CPP: Less now or more later?

At some point you’re likely to find yourself thinking of retiring early. You know you can start drawing your Canada Pension Plan (CPP) any time after 60, and after decades of seeing those contributions come off your paycheque, it sure would be nice to start cashing in. But you also realize that if you start CPP before age 65, you’ll get a reduced rate. So should you take smaller payments sooner, or hold out for larger ones later?

Deciding when to start taking your CPP is one of those classic personal finance dilemmas. And, like many such dilemmas, there’s no easy answer. Your CPP pension is a cornerstone of your retirement. It provides you income for life, adjusted for inflation, based on the contributions made by you and your employer while you worked. But—unless you’re an actuary with lots of time on your hands—you’re probably not sure how the complicated calculations that determine your pension work. And you may have heard that CPP changes are in the works—and wonder how that affects you.

Years ago, you weren’t able to start CPP early, so it was simple: you usually drew it at 65, and you got what you got. “Now you get a choice, which is sort of nice,” says actuary Malcolm Hamilton, a partner with Mercer Human Resource Consulting. “But you don’t have any easy way to make that choice, which is sort of not nice.”

Fortunately, we can help. We’ll outline how CPP works, describe the coming changes, explain the calculations, and provide guidance about the factors you should consider before making your decision.

The new CPP
Changes will soon make the CPP more flexible. Right now you have to actually quit your job—or at least earn very little—before you can collect CPP. Once you start your pension it’s essentially set, subject to inflation increases. But come January 1, 2012, you can continue to work and also start drawing CPP. If you do collect your pension and work at the same time, you’ll be required to make further contributions that will add to your entitlement. (The contributions are compulsory until 65, and voluntary thereafter.) You might find this handy if you plan to work part-time in your 60s and you need your CPP benefit to round out your income.

But the changes will also force you to accept a greater reduction in your payouts if you start CPP early. Currently your payout is reduced by 0.5% for each month you start CPP before age 65 (that’s 6% per year). Starting next year the reduction will be 6.24% annually, and it will eventually rise to 7.2% in 2016.

The good news is that if you’re into delayed gratification, there’s a corresponding increase to your CPP payout if you start your pension later than 65. (See “What’s new with CPP?” for more details.)

So far, taking CPP early has been by far the most popular option. About 65% of those who are eligible start their pension before 65, another 30% start it right at 65, and only 5% wait until later. But popular or not, does it make financial sense for you to take CPP early?

It’s not that easy to say. The new adjustments to CPP were designed to ensure that if you live an average life span, there is neither an advantage nor a disadvantage to taking it early. The actuaries have done their best to create a level playing field, based on typical circumstances. “If you’re a ‘normal’ person, this should be a matter of indifference,” says Hamilton. If you start CPP early before the changes, you might come out ahead. Even then, the new rates will be phased in so gradually that it doesn’t make a huge difference overall if you’re about to retire.

But what if you’re not “normal” in some way that’s critical to the CPP calculations? In what follows, we’ll describe three major factors that tend to tilt the decision in favour of taking early CPP. We’ll also describe two circumstances that might encourage you to take CPP at age 65 or later.

Reason #1 for early CPP
You’re in poor health. If you’re in your early 60s and your health is poor, your life expectancy may be shorter than average. So chances are you’ll do better by starting your pension early and collecting more payments at a reduced rate, says Hamilton. If your health is poor enough, you may also not be working much and you might need the cash.

Reason #2 for early CPP
You expect to collect GIS. The Guaranteed Income Supplement (GIS) tops up government pensions for low-income Canadians starting at 65. But most kinds of income—including CPP payments—result in a steep clawback: you give up 50 cents of GIS for every dollar of CPP pension. (Old Age Security payments don’t count against you in the GIS calculation.) That’s a good reason to take your CPP entitlement before 65: lowering your benefit after that age may help you keep more of your GIS benefit.

People who collect GIS “live in a perverse world where anything they can do to get their CPP out before 65 is preferred,” says Hamilton. If you don’t actually need the money, draw CPP early anyway and put it into a Tax-Free Savings Account. Taking money out of a TFSA later won’t trigger a clawback on your GIS payments.

Reason # 3 for early CPP
You spent several years out of the workforce. There’s a good chance this little-known technicality applies to you if you spent a lot of time away from work years ago, and you’re now retiring for good. It’s complicated, so bear with me while I try to explain.

Your pension amount depends on averaging your contributions and “pensionable earnings” from age 18 until you start taking CPP. You’re allowed to drop 15% of your lowest-earning years from the calculation, which amounts to seven years if you retire at 65. If you took time off work to raise kids or because you had a serious disability, you get to drop even more of your low-earning years.

The thing is, it’s easy to use up all your drop-out years if you spent a long time getting an education or just “finding yourself.” If you then stop working in your early 60s and don’t take CPP right away, you’ll immediately start adding more years of zero earnings to the calculation. This will lower your average pensionable earnings, which in turn will make your benefit go down. Under these circumstances, you’re clearly better off starting CPP early.

By my estimates, this factor in isolation can reduce your pension by as much as 2% to 3% for each year you delay taking CPP after age 60. So for people in this situation, the overall net cost of starting CPP early is liable to be 3% or 4% per year (that’s the current 6% overall reduction, minus 2% to 3%). That can make early CPP a bargain.

One MoneySense reader was surprised to discover this the hard way. “It makes no sense,” he wrote. “Since my CPP will start shrinking, it would be insane for me to wait any longer.”

Now let’s have a look at a couple of reasons that might encourage you to start taking your CPP benefit at 65 or later:

Reason #1 for later CPP
You have a longer-than-average life expectancy. If you expect to live to a ripe old age, it pays to delay the start of CPP so you can draw larger monthly payments, because you’ll collect more over time. However, it’s hard to tell in your early 60s whether you’re going to be one of those Methuselahs. Having a lot of exceptionally long-lived forebears provides the best clue. “If all your grandparents lived to be 100, then you probably have a long life expectancy, unless you’re in poor health,” advises Hamilton.

Reason #2 for later CPP
You plan to continue working and earning a good income. Starting in January, you’ll be able to start drawing early CPP even if you’re working full-time. But why start your pension if you don’t need it? Delaying the payments not only helps you avoid seeing your payments adjusted downward—it may also keep you in a lower tax bracket. For similar reasons, if you have started drawing a sizeable employer pension early, you probably won’t need the extra income from CPP.

Final thoughts
Any of these factors might encourage you to take CPP early or later, but there’s one that trumps everything: your genuine need of the money. Taking CPP early won’t maximize your lifetime benefit if you live to 103. “But if you have no viable way to live without the income, then you need the income,” advises Hamilton. And if none of the factors we’ve described tilts your decision one way or the other? Well, then you can’t go too far wrong.