Getting it right

In Ontario, government programs guarantee single seniors an income $16,200 per annum, after tax. Couples get $26,300. In Canada, poverty rates for seniors are among the lowest in the world—even lower than Sweden. Those with low incomes will typically experience an increase in their standard of living upon retirement at age 65.

As we move up the income spectrum, the story becomes less encouraging. An unmarried Ontario resident earning $50,000 per annum and retiring at 65 will receive $20,600 from government pensions and supplements. This covers the necessities, but it replaces only 55% of pre-retirement net income (net income is employment income, pension income and refundable tax credits reduced by taxes and contributions to the CPP, EI and retirement savings plans). Still, a relatively small amount of personal saving—say 2.5% of pay contributed to a tax-free savings account for 40 years—can make a big difference, increasing the net replacement ratio from 55% to 68%, assuming a 3% real rate of return.

Some people believe that Canadians with below average incomes cannot be relied upon, and should not be expected to, save voluntarily for retirement. They believe that expanding the CPP is the best way to shore up our retirement system. One proposal calls for CPP benefits to be doubled on a fully funded basis. Contributions would increase by 6% (evenly divided between employees and employers) of covered earnings over five to seven years, at which time the CPP would be collecting an additional $25 billion per annum.

Benefits would double much more slowly—over 45 years or so. This would dramatically increases the size of the CPP pension fund at maturity, from about $138.6 billion (for the current CPP) to over $1 trillion. The CPPIB would need to take significant investment risks to earn the 4% real return needed to support the 6% contribution rate. In years like 2008 the losses could be sizeable, possibly $250 billion. In bad times the 6% contribution rate could slowly double to address funding deficiencies. In good times the 6% contribution rate could gradually disappear.

Three aspects of this proposal would benefit from further discussion.

First, those earning less than $20,000 already have net replacement ratios above 100%. Why would we ask them to contribute more today, when they are struggling, to boost their incomes later, when they will be better off?

Second, if middle income Canadians aren’t saving enough to retire in comfort, why should their employers pick up 50% of the cost of supplementing their pensions? If we want Canadians to save more for retirement we should expect them, not their employers, to contribute more to the CPP.

Third, if our objective is to improve post-retirement living standards of Canadians, why pick a solution that transfers large amounts of money from low income workers to the federal government by way of the Guaranteed Income Supplement (GIS) clawback?

Of the additional $8,300 per annum that a single Ontarian earning $35,000 would collect from a doubled CPP, the recipient would keep only $2,900. The other $5,400—65% of the total—would go to income taxes and GIS clawbacks. The federal government would harvest 60% of the benefit in exchange for a 15% tax credit on contributions—a good deal for the government, but not for the Canadians we are trying to help.

A less ambitious, better targeted CPP expansion program would be a more ideal approach. More money for those who need help—less for the federal government. Here’s how it would work.

• Employees would contribute an estimated 5% of earnings between 40% of the YMPE (about $20,000) and 100% of the YMPE (about $50,000). The maximum employee contribution would be 3% of the YMPE (about $1,500) and the maximum out of pocket cost would be about $1,200. Those earning less than $20,000 would pay nothing.

• Employers would not contribute to this supplemental program, thereby eliminating concerns about the impact on corporate profits, job creation, etc.

• The extra pension would amount to 50% of the CPP maximum pension, or about $5,600 per annum for those contributing the maximum for 40 years. Those contributing less than the maximum and those contributing for fewer than 40 years would receive proportionally less.

• The extra CPP pension amount would be taxable, but it would be excluded from the GIS clawback so that all Canadians enjoy a reasonable return on their contributions.

• Finally, the CPP extension would be operated and communicated as a target benefit plan, rather than as a defined benefit plan with guaranteed benefits. Risks can then be equitably divided between contributors and beneficiaries by moving contributions and benefits about their respective targets.

With these changes, net replacement ratios would stay above 70% for single Ontarians earning up to the YMPE and above 65% for couples earning up to about $80,000. The benefits won’t be as large as in a doubled CPP, but they will be better targeted and less expensive.

Canadians earning more than $50,000 per annum will still need to save heavily on earnings above the YMPE, as will those planning to retire before 65 and those coveting a more luxurious post-retirement lifestyle.  

Malcolm Hamilton is a partner in Mercer’s retirement, risk and finance business.

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