Posted by Robert on January 3, 2011
This is a guest post by Robert, who lives in Calgary and works as a financial adviser. He is married, has three kids and plans to retire at age 35. Robert and his wife then plan to return to school and become teachers, eventually living and working overseas.
I like to joke that I don’t understand why no one checks with me before developing public policy. In reality, if I want my ideas to become a part of the conversation, I need to publicly join the discussion. I understand that it’s easy to criticize the government’s policy, but creating public policy is complex. The needs of all citizens should be accounted for, and it needs to be presented in a way that is politically palatable. Let’s look at the philosophy and values behind retirement and pension reform.
Where does our feeling that we are entitled to retire come from? A couple hundred years ago, entire families would do hard manual labour, such as on a farm or in coal mines and life expectancy was around 35 years old. If children survived to adulthood, they could expect to live to age 65 on average. In a predominantly agrarian or industrial society, workers were considered unable to contribute if they survived to age 65. A pension would retire them from the factory floor and pay them as long as they survived, probably at most 5 years. Today, with advances in public health, life expectancy from birth is around 67, although adults can expect to live well into their 80s. Further, our economy has shifted from agrarian and industrial to knowledge-based. The physical demands on knowledge workers are not comparable, besides which their expertise increases with age.
There is no real physical need for most people to retire. In an agrarian society, most children begin working quite young. Retirement is unlikely in such a society, so let’s suppose that over 65 years of life, 57 of those are spent working for a ratio of 88%. Today, public and higher education account for the first 22 years, with children seldom working during this time. Assuming a person works to age 65, then retires for a further 20 years, the ratio of working years becomes just 53%. Because people are able to be productive longer, due to work that is less physically taxing, and because people are living longer, retirement must not be mandatory. I think this is already the case, in most of the country.
We want to retire, but this is a preference, not a need. Who should provide this retirement? In the past, employers have provided it, in order to remove physically unable workers. Today, workers are living longer and pensions are underfunded. Retirement savings should be a personal decision. But employers are ideally situated to withhold savings from paycheques. The government has taken advantage of this in instituting CPP. Why is the government involved? Elderly citizens, some of whom are unable to work or who have no experience working, should not be allowed to live in poverty. Having a minimal pension scheme provides assistance to these valuable members of our society.
When a public pension system was originally envisioned, Old Age Security was instituted as a temporary measure until CPP began functioning. As with many government programs, the political will didn’t exist to end the temporary measure. One of the benefits of OAS is that it is means-tested, meaning that people who are over age 65 and have more than $70,000 income receive only a reduced benefit. Since CPP is conceived as a forced saving pension benefit, it should be fully funded. It is currently near 20% funded, with a goal of reaching 30% funding by 2075. This benefits current recipients at the expense of future recipients.
My preferred solution would be to immediately shift the payments of benefits from CPP to OAS. Current savers should expect to receive their entire CPP benefit from a fully funded public pension at retirement age. Current recipients, however, should receive a larger proportion of their income from OAS (which is means-tested) instead of CPP, especially given that the total contribution was under 4% for many years. Assuming the maximum entitlement, instead of receiving $517 from OAS and $960 from CPP, current pensioners would receive $1285 from OAS and $192 from CPP. More of the money would be subject to clawback, meaning that it would once again become a safety net for elderly Canadians. Once CPP is fully funded, it will provide a greater proportion of government retirement benefits and it will be more secure.
Because only working Canadians are entitled to CPP, but all Canadians who lived in Canada at least 40 years are entitled to OAS at age 65, some modifications would need to be made. A couple where only one spouse worked (2 OAS + 1 CPP) would receive a larger entitlement ($2762 vs. $1994). At the death of one spouse, OAS ends, whereas CPP pays a 60% pension to the surviving spouse ($1400 vs. $1093). Whether or not this would require a greater public expense depends on the income of Canadians over 65 (the age OAS begins). This could be addressed either by reducing OAS or by increasing the retirement age, possibly to 67, and also allowing people to begin CPP as early or as late as they choose.
CPP should maintain the mandatory component, but could add an optional component. This way, 9.9% of each paycheque, up to $4700 per year (currently), would be saved toward retirement. If a worker chooses, they could have an additional amount, possibly 9.9% of each paycheque beyond the current maximum, also saved for their account. In this way, they would either have a larger retirement benefit or an earlier retirement date. Because of the increased fund size, larger provinces, BC, AB, ON, should set up their own provincial pension plan, the way Quebec has.
For healthy people, retirement is not a right. It is a preference that must be planned for and prepared individually. It is helpful that we have CPP to provide forced savings, but it is unsustainable in its current form. OAS is a program that provides for seniors with only moderate income. Shifting the benefits from CPP to OAS would allow CPP to become sustainable and OAS to be modified as conditions require. How would you react to a government proposal of this type? Would you write your MP to endorse it?
Posted by Robert on December 27, 2010
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?
Posted by Canadian Dream on September 15, 2010
If you have ever worked two jobs in your life you know it can be a little stressful at times. It often can become very stressful when you finally get around to doing your taxes and realize that you weren’t paying enough tax all year. So how do you avoid an end of the year surprise tax bill? Actually it’s not that hard with a few steps.
- Determine what you should be paying in tax. The problem with two jobs is they both only assume you have just one job. So at least one of your jobs should be taxed at your marginal tax rate (for example 35%) while typically your employer is only taking off the lower tax rate (for example 26%). That leaves you holding a tax bill for the missing 9% (35%-26%). To find out your tax rates just head over to Taxtips.ca and find your province. You just look up your rate for both jobs as a single job and add them together to find your marginal tax rate.
- Pay more tax during the year? A common solution to knowing you are going to have a higher tax bill is to fill out at TD1 form at one employer to have the additional tax deducted. This way you make sure you are paying the missing 9% or what ever you owe. The problem with this method is you are assuming that you will just pay the tax bill instead of looking at a different option.
- Avoid the tax bill entirely. Another solution is the save your extra ‘tax owing; money into an RRSP if you have the contribution room. That way you are building some savings and creating a tax break to offset your extra tax bill. This becomes a little easier to save since you can use the very money you would owe in tax to fund the RRSP.
I’m personally have two jobs this year and I’ve decided to skip #2 and instead I’m using #3. The great thing about this option is it allows you a larger free cash flow during the year to do what you want. For example, for the first half of the year I paid down my mortgage a bit faster and for the last three cheques of the year I’ll be putting the extra money into my RRSP to reduce my tax bill.
This solution seem nice until you realize that getting an accurate estimate of your tax owing can be a little complex as you add in a few extra complications like: investment income, income from a small business, determining your EI and CPP over payment (since they are getting deducted twice) and then any other tax credits you qualify for. Basically to do it right you would have to do your taxes twice: once as an estimate and then again when you file. I’ve decided to skip the detailed estimate and use a rough one. I might be wrong, but I should at least be close.
If you have two jobs or multiple income sources, how to you plan for your taxes?
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Filed Under: Tax
