Understanding CPP’s Shortcomings
How the benefit shrinks with age and what that means for retirement security
October 18, 2018
The Canada Pension Plan (CPP) is a universal plan provided by federal and provincial governments and administered by the Federal Government. It is available to all eligible Canadians, regardless of where they live. On the other hand, it is but one element of the Canadian retirement savings philosophy “The 4thPillars”.
CPP is funded via contributions made by employees, and employers (currently 9.9%) and participation is required by law. CPP earns revenue by pooling contributions into investments which are managed by the CPP Investment Board (CPPIB) which currently manages about $356 billion in CPP assets.
Some contend that government paid retirement income should be sufficient to replace Canadians’ accustomed pre-retirement living standards while others argue it should simply be more inclusive since many people don’t quality for CPP. In either case, Paul Owens, Alberta Deputy Superintendent of Pensions, concluded that CPP, OAS and GIS are not sufficient to retire comfortably. Not surprising since the average CPP payout is about $673 per month.
When to take CPP? –A common question
Most experts advise taking CPP early because you can get up to five more years of pension income. Your monthly CPP however will be smaller but the total amount you likely will receive over your retirement will be greater than the amount you lose each month by taking it early. For example If you start receiving CPP at age 60 you’ll be ahead until you’re 75. More importantly, you never know when you are going to die.
You can receive CPP on turning 60, or, defer it to age 70 (more than two-thirds of Canadians take it before 65). But, there is a penalty for taking it early: for each month you take CPP before 6: penalty (reduction) of 0.6 per cent a month. If you turned 60 and took the CPP your monthly payment would be 32.4% less than if you’d waited till 65. You could also gamble (assume you will live a very long time) and increase monthly CPP by 42% if you delayed until age 70.
What can affect the CPP benefit?
CPP is based on earnings but the eight lowest income years are deducted in determining the benefit. Easing into retirement or losing your job late in life may reduce your CPP. — i.e. if your income decreases during these years and is less than the previous ‘eight adjusted’ years, your CPP pension will be based on a lower average. In other words, additional low-earning years shrink your CPP.
Annual CPP Benefit Adjustment
CPP is adjusted annually based on the Consumer Price Index (CPI) to offset inflation. However, CPI is not effective in maintaining purchasing power. CPI is but one of several measures of inflation and excludes some significant costs incurred by Canadians.
Unfortunately many items included in a typical Canadian ‘shopping cart’ are excluded from CPI. This shortcoming is discussed in a Globe and Mail article “CPI doesn’t measure household inflation – and it wasn’t meant to“. For example, between 1997 and 2011 a broader measure of Canadian inflation ‘Household Spending’, increased by 3.4% while CPI only increased by 2%. Over a retirement period, a relatively small difference like this results in a significant shortfall in CPP benefits — e.g. 1.4% difference compounded over 25 years results in about a 40% shortfall in retirement purchasing power.
Indexing is a critical aspect of CPP due to the impact of the ‘compounding effect’. Therefore it is important that the annual CPP adjustment be sufficient to maintain purchasing power.
Some Canadians are fortunate enough to have indexed defined benefits plans as well as receiving CPP and OAS. For example, public service pension plans for retirees and their spouses are automatically adjusted annually based on CPI (1.6% for 2018). Regrettably, many private sector DB plans, and DC plans and CAPs, are not.
CPI – What’s missing?
CPI includes eight broad expense categories: Food, Shelter, Household Operations, Clothing, Transportation Health, Recreation, and Alcohol. Each category includes several sub-components e.g. Food – 74, Clothing – 19, Transportation – 25, etc. These sub-components are supposed to reflect typical Canadian consumer spending. The basket is updated every four years based on the average daily spending of a fixed basket using the retail cost goods and services. Unfortunately many government provided goods and services for which there is no market or comparable retail price are excluded.
Survey of Household Spending
The federal Government’s Survey of Household Spending (SHS) is a more inclusive indicator of consumer retail spending which is also used to measure inflation. SHS would be a better benchmark for adjusting CPP annually but it too has shortcomings. For example, both SHS and CPI exclude indigenous reserves, military camps, seniors in residences, permanent school residents, and communal colonies which represent about 2.5% of the population. Further distortion occurs because SHS uses longer reference periods for goods and services that are more expensive or, purchased irregularly.
The biggest difference between CPI and SHS is the measurement of shelter costs — 27% of the CPI basket. CPI excludes mortgage payment principal, land costs, renovations, condo fees, indirect taxes and many costs associated with second residences whereas SHS includes them. CPI treats homeownership as if owners rent their homes. It does include shelter costs by using a long-term housing depreciation estimate vs. acquisition. This results in a much lower cost allocation to CPI Shelter component. Rocketing house and land prices in Toronto, Vancouver, Montreal and other major cities and communities are therefore understated in CPI.
SHS is also used to calculate such key statistics as GDP and CPI and is used by federal and provincial ministries and departments to develop social and economic polices. While not a perfect measure, SHS would appear to be a more appropriate measure for determining the annual CPP adjustment.
Change requires Action
Governments rely on the average Canadian being ignorant and complacent about CPP and OAS: it’s to their advantage to keep the payouts as low as possible. The annual CPP adjustment clearly understates average Canadian spending and inflation. As a result, the average Canadian household is subjected to an unrelenting erosion of 1 to 2% annually in purchasing power.
Important question – “who would pay for higher CPP adjustments?”
The annualized returns on CPP investments over last 10 and five years and for fiscal 2018 are 8%, 12.1% and 11.6% respectively. In addition, CPP is projected to be self sustaining for at least 75 years. An annual increase of 1 to 2% in the CPP benefits could easily be covered by CPP investment earnings at no additional cost to taxpayers or the government.
Canadians are required to pay into CPP and are entitled to a fair benefit which maintains its purchasing power over time. Change will only happen, however, if Canadians react: both retirees and millennials should make this an election issue.
Contact your MPs and make them aware of your awareness and concern about the inadequacy of CPP due to inflation.