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 December 22, 2010
If I read just one more story about pension reform I might just have to scream. Why? Because the main reason they are looking at it is basically everyone collectively realized many of the boomers have failed to save for retirement. Yet ironically any of the proposals coming out to either expand the CPP or this new Pooled Registered Pension Plans fail to address the original reason.
Let’s for example look at expanding the CPP. If you did so, the system is based on a pay as you go model now. So even if you doubled the benefit (in some extreme proposals) the boomers would see almost no increase into their benefit since they will only pay in a for a few more years. Only kids just out of high school would ever see the full increase regardless of the increase of benefit chosen.
While I appreciate the idea behind the Pooled Registered Pension Plans (PRPP) and making people default to opt in with them I think the government is is needlessly complicating matters. Saskatchewan for example already has a low cost, pooled plan that happens to be voluntary and heck even available to non-Saskatchewan residents. All you would need to do is add on a default opt in for anyone who didn’t have a pension plan in the province and you would have created the same idea as the PRPP’s. Yet the same problem will occur with the boomers, they won’t put in enough to make any significant difference to their retirements.
Basically the boomers that didn’t save are already fucked. They will have to work to at least 70 in order to max out any CPP they get and save what ever they can for their last working years and hope to God that a future government doesn’t cut back OAS on them. It isn’t nice, but it is true: they won’t be saved by any pension reform. At best we can take the lesson to younger generations to get your act together or have the government force you to save at some point. Forced savings isn’t nice for those that do have their act together, but the option for governments is starting to look better and better to solve the issue. The carrot of RRSP’s has failed to partly do its job, now it will be the stick.
So are you sick of hearing about pension reform? Or have you heard any good ideas yet on what to change?
Posted by Canadian Dream on December 3, 2009
Well yesterday I pointed out some flaws in upgrading the CPP system to a Universal Pension Plan. That’s not to say I think we should do nothing. Since doing nothing will have some issues like:
- OAS – Payments come out of general revenue from the government, if we don’t fix pensions we could end up having a lot of people relying heavily on this meaning making any reduction in payments could be a very long and hard uphill battle as the tax base sinks after the baby boomers retire.
- Government Defined Benefit Plans – These will become much more of a burden on the tax base if we don’t deal with plans sooner than later.
- People Shouldn’t be Left Behind. Granted there is case for offering retirees a minimum standard of living since we don’t want be heartless about things and second there is a basic economic idea behind this. Poor people tend to use more government services that those that are better off. If we do nothing we still pay in the end, so let’s be proactive and nice all at once.
So here’s the outline of my modest proposal.
- Make the Default Option on all Retirement Savings Plans an Opt In. The idea here is simple, people are lazy, so let’s make saving easy for them. Also people don’t tend to notice they are saving if it comes off their cheque. So if you really don’t want to save in the plan you need to file paper work to that effect.
- Raise the YMPE by $20,000 for CPP. This would only be a one time adjustment to boost inflows to the CPP plan and raise the maximum payout by about $4700 per year (FYI: current YMPE is $46,300 and max pension is $10,905/year). The brilliant thing about this adjustment is it won’t significantly alter benefits to boomers since CPP benefits are calculated with the average of your earnings during your working life. So a raise of contributions by the boomers just a few years prior to their retirement will only very slightly increase their payouts. This will also allow existing retirees to keep more pension money if their spouse dies and they take over their spouses CPP payout. This is a good idea since right now if a spouse dies and you are both at the maximum CPP payout it can drop the surviving spouse into near poverty conditions if they have no additional savings since they also lose their spouses OAS. Also raising the YMPE won’t effect those in lower income jobs by taking any more money from them and will allow younger people who pay in for longer to get more of the benefit over their working life. Total additional cost per person per month is $82.50 assuming you make up the maximum YMPE. So it’s a modest impact even for those that are going to retire early.
- Close off all Defined Benefit Government Run Plans. Then switch all new workers over to a defined contribution. We collectively can’t afford the unlimited liability from these defined benefit plans going forward.
So that’s my modest fix for pensions and retirement savings in Canada. Now obviously I likely haven’t thought of every angle on this yet, so I want to hear your ideas on this proposal. Is it good, bad, or do you have a better idea? Please share your ideas with a comment.
