CPP Isn’t a Good Deal

Tim’s post on pension reform struck a chord with me. I agree with him that the proposals by government for expanding the CPP are a bad idea. I have three major problems with this idea, only one of which I will explore in detail. First, the idea that Canadians aren’t saving enough is based on too many assumptions for me to be convinced. It’s also the result of a conflict of interest, in that the CPP investment board would rather manage more funds. But whether or not the conclusion is correct, my second problem is that $127.6 billion (or more) is too much money to entrust to the care of a small group of people. Third, CPP doesn’t offer Canadians a good deal. This is the idea that I want to explore.

Let’s begin by looking at how much is saved each year on your behalf. The total contribution, employer + employee, is 9.9% of your pensionable income (maximum of about $47,200). That is an increase from 3.6% in 1985. For 2010, the maximum contribution (for anyone earning over $47,200) is $4672.80 (for self-employed people, or split equally between employer and employee). Benefits are calculated based on 25% of average pensionable earnings, so for this example we will assume that the maximum was saved each year.

For the purpose of this example, let’s assume an individual graduates from university at age 22 and begins working with an income of $47,200 (or more) and maintains at least this level of earnings over their career. They retire at age 65, having worked for 43 years. We will use constant dollars, ignoring the effect of inflation since benefits are adjusted for inflation. This means that the 22 year-old graduate will contribute, either personally or from the employer, $4627.80 each year for 23 years. The total contributions will be $107,474.40.

The resulting amount of capital, $107,474.40, includes no investment return. To see what rate of return is implied by CPP benefits, let’s look at the current cost of annuities. (Disclaimer: this uses data for a female, whereas an annuity for a male at the same age would cost less, implying a lower return from CPP.) At age 65, a woman can expect an annuity to pay out interest and capital at a rate of about 6.84% per year. This will last to the end of her life, with no value at death. In this way, it works exactly like CPP. At age 65, the maximum CPP benefit is $960.00 per month. This is the amount of the benefit that would be earned in the example given above. In order to buy an annuity with a similar benefit, assuming a 6.84% payout rate, would cost $168,421. An indexed income, which CPP provides, would cost somewhat more than this.

Now it’s time to complete a future value of money calculation. Saving $4627.80 each year over 23 years and finishing with $168,421 implies a rate of return of 3.95% per year compounded. Add to this the fact that CPP may be around 20% funded, with the goal of being 30% funded by 2075. The fact that the fund is transitioning from pay-as-you-go (ie. current workers pay for current retirees) to a hybrid structure (ie. partly funded by current workers saving for their own future benefits) explains the low rate of return. The difference between this and the expected (market) return is what increases the funding level and the stability of the plan.

Personally, I expect not to rely on CPP. I can get a better return than 3.95% and I can take responsibility to save for my own retirement. And it’s a good thing, since I won’t even have the option of paying into CPP if I have no earned income. When I retire early and begin to rely on investment income (or move abroad), my contributions to CPP will end and my expected benefit at age 65 will stop increasing. People who are self-employed also have this option. If they take their income as dividends instead of salary, they don’t contribute to CPP and are wholly responsible for their own savings.

I don’t believe CPP is a bad idea. It provides a minimum income so that elderly Canadians are less likely to live in poverty. A couple who receives maximum CPP for a single spouse and OAS for each spouse should receive around $2000 per month. But it doesn’t mean we should expand CPP. It provides only a safety net and, as was mentioned in the comments to Tim’s prior post, different people prepare themselves in different ways. Who am I to say that choosing to reduce your spending, choosing to move to a lower cost country or choosing to reverse mortgage your house aren’t equally valid ways to deal with the need for income in retirement.

How do you feel about CPP? Do you appreciate the safety net it provides? Should people be forced to save more? Is it the government’s place to help us retire?

17 thoughts on “CPP Isn’t a Good Deal”

  1. Thanks for the post, this mirrors what I have thought for a long time. I once attempted the same calculation and got an implied return of 1.5%. Regardless, it isn’t much.

    Had a conversation once with a friend who recognized the poor returns of CPP but (as self employed) wanted to contribute to diversify his pension incomes and have the guarantee that a portion of his pension would always be there.

    I recently came across an article on the Sask. Pension Plan (SPP) which is open to everyone and provides a locked-in contribution and an annuity at the end, but based on market returns (although with limited investment choices). This would seem to make more sense than choosing to contribute to CPP. This is also similar tot he Reg’d Pension Plan idea that Flaherty was proposing.

    As a self-employed person myself, I have chosen to not contribute to CPP for a few years now. If I do choose to contribute, then it may make more sense to do so in the next few years before contribution rates go up even more. I had many years an an employee and can’t do anything about those contributions, but it may make sense to “top it up” and get closer to the maximum CPP possible. Maybe.

  2. Either I’m not following something or the numbers are muddled. You suddenly started using 23 years of work instead of 43 years. A couple of other points:

    1) The difference in cost between an annuity that pays a level monthly income and one that increases with the CPI is substantial.

    2) The 3.95% return you calculated is a real return meaning that this is above inflation. If I thought the CPP was actually going to earn 3.95% per year above inflation from now until when I retire I’d be quite happy to take it.

  3. This is a really great post with excellent detail. As someone who’s 26, I’m starting to worry just how far the CPP will last. It seems, I’m going to be paying for the baby boomer’s retirement and health care, not to mention all their social programs.

    Where I think the real key, is retiring at 65 needs to be looked at. When was this number set? Our standard and quality of life is much higher, and we live much longer — what if we said everyone 50 and above retires at 65… but if your under 50, you now work till 70? Something like that, helps ease the burden, without screwing over those who are 64.5.

  4. While you arguement is correct I’m not able to follow your numbers.
    As Michael James points out 43 years at $4627.80 is $198,995.40 not $107,474. Also as pointed out an index annuity is substancially more – I could only find one rate online that was $404 per thousand for a fully indexed life annuity that would imply a value of $238,000.

  5. Like some of the other commenters, I also don’t like the idea of relying on the CPP to be around when I hit 65 (currently 25). The thought that I have a hard time reconciling is that we live in a very social society and part of what makes Canada great on a global scale are the programs like CPP. If we don’t like them, we should either lobby hard to have them changed or leave the country. Not everyone is in the position to provide for their own retirement (as much as I would love to not have to pay into CPP and choose how to invest that money myself). This blog is a great example of voicing your opinions. As a 25yr old engineer your blog jives with me. I heard you on CBC awhile ago and have been following since.

  6. David-

    Plan on becoming self-employed within 5 years or so. Get some experience under your belt and make sure you have found a niche you love. Then make the jump to self-employment as long as you can be disciplined about saving some money (as there will be no EI and there WILL be periods of unemployment). You can then choose to contribute to CPP or not, or a little bit of CPP, etc.

    Is the post author going to address the “numbers” issue raised in the comments? This isn’t my area of expertise and I would appreciate an attempt to reconcile the differences.

  7. Wow, I chose an inopportune time to take a vacation. I find many benefits from writing guest posts for Tim’s blog. One of the many is that I can count on our intelligent and courageous readers to play a role as loyal critics, gently pointing out errors or oversight. In this case, it appears I need to review this. I apologize for the confusion, but I stand behind my conclusion. I’m going to review the numbers and try to get a quote for an increasing annuity. The only problem is that annuity costs fluctuate with interest rates, so it’s not fair to generalize the “value” of CPP based on current annuity prices. Still, there’s not a better alternative.

    Thanks for all the great comments, and I’ll check back when I have reviewed the calculations.

  8. Saving $4,672.80 per year (either self-employed or employer+employee) for 43 years (age 22 to age 65) equals total savings of $200,930.40.

    Patrick pointed out that an indexed annuity paying $960 per month (similar to CPP) would cost approximately $238,000.

    Saving $4,672.80 per year and having it grow to $238,000 after 43 years implies a compound rate of return of 0.79% (nominal). This fits much better with Bob’s calculation and my back-of-the-envelope calculation prior to writing this post. This amount would change with annuity costs, which are affected by interest rates, gender and health. But I feel it gives us a reasonable understanding of the issue.

  9. I still feel that CPP is a reasonable program, especially within a country such as Canada. As Bob suggested, it diversifies our sources of income in retirement, provided some guarantees, which are valuable for peace of mind. To David’s comment, the value of CPP is not in the investment returns (as I feel I have shown), but in the safety net it provides. I agree that we shouldn’t rely on it, but I don’t want to see elderly people living in poverty. CPP doesn’t provide much, but it should keep people from eating cat food.

    The future value of money calculation provides only a nominal return. (3.95% – 2% inflation is 1.95% real return.) However, this was in error and the nominal return of CPP is probably somewhere between what Bob calcualated (1.5%) and what I found (0.8%). That means taxpayers are achieving a negative real return. That makes sense, since the investment return is being used to increase the level to which CPP is funded (from 20% funded to 30% funded).

    65 years old was chosen as the retirement age as it was the life expectancy in industrialized Germany when the idea of retirement was put forward. Factor workers couldn’t be expected to work past that age. It was probably more profitable for employers to pay old workers to leave the factory. If we’re going to have a public conversation about retirement, we should start by asking what entitles us to retire in the first place? If we do want to retire, is it the government’s place to provide that? If it is, there’s nothing magical about age 65. If we stick with the life-expectancy approach, retirement age should be closer to 85, with personal savings providing any earlier retirement. As it stands, retiring at age 45 will drastically reduce a person’s CPP contributions and entitlement.

    Again, I apologize for my confusion over the numbers and I appreciate the great feedback. Happy New Year to everyone!

  10. @Robert: The return you calculate is not a nominal return. You used present-day figures. If this hypothetical woman were retiring today she would get the $238,000 value but would have paid less than $4672.80 in 42 of the past 43 years. The calculated return is a real return.

  11. Michael, thank you for clarifying. Now I understand why you’ve said that it’s a real return and I agree with you. In this case, the real return I calculated was 0.8% and the nominal return should be 2.8% (using the Bank of Canada’s target rate for inflation of 2%). It’s nice to know depositors to CPP are keeping up with inflation.

  12. @Robert, good point on “what entitles us to retire”. For fun I looked up the average life expectancy for someone born in 1965 (about 71 years) and someone born in 2010 (about 81 years). So when the CPP was formalized they envisioned an average “retirement” of 6 years essentially. Now that same program is being asked to fund a retirement of 16 years (at 25% of your earnings). No wonder contribution rates have increased so much!

    There was an assumption that 4 pieces (25% each?) would fulfill retirement income – OAS (1952), RRSPs (1957), CPP (1965), and private pensions. For many of us, the idea of a private pension is laughable. I was never eligible for one in the private sector, and couldn’t envision working for a government.

    Thankfully, I have been paranoid about it for years and am focused on saving for myself.

  13. CDFA45,thanks for the calculation and those made by other readers.

    I am not smart enough to compute the numbers, but this is what I know –Government, stay away from my pocket.

    I plan not rely on Government for my retirement, so when time comes, I will refuse to take a cent from Government handout, and I will brag about it everwhere I go. (For most people this will be very hard to do since it is “free” money)

    I remember several months ago that the Unions wanted the Government to pay higher CPP benefits for retired workers.

  14. It’s bad because it’s really…insurance, not a pension plan.

    The rules, you find, are there to purposefully maximize the amount the government can keep.

    The worst case scenario is if you die in your 40’s or 50’s. You have likely contributed 10’s of thousands of dollars by this time, and guess what your estate or loved ones get?

    $2500 maximum.

    So I wish they would STOP calling it a pension, it’s really an insurance policy in which you PRETTY much loose your shirt if you die early.

    Wouldn’t everyone rather contribute to a real fund, and get returns AND then be able to will the entire amount to a loved one?

    I’m left leaning and think we’d all be better off with ALL of this in banks and mutual funds. Then at least we’d get something out of it if we die early….or should I say our families can.

  15. Sorry the above is from another Robert, not the one from earlier! 😉 I’ll call myself Robb if I post again to avoid confusion.

  16. Hi Robb, you’re right that there is an element of insurance. You mentioned the $2500 death benefit. There is also a disability benefit if a person is totally and permanently disabled (can never work again at all). It pays about $800 per month. There is also a survivor’s benefit, so that if the worker dies, the spouse receives the pension. It is only about $300 per month, with another $200 per month for each child. You can find more information here: http://www.servicecanada.gc.ca/eng/isp/pub/factsheets/rates.shtml

    I agree that having your own savings provides the most control and choice. Opting out of CPP is not easy, but it can be done by becoming self-employed and taking income as dividends.

  17. Thanks Robert.
    Yes I may have come across doom and gloom! There are many benefits available.

    I’m sure I’ll welcome the money come the time, but as it stands being single right now….all that money I’m paying is “flushed” down the proverbial sh##ter if I die early. And that does make me a bit angry.

    Since most people are likely to contribute more than they get, they should start calling it Pension Insurance, just to get the point across that this is not something anyone’s going to get ahead with. I’m much too lazy to do the numbers today, but I’m betting the government always comes out ahead….like Vegas!

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