Could retiring at 61 significantly reduce your CPP benefit?

Q. I have made Canada Pension Plan (CPP) contributions every year since 1975. In 31 of those years, I contributed the maximum. Seven of my less than maximum contribution years were while I was a primary caregiver to a child under 7 years of age.

I am looking at retiring from my current job later this year, when I turn 61. I was hoping to use part of the low-income drop off provision to cover low or zero contribution years between ages 61 and 65, but I read somewhere that your earning in your last five years before retirement have an impact on the calculation of your pension.

If this is true, should I apply to take my CPP early, or am I better off waiting until I turn 65?
–Ellen

A. Before we can answer your question, we need to look at how all of the different elements of your situation—years of maximum CPP contributions, years with no contributions, and years with low contributions, including when you were raising a child—are incorporated in the calculation of your CPP retirement benefit.

The Canada Pension Plan is an important part of many Canadians’ retirement income plans. Unfortunately, understanding how much your retirement benefit will be can be challenging.

As I’ve written before, the Canada Pension Plan includes “drop-out” provisions which automatically remove no- and low-income months from the calculation of CPP retirement benefits. In your case, Ellen, there are two drop-out provisions that will apply to your benefits calculation: the “general” low-income drop-out provisions, and the child-rearing drop out provisions.

Here’s how each of these drop-out provisions work:

• The general drop-out is available to everybody who is applying for a CPP benefit. This rule “drops out,” or excludes, 17% of your lowest-income months from the calculation when your CPP retirement benefit is determined.
• The child-rearing drop-out is available to anyone who was primarily responsible for raising a child from birth to the age of seven. This provides an extra drop-out rule to exclude months in which you had low income and were raising a child or children.

When your CPP retirement benefit is calculated, it’s based on:

• The number of years you contributed to CPP, starting at age 18 and ending when you start your CPP retirement benefit (as early as age 60, and as late as age 70), which, in CPP lingo, is your “contributory period”;
• Your income, and thus the CPP premiums you paid during your contributory period, relative to the maximum pensionable income (the income covered by CPP) during those years; and
• The “drop-out” rules that remove some months from the calculation of your retirement benefit.

That is, your benefit is based on how long you paid in, how much you paid in, and how much gets “dropped out.”

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In your case, Ellen, based on the information in your question, you started paying into CPP right when you turned 18 (in 1975), and have paid CPP premiums for a total of 44 years (from 1975 to 2019). (You can confirm these amounts by requesting a copy of your CPP Statement of Contributions.)

If you started paying premiums when you turned 18 (in 1972), and will start your CPP retirement benefit at age 65, this gives you a contributory period of 561 months. (This is very close to the maximum possible contributory period of 564 months covering the years from age 18 to age 65 inclusive.)

From these 561 months, the child-rearing drop-out provision is applied first. In your case, this would remove 84 months (seven years) from your contributory period. That gives you a personal contributory period—the months used to calculate your retirement benefit—of 477 months.

Then, from that tally of 477 months, the general drop-out provisions remove another 17% of low-income months from the calculation of your retirement benefit. Seventeen percent of 477 is 81 months, giving you an adjusted contributory period (after the child-rearing and general drop-out provisions are applied) of 396 months (33 years).

Once your contributory period has been established and the drop-out provisions applied, your retirement benefit is calculated. In your case, you have 31 years of maximum contributions and two remaining years in which you contributed less than the maximum (because your earnings were below the maximum pensionable earnings for those years). As 31 is about 94% of 33 years, Ellen, you should receive at least 94% of the maximum CPP payment—even if you stop working at age 61 and don’t take your benefit until age 65.

In your question, Ellen, you asked how earnings—or lack thereof—in the five years before retirement impact your retirement benefit. The answer is found in the general drop-out provisions: if you have many years of low income before you stop working, then additional years of no contributions before the age of 65 may reduce your retirement benefit.

In your case, however, because you have many years of maximum contributions before your expected retirement age of 61, adding four years of no contributions—from your age 61 to age 65—won’t impact your retirement benefit. Instead, those no-contribution years will be automatically removed from the calculation of your retirement benefit under the general drop-out provisions, so your CPP benefit at age 65 will be very close to the maximum benefit (which is $1,154.58 per month in 2019, and will go up each year in accordance with any increases in the Consumer Price Index).

In your question, you also asked whether it would be prudent for you to take CPP early, before the age of 65.

If you opt for early CPP, Ellen, your benefit is reduced by an entirely different set of calculations than the general and child-reading drop-out provisions.

Let’s say you choose to take CPP starting at age 61, versus at age 65 when the full benefit is available. In that case, your benefit at age 65 would be calculated, and then discounted by 0.6% for each month you receive it before age 65 (or 7.2% per year). This means that an individual who starts receiving their CPP retirement pension at the age of 61 will receive 28.8% less than if they had taken it at 65 (0.6% discount for each month, multiplied by 12 months per year, and then by the four years before age 65).

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The good news, Ellen, is that based on what you’ve told us about your situation, you may receive very close to the maximum CPP retirement benefit even if you add four years of no contributions before you start the benefit at age 65. If you chose to take your benefit before age 65, however, it would be reduced from that maximum. Will you be able live as comfortably as you’d like in retirement with a reduced CPP benefit? You may want to consult a financial planner who specializes in retirement planning to help you make that decision.

You can also see that the calculations which lead to your retirement benefit are complex, as the amount you receive is based on multiple calculations and provisions that can change your benefit—both up and down—depending on your personal history of contributions, your age when you stop working, and your age when you start receiving your CPP retirement benefit, whether you were responsible for raising children, and more.

Alexandra Macqueen is a Certified Financial Planner and retirement expert providing advice through Pension Acuity Partners.

MORE BY ALEXANDRA MACQUEEN:

• How to understand your CPP Statement of Contributions
• The right time to take Canada Pension Plan benefits
• How will a pension buyback impact your income tax return?
• How to make the right pension decision when longevity is so variable