How CPP reforms will affect your nest egg

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It's a simple fact -- Canadians are living longer. Many Canadians are also working longer and might want to delay taking up their retirement benefits. Recent changes to Old Age Security are designed to encourage flexible choice for retirement, applying an actuarial adjustment to the pension so that if a person postpones receiving OAS they will receive a higher monthly benefit. The 2012 Federal Budget states that "individuals will receive the same lifetime OAS pension whether they choose to take it up at the earliest age of eligibility or defer it to a later year."

The Canada Pension Plan (CPP) contains a similar benefit adjustment. Since 1987, CPP has allowed for retirement as early as age 60 or as late as age 70. For every month a person postpones the initiation of their CPP benefits, a bonus is included in their monthly cheque forever. However, the calculations for this actuarial bonus remained the same for 25 years -- even though life expectancy continued to grow at a very rapid pace.

The increasingly out-of-touch pension adjustments paid overly-generous pensions for early retirees, and shortchanged those who wanted to work longer, encouraging many Canadians to enter retirement early. But now, things have changed. New rules enhance the strength of the actuarial bonus when CPP benefits are delayed past age 60, diminishing the previously-strong financial incentive to retire early.

Will the new rules succeed?

In a paper for the C.D. Howe Institute, we examined how the recent changes to the CPP will affect the financial incentives for retirement. We simulate the lifetime flow of pension income for retirement at different ages. When this lifetime flow of pension income (which we can think of as 'pension wealth') is the same for every age of retirement, the timing of retirement has no impact on total pension wealth. Ideally, well-chosen pension adjustment factors will deliver equal pension wealth across potential retirement ages, maximizing freedom of retirement choice.

On a gross, -- before-tax -- basis we find the reforms will indeed tilt the system away from penalizing later retirements. In fact, we estimate that pre-tax CPP pension wealth now increases with retirement age. Retire early and an individual receives less; retire later and he receives more than before the reform.

Accounting for taxes and clawbacks changes the calculations, however. CPP income is taxable and reduces income-tested benefits, such as Ottawa's Guaranteed Income Supplement (GIS) and Ontario's Guaranteed Annual Income System (GAINS). In our C.D. Howe paper we show that taxes on CPP payments and benefit reductions can reverse the retirement incentives for some people.

We looked at two cases: one where a typical retiree receives $20,000 annually of employer sponsored pension and another where the only taxable income in retirement -- other than OAS -- is from the CPP. In the former case, the extra income puts the individual above the GIS threshold and out of reach of the GIS clawback. For the second case, any actuarial bonus received through delaying uptake of the CPP ends up clawing back some of the GIS payment, which really reduces the effectiveness of the CPP actuarial adjustments.

For those above the GIS thresholds, the new CPP rules mostly succeed in balancing the financial incentives for retirement. After-tax pension wealth is fairly flat across potential retirement ages, getting close to the ideal situation where individuals can freely choose their age of retirement without penalty.

However, for those who collect the GIS in retirement, after-tax pension wealth decreases sharply with retirement age, meaning the system pushes people into retirement at age 60. There remains a strong penalty for extra time at work for many lower-income individuals who receive GIS.

Actuarial adjustments may sound boring, but can matter a lot to those with limited lifetime earnings, such as women, immigrants, and those with a history of unemployment. These Canadians might want to work a few more years to buttress their retirement security. Even with the new enhanced CPP adjustments, the system is continuing to penalize further work for those who may want to do so.

Over all, we think the new CPP pension adjustment factors move in the right direction, but still fall short of offering all Canadians the same value for their CPP benefits. In particular, those affected by the GIS clawback continue to face substantial financial disincentives to working longer. As we have proposed before, the simplest remedy would be to sever the link between work after age 60 and lower future GIS payments. This could be achieved by exempting the actuarial-adjustment portion of the CPP earned by delaying retirement past 60 from the GIS income test.

Kevin Milligan and Tammy Schirle are Associate Professors of Economics at, respectively, the University of British Columbia and Wilfrid Laurier University. Alex Laurin is Associate Director of Research at the C.D. Howe Institute. Their recent C.D. Howe Institute study is available www.cdhowe.org.