CPP changes may not ensure appropriate income

For all it’s worth, I have already given the recent Canada Pension Plan enhancement a passing grade. As I noted in our firm’s July report on the CPP, “a larger enhancement would have been strongly opposed by businesses while a smaller enhancement might have led to the balkanization of Canada’s retirement income system.”

It might, therefore, come as a surprise that the CPP enhancement seems to do so little to ensure that future generations have an appropriate level of retirement income. That’s the startling finding of an ongoing research project that received the support of the Society of Actuaries, the Canadian Institute of Actuaries and Morneau Shepell. We also used the expertise of Bonnie-Jeanne MacDonald, an actuary and academic researcher in Halifax, to revive LifePaths, a sophisticated simulation model that was the brainchild of Statistics Canada.

This is how much more you'll get from the CPP changes

With this simulation model, MacDonald projected the retirement income of Canadians who would be retiring after the CPP enhancement was fully phased in, which won’t happen until 2070. The simulation showed that without the CPP enhancement, just 33 per cent of middle-income Canadians would retire with income in the ideal range.* With the enhancement, that percentage barely budges; it goes from 33 per cent to 35 per cent. The other nearly two-thirds of the middle class will still be outside the ideal range, retiring with either too little or too much pension. How can that be?

There are at least three reasons for this counter-intuitive finding. First, the government will claw back some of the enhanced CPP pension in the form of smaller old-age security and guaranteed income supplement benefits.

Second, the CPP enhancement will push some people out of the ideal range and into the realm of having an excessive pension. What counts as excessive? In the study, we defined it as having sufficient income to improve one’s living standard in retirement by at least 15 per cent. We did assume that some employers would reduce benefits under their workplace pension plans to offset the bigger CPP benefit, but not everyone will do this, nor will they reduce workplace plan benefits dollar for dollar. Many plan sponsors will take the path of least resistance, which is to do nothing. As a result, most participants in workplace plans are likely to end up with bigger pensions (from workplace plans plus the enhanced CPP).

The third reason is that the CPP enhancement isn’t that big. You wouldn’t know it from the complaints from small businesses about the extra payroll cost, but we shouldn’t have expected that an extra percentage point of contribution from employers and employees would change the world.

How CPP payouts work when you already have a pension

Is the CPP enhancement still worthy of a passing grade? The answer is still yes. If the OAS pension continues to decline in real terms, as expected, we’ll be happy we have a bigger CPP. In addition, the vast hordes of private sector employees without workplace plans will be a little better off in retirement than they would be otherwise (see chart below).

As for employees in very generous workplace plans who end up with excessive benefits, we can’t blame the CPP enhancement if some plan sponsors choose not to trim back the promises under those plans to a reasonable level.

So will the provinces go back to the drawing board? This is highly unlikely for quite a while since we’re all suffering from pension reform fatigue. I would give it 10 years before we take another look at the issue of pension adequacy. By then, we might also factor in how rising retirement ages affect the result.

The first part of our report on the CPP, which detailed the history of the CPP, is available here. The second part, including details on the above analysis, will be available in early September.

*In our study, we assumed the ideal level of retirement income would produce the same disposable income that a person had on average in the 15-year period before retirement. To estimate net-replacement ratios, we reduced gross income by income tax, payroll deductions, retirement savings, mortgage payments and child costs.