An early look at what ‘Big CPP’ will look like

NationalPost.com – FP/Personal Finance/Retirement
09/11/13.   Fred Vettese

The announcement coming out of the Nov. 1 meeting of the provincial and territorial ministers of finance suggests expansion of the Canada Pension Plan is much closer to becoming a reality.

This is a far cry from December 2009 when the same ministers met in Whitehorse and concluded that the country’s retirement system was in need only of a little fine-tuning. Since then, the two main holdouts, Alberta and Quebec, have apparently jumped onto the Big CPP bandwagon and even the federal government, which would prefer a voluntary savings plan solution, is likely to come onside.

So, what will an expanded CPP look like? The announcement was short on details but the carefully chosen words still offer a few insights on what to expect. First, the ministers agreed that any improvement should be “fully funded and focus on today’s workers.”

This phrase strongly implies that any improvements will apply only to future service since an increase in existing benefits would not be fully funded for generations. If the ministers really mean “fully funded,” younger workers especially should be relieved. We have already seen what happens when we decide to grant ourselves benefits without paying for them. The current CPP benefit is worth only 6% of pay but is costing us 9.9% into perpetuity because the previous generations did not pay enough.

The announcement also asserts that it is “important to improve the future incomes of middle-income workers.” This has to mean that the CPP earnings ceiling, which tracks the national average wage, will be raised since the current ceiling of $51,100 is too low to capture much of the income of middle-income workers.

Once again, this is quite encouraging since raising the ceiling is the most effective change we can make to the CPP.  To explain why, we can use the results fromLifePaths, a sophisticated computer model developed by Statistics Canada which, among other things, estimates the income replacement rates of retirees. Most people want a replacement rate of 100% meaning they could maintain the same standard of living after retirement as while they were working.

Because so many big expenditures vanish by retirement, we can have much less income after retirement than when we were working and still achieve a 100% replacement ratio.  With this in mind, the LifePathsresults show the retirement problem is really concentrated within one income group.

Consider first those who earn less than half the average wage. Almost all of them will enjoy replacement rates of 100% or more, thanks to Old Age Security and the Guaranteed Income Supplement (GIS) alone. They won’t even need CPP to get there and higher CPP benefits would reduce their GIS income.

Those who earn between half and one times the average wage (i.e. $25,000 to $50,000) are doing nearly as well. Over half of the recent retirees in this income group have replacement rates of at least 115% while only 1 in 10 has a replacement rate below 85%.

The next income group consists of individuals who earn one to two times the national average wage, i.e. $50,000 to $100,000. These are the middle-income earners and about a third of them will have a replacement ratio less than 85%. Certainly they could be helped by increasing the benefit accrual rate (see below) but that would be overkill for the lower-income groups.

The more effective solution is to raise the CPP earnings ceiling. While I am on record as endorsing a $75,000 ceiling, PEI recently proposed increasing it to $102,000, which is defensible but is it affordable in this fragile economy, given the extra employee and employer contributions it entails?

The Nov. 1 announcement is less clear on whether the pension accrual rate would be increased but most proponents of Big CPP have suggested it should be. The CPP pension is currently 25% of the average earnings ceiling in the last three years before retirement. Whether it should be increased to 30%, 35% or 40% is not immediately clear. We should be determining the lowest rate north of 25% that produces a satisfactory outcome for the largest group of workers.

Unfortunately, nothing in the announcement suggests that a higher normal retirement age is on the ministers’ radar screen but raising it to 67 makes sense for three reasons. First, we are living longer and should expect to work a little longer to pay for it. Most developed countries are already phasing in a normal retirement age of 67 or 68 for this reason. Second, the economy will eventually need 60-somethings to work a little longer so a higher retirement age supports the public interest. Third, a normal retirement age of 67 would align the CPP with Old Age Security and the Guaranteed Income Supplement, where the normal retirement age is rising to 67 by 2029.

CPP at 67 would be easy to implement because no one would be forced to work longer and no one would suffer a drop in pension, provided the CPP accrual rate is raised and individuals retain the option to retire as early as age 60. For example, consider a worker earning $50,000. Under the current CPP, she would have a CPP benefit of $12,500 at 65. If the CPP normal retirement age became 67 and the benefit was raised to 35%, she could still retire at age 65 in which case her reduced pension would be about $14,100.

This is based on 35% at 67 then reduced by 7.2% per annum between 65 and 67.

The change would not have to take effect for another 20 or 30 years but it should be announced in conjunction with the improvements described above. It will be much more contentious to make it happen after the fact.

Although the finance ministers appear to be on the right track, they might want to articulate the pension deal between Canada and its citizens. Clearly, we want everyone to be able to achieve a 100% replacement rate but should the government be responsible to ensure this happens? Shouldn’t individuals bear some responsibility, too, by saving in RRSPs and TFSAs? We should also consider at what point forced savings infringes unduly on individual freedoms. Assuming we don’t leave ourselves destitute, shouldn’t we be permitted to enjoy our income while we are still young rather than being forced to save it all for our twilight years?

We should expect to hear more by December when the finance ministers meet again, this time with the federal finance minister.

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Some questions about expanding the Canada Pension Plan

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Will it be fully funded? If provincial and territorial ministers really meant “fully funded,” younger workers especially should be relieved since it means they don’t have to pick up the cost of improving existing pensions for older workers or retirees.

Is it time to raise the CPP earnings ceiling?
 The current $51,100 is too low, and PEI has proposed $102,000, a $75,000 ceiling is more affordable.

Should the pension accrual rate be increased?
 The CPP payout is currently 25% of the average earnings ceiling in the last three years before retirement. It should be raised to the amount that gets most workers over the “adequacy threshold”; this may be 30% or 35% subject to further testing.

What age can we retire?
Raising the normal retirement age from 65 to 67 makes sense for longer life spans, a coming worker shortage, and to align with OAS and GIS, even if change wasn’t implemented for 20 or 30 years. Early retirement from age 60 should still be allowed.

What’s the end game?
 The finance ministers should clarify the pension deal between Canada and its citizens and how far the government should go before it infringes on individual freedom to decide how much we spend versus save.

What’s next? Finance ministers meet again, this time with federal Finance Minister Jim Flaherty, in December.

 

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