Policy makers may be misleading Canadians into thinking the expanded Canada Pension Plan is on firmer financial footing than it actually is, and if the plan’s investment returns stumble, younger workers could be left footing the bill for older Canadians, says a report released Tuesday by the C.D. Howe Institute.
According to the authors of the report, economists William Robson and Alexandre Laurin, the problems stemming from an increased investment risk embodied in the expanded CPP are twofold: The plan might not hit its return targets and the actions policy makers can take to rectify any shortfalls are not yet set, which means younger working Canadians could be on the hook.
“We’ve seen this again and again with pension plans, including with the CPP in the past: The plans make promises that they aren’t able to keep,” Mr. Robson said in an interview Tuesday.
“When that happens, the typical response is to raise contribution rates, meaning that young people end up paying for older people,” he said. “With all the evidence before us, it’s disappointing that we’re potentially walking into the same situation with CPP2 now. There are plenty of reasons to be concerned that we won’t hit the CPP2 return target – and if we don’t, we can’t cut benefits, so the risk is we’ll once again see young people being asked to pay more to cover previous groups of workers.”
What Canadians need is more transparency regarding the risk exposure of the CPP – which its participants will bear the brunt of – and how the plan will respond if things don’t work out as expected, Mr. Robson and Mr. Laurin wrote in the report.
The authors are not the first to criticize the assumptions on which the expanded CPP is based. Joe Nunes, an independent actuary and president of Oakville, Ont.-based Actuarial Solutions Inc., has raised questions about the strength of the projections used to bolster CPP2.
“Balancing contributions and benefits among generations is not an easy task, which is one of the key reasons I have been opposed to expanding the CPP in the first place,” he said.
He points out that “if the investments do better than expected, the current generation might end up paying for benefits enjoyed by future generations. But if the investments do well, I am sure there will be political pressure to improve benefits as soon as possible, again pushing the risk of insufficient assets to a future generation.”
In June, 2016, the CPP was expanded to replace more of the income Canadians earn during their working years. Under changes made to the revamped CPP, working Canadians would contribute 1 per cent more than current rates for the “base” CPP benefit and an additional 4 per cent on newly covered earnings above that amount. Employers would be required to match these increased contributions.
While the current CPP is designed to cover up to 25 per cent of the average industrial wage, the expanded CPP – or “CPP2” – would cover up to 33.33 per cent of the higher covered earnings amount.
The problem, according to Mr. Robson and Mr. Laurin, is that federal and provincial policy makers have described the CPP enhancements as “fully funded,” but that might not mean what most Canadians think it does.
In the context of a defined benefit pension plan, a “fully funded” plan has assets sufficient to cover the present value of benefits earned by plan participants to date. In the context of the CPP, however, “fully funded” means the plan’s investment returns are expected to offset the need for contribution increases as the number of contributors (working Canadians) falls in the coming decades, relative to the number of retired Canadians receiving CPP income.
Canada’s chief actuary has calculated that CPP2 will be able to pay the projected increased benefits from the higher increased contribution rates so long as the Canada Pension Plan Investment Board (CPPIB) is able to earn a 75-year average rate of return of 3.41 per cent, after investment management expenses.
If this assumed rate turns out to be too low, retirees could expect higher benefits or lower premiums (or both). Alternately, if this rate of return is not attained in reality, the C.D. Howe report, entitled “Bigger CPP, Bigger Risks: What ‘Fully Funded’ Expansion Means and Doesn’t Mean,” says Canadians may end up with lower-than-expected benefits or higher-than-expected costs.
Achieving the projected long-term rate of return requires “a fair amount of investment risk and uncertainty,” Mr. Robson and Mr. Laurin said. In addition, they believe that low-risk, relatively secure assets – such as long-term government bonds – are not producing a rate of return that is close to the 3.41-per-cent CPP minimum.
As an example to illustrate the gap between the return on low-risk assets and the assumed return for CPP2, they pointed to the rate of return for a federal long-term, real-return bond, which is currently yielding 0.7 per cent. “If the CPPIB were to invest in such an asset [to produce the required investment returns], and its yield stayed at that level,” the authors wrote in the report, the contribution rates on CPP2 would need to more than double, or promised benefits would need to fall by more than half.
The CPP legislation provides that contributions can be increased in the future, if the provinces consent. Rate increases, however, are limited to not more than two-tenths of a percentage point a year, which might not be sufficient to cover shortfalls, and if the provinces and the federal government cannot agree on contribution rate hikes, the rules about changes to benefit levels and contribution rates (which themselves will also be subject to provincial consent) have not yet been written.
The C.D. Howe report recommends that the provinces and Ottawa consider developing safeguards to protect against CPP2 increasing contributions from (younger) working Canadians to cover shortfalls for older (retired) Canadians if the realized investment returns from the CPPIB don’t meet the minimum required threshold rates.
One option would be to adopt a “target benefit” model, in which benefits above a target amount (for example, 80 per cent of the base benefit) are protected, but benefits above this basic amount are allowed to adjust downward in the event of a plan shortfall.
starting place for this discussion,” said Mr. Robson and Mr. Laurin, “needs to
be understanding among the officials and interested Canadians that, in an
uncertain world, even the Canada Pension Plan makes no guarantees,” as neither
the base CPP nor CPP2 are, or will be, “fully funded.”
Alexandra Macqueen, CFP, teaches and writes about finance in Toronto. She is co-author, with Moshe Milevsky, of Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income For Life. You can follow her on Twitter at @MoneyGal.