47% (previous year was 39%) of assets are categorized as being Level 3 valuation basis (meaning that the ‘fair value’ of the assets is estimated on inputs that are not based on observable market data.(i.e. effectively no liquidity). This might make many objective observers concerned. The $17B excess return indicated by the CPPIB over the past 10 years represents 12.5% of the $127B Level 3 assets (47% of about $270B assets). The question is: What is the uncertainty of the valuation of those $127B Level 3 type assets? So even though one might argue that for example infrastructure derived income might may be more suitable and less volatile than asset values whether public or private, but it might be difficult to take to the bank an argument that $17B excess return when it is based on valuation of $127B level 3 type assets. (By the way, the CPPIB is not the only Canadian public pension plan which has dialed up the risk in its portfolio as discussed in Canadian public pension funds intensify leveraged strategies .)

What’s more left to be done?

While I believe that CPP expansion is a key element in addressing Canada’s pension crisis and it is just a small but important step forward, and it is difficult to argue that Canada’s pension crisis (or retirement income crisis) has been solved. That is not the case. The benefit of the expanded (or overlay CPP) is different by age group due to the way the contributions and benefits are being phased-in over a 49 year period: those aged <16 (100% of benefit), ages 25-45 (will get about 40-90% of the benefits), ages 45-65 (will see a small part (average of <20% of the indicated benefit) and >65 (retirees will see zero benefit).

So what else needs to be done to deal with Canada’s disappearing pension system? What’s the benchmark against which we can measure the CPP enhancements. Let’s consider the areas where Canada’s retirement income system is in dire need for reform; here are four key areas and an assessment of the impact of the expanded CPP:

1. Insufficient savings- CPP benefit-implied saving is being increased from 6% (not 9.9%) to 8% for earnings up to $54,900 and from 0% to 8% for earnings between $54,900-$82,700 (combined employer and employee contribution). Required voluntary/mandatory savings should be of the order of 20% of total wages; if 6% buys 25% replacement rate of pensionable earnings then 18% of total earnings should buy 75% earnings replacement (so 20% should buy close to 100% replacement of income less savings; what’s even more important as one approaches retirement is to aim to cover expected spending in retirement) …STATUS: BETTER but far from minimum acceptable level
2. Corrosive effect of high cost investments during accumulation (and decumulation). Most Canadians are still heavily invested in mutual funds which cost 1-3% annually; annual 2% cost reduces savings accumulated for retirement by 30-50% over 40 working years and further erodes deliverable retirement income from each dollar saved by an additional 25% over a 30 year retirement. The financial industry has to step up to a fiduciary level of care to be deserving to manage Canadians’ retirement investments …STATUS: No change…FAILED
3. Lack of access to cost-effective and simple decumulation plans such as systematic withdrawal plans and longevity risk management mechanisms. Cost matters, just as in #2 above, but decumulation requires more sophisticated strategies than accumulation…and there is still no access to longevity insurance in Canada…STATUS: BETTER …due a higher level of inflation protected life-time base retirement income to help with fixed (non-discretionary) expenses, but insufficient
4. No protection of private sector earned pension benefits (deferred wages) even in trust-funded plans, when employer declares bankruptcy with an underfunded pension plan. Nothing has been done in this area, despite the fact that Liberals and NDP when in opposition supported a private member bill to provide private sector pension protection in case of bankruptcy….STATUS: No change ….FAILED

Further retirement Income System changes required

-increase savings rate by adding auto-enrolment/save-more-tomorrow features to all retirement saving plans and only using low cost investment vehicles

-allow voluntary contributions to CPP and/or other public pension plans by using: lump-sum or regular contributions (i.e. to buy additional CPP-like income using the CPP overlay formula and actuarially fair payout); this is especially important during the 49 year enhanced CPP phase-in period

-reduce proportion of Level 3 assets in CPPIB managed plan

-fiduciary level of care of all retirement funds (similar to new DOL rule in US); without sign-up to a fiduciary level of care the financial industry (saving/investment and insurance) has not earned the right to provide advice or manage retirement funds (including: RRSP/RRIF/TFSAs or PRPPs)

-enable a longevity insurance option in (and out of) RRSP/RRIF

-allow a later CPP start >>70, possibly even (longevity insurance like) age 85, and extend delayed CPP benefit improvements to surviving spouse

-access to low-cost systematic withdrawal plans

-higher priority for claims associated with already earned pension benefits of private sector DB pension plans when employer goes into bankruptcy with underfunded plan

-allow private sector DB plans access to public pension plans in actuarially fair basis whether Defined or Target Benefit to allow plans to benefit from the larger scale and professional management

-offer individual retirees access to low cost dynamic systematic withdrawal plans based on conservative longevity assumptions

-offer caregivers’ retirement income options to improve the retirement security of caregivers who do unpaid-work to raise children, care for elderly or disabled/sick

-create a Ministry of Retirement Income tasked with creating an environment enabling Canadians to achieve and maintain a retirement lifestyle consistent with their working years at a minimum cost