Many countries face solvency crises in their public pension plans. Contributions are too low or benefits are too high to sustain the programs as they are. But in Canada, the reforms of the 1990s put the Canada Pension Plan (CPP) on a solid financial path. Perhaps alone in the world, Canada is looking at its main pension plan and discussing not how best to shrink it, but whether and how best to grow it.
A recent round of negotiations on reforming —  and possibly growing —  the CPP has been moving slowly since 2010. Last December, the country’s finance ministers met at Meech Lake to review their options, with plans to meet again this month. When they do, three questions should frame the discussion on the shape of any CPP expansion. How should coverage be expanded? What should be mandatory and what should be voluntary? What role should the Canada Pension Plan Investment Board (CPPIB) take?
There are two distinct elements to the expansion of CPP coverage. Distinguishing between on the one hand a deeper CPP and on the other a broader one is important, because these options line up very differently against the needs of Canadian workers.
A deeper CPP would pay a worker retirement benefits covering a larger percentage of his or her lifetime earnings, paid for with higher CPP contributions when that worker is in the workforce. Right now, the CPP pays benefits at a rate of up to 25 percent of lifetime earnings. That is, for a typical worker an extra $1,000 a month of average lifetime earnings would bring $250 a month of CPP benefits on retirement.
Many ”big CPP” proposals have suggested this percentage could be increased, perhaps to 50 percent of earnings. Retirement planners aim for retirement income coverage rates of 60, 70 or even 80 percent of earnings. In the United States, Social Security retirement benefits use a replacement rate schedule that pays a typical worker a mix of 90 and 32 percent of his or her lifetime earnings. The CPP’s 25 percent replacement rate looks meagre in comparison with those numbers.
However, these comparisons are misleading. In Canada, almost all retired Canadians receive a flat Old Age Security benefit, and about one-third of those over 65 also receive the Guaranteed Income Supplement top-up. When you include the income from these benefits, the total picture of the retirement income replacement rate changes dramatically. In fact, if you sort Canadians by their lifetime earnings, more than half of those in the lowest fifth of the lifetime earnings rankings will have higher incomes in retirement than they had when they were working, and very few of the others in this bottom fifth replace less than 60 percent of their earnings.
A deeper CPP would make all Canadians contribute more while they are working to provide for higher income when they retire. In light of the fact that many lower-earning Canadian workers already see as much income in retirement as when they were working, this is perverse. Few would desire to take away income in the middle part of life, when the spending demands of children and housing are most acute, and transfer it to their already adequately funded futures.
Of course, some may argue that we should aim higher than just to replace the earnings of those who have struggled through a lifetime of modest earnings. While there may be merit in this goal, the CPP is the wrong tool to use to redistribute in favour of those with low lifetime earnings. CPP was envisioned and designed as a pension to replace earnings. To the extent we want to use our public pension system to redistribute, the Old Age Security and Guaranteed Income Supplement pensions are much better placed to lift the retirement incomes of those who had low lifetime earnings. The reform of the CPP should not be motivated by redistributive considerations.
There is a second aspect of the potential expansion of CPP coverage where arguments are stronger: A broader CPP that would cover a wider range of earnings. Currently, the CPP covers earnings between $3,500 and $51,100. The upper limit on this earnings range is reset annually, based on changes in national average earnings. For those earning more than the average level, this means the CPP doesn’t cover all earnings —  the earnings above the upper threshold are not covered. In contrast, the equivalent coverage cap in the United States Social Security system is $113,700 for 2013, more than double the level in Canada.
Several studies have provided evidence that the incomes of a substantial share of those whose earnings were above average when they worked drop quite a bit when they retire. The key determinant seems to be whether or not the person works at a job that features an employment-based pension. A broader CPP that covered a larger range of earnings would enable these Canadians without workplace pensions to increase their retirement incomes.
For those who have workplace pensions, increasing the income range for CPP runs the risk of over-providing retirement income. These people are already covered through their employment-based plan, so a bigger CPP would force them to pay more while working in order to fund retirement income they don’t actually need. However, this concern is mitigated somewhat by the fact that many workplace plans can ”carve out” the CPP from their own pension formulas —  many workplace plans can effectively shrink themselves to make room for the enlarged CPP. Such arrangements need a few years to be planned and implemented, but these kinds of arrangements have been made after past CPP reforms.
Overall, this analysis suggests the finance ministers have to be careful: a bigger CPP is not necessarily a better CPP unless it is done right. Doing it right means providing expanded coverage where it is needed (a broader CPP covering more earnings) rather than where it is not (a deeper CPP with higher replacement rates).
Most debates over a bigger CPP have envisioned reforms that are part of the existing mandatory CPP program. But there are related proposals that entail voluntary add-ons. For example, in the past two years both the New Democratic Party and the Liberal Party have advocated special add-ons with investment options tied to the CPP. In addition, the Pooled Registered Pension Plan developed by the Conservative government, while it has no direct ties to the CPP, is a voluntary add-on to the retirement income system.
A prolonged debate in the current discussion on CPP expansion is not out of line.
Mandatory participation in savings and investment decisions might raise concerns about paternalistic interference in the decisions of individuals. However, in the context of pensions, there are two special reasons why mandatory participation has special allure.
First, people are sometimes myopic about trading current consumption for future consumption. Traditionally, economists often assumed that people act through careful and rational consideration of present and future needs and opportunities. However, over the last decade, many economists’ views of the psychology of decision-making have evolved to accept that individuals systematically have trouble with some types of decisions. The psychological salience of consuming in the present is quite high, while the idea of consuming a bit more or a bit less 40 years in the future remains fuzzier in the minds of most of us. For this reason, our ”future self” may be thankful that our ”current self” operated in an environment with an element of mandatory savings.
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A second reason that mandatory participation has allure comes from the nature of insurance. In insurance markets, mandatory participation unlocks pivotal market mechanisms. Insurance is an important aspect of pensions because the transformation of accumulated savings into a flow of income depends on annuitization, and annuitization depends on the life expectancies of the potential annuitants, which are unknown.
The insurance involved in trading current consumption for a flow of income of unknown duration creates troubles for insurance companies because those expecting long lives may be more likely to annuitize than those expecting short lives. This makes the individual purchase of annuities expensive. Mandatory participation changes this annuitization equation by forcing all people into the risk pool; the ”bad risks” won’t swamp the system. In a mandatory system, annuitization of accumulated assets is therefore much cheaper than in a system with voluntary annuitization.
Each of these factors speaks to an element of the CPP debate. The voluntary aspects of an expanded CPP may fail to deliver results if those who would benefit from more savings fail to take up the new options. Moreover, even if large new savings do accrue under a reformed CPP scheme, some potential gains may be left unfulfilled if insufficient thought is given to the annuitization of those new savings.
Of course, there may be a tradeoff between potential benefits of mandatory participation and allowing people the freedom to make their own choices. One intriguing way to avoid this trade- off is to push policy in the direction of informed ”default options,” in which individuals are by default opted in to a program but are free to exit if they so choose. An appropriately chosen default option nudges people toward a certain behaviour without forcing them against their will. In the case of an add-on to the CPP, this would take the form of a system that one could opt out of, but into which one is placed by default.
The CPPIB started operations soon after the CPP reform in the late 1990s. It was tasked with investing the surplus of contributions over payouts in the Canada Pension Plan. The 1990s reform set contributions to be substantially larger than payouts, for a generation, in order to partially prefund the retirement benefits of the baby boom generation. This partial prefunding has accumulated in an ever-larger stock of funds to be managed by the CPPIB. As of December 2012, the CPPIB controls $172.6 billion of investments, a pool of capital that is expected to reach $300 billion within 10 years.
A bigger CPP would create an even larger role for the CPPIB. In a direct way, a bigger CPP would lead to more investable funds being put in the CPPIB, as the higher CPP contributions would accumulate in the CPPIB before they are eventually needed to pay out the higher CPP benefits. Beyond this direct effect, an expanded CPP would likely lead to employment-based pensions shrinking and individuals contributing less to Registered Retirement Savings Plans. Combining a growing CPPIB with shrinking alternatives means that the CPPIB would grow into an even more dominant force in Canadian capital markets.
The upside of concentrating more asset management in the CPPIB is the possibility of better investment results with lower management fees than most individuals achieve with their RRSPs. Individually managed RRSPs often charge large fees for dubious advantage. On the other hand, a bigger CPP might cause shrinkage in large, well-managed employment-based funds (for example, the Ontario Teachers’ Pension Plan). In the case of these funds, it is harder to argue that on average the CPPIB would perform appreciably better. However, the CPPIB may be cheaper. If so, then support for CPP reform could come from large employers who see a way of offloading part of their expensive pension burden to the CPP.
There are downsides to the concentration of funds in the CPPIB. The retirement incomes of CPP beneficiaries would be more susceptible to any investment errors by CPPIB fund managers than with some diversification among managers. Moreover, in thinking about the functioning of capital markets, those on the sell side of transactions who are trying to find good prices for initial public offerings and other financial instruments could see a big drop in competition on the buy side, as the CPPIB towers over other pension funds. As one example, the potential leveraged buyout of Bell Canada Enterprises in 2007-08 saw competition between one consortium headed by the Ontario Teachers’ Pension Fund and another led by the CPPIB. The dynamics of this battle might have been quite different if it had taken place with a swollen CPPIB and a shrunken Ontario Teachers’ Pension Plan.
Many of these concerns about the CPPIB were raised when it was initially proposed in the 1990s. The experience of its first decade and a half suggests these concerns may have been overstated —  the CPPIB’s performance has been admirable so far. However, it is worth considering whether any of the concerns over the size of the CPPIB may start to gain more traction as it becomes an even more dominant investment fund.
One way to expand the CPP without enlarging the CPPIB is to build on the idea of a pension exchange, which was proposed by Tom Mulcair during the NDP leadership race in 2012. Contributions could be collected through a centralized payroll deduction mechanism and organized through the CPPIB. Funds would then be invested by the fund manager of one’s choice.
Beyond the typical financial institutions, one could imagine the Ontario Teachers’ Pension Plan, the CPPIB itself or other big public or private pension managers placing options on the exchange. The attractiveness to financial institutions of being able to offer funds on the exchange would allow ample room to tightly regulate access to the exchange by mandating low fees and simple, clear investment options. Of course, building such a pension exchange would be a large administrative and regulatory endeavour. A strong case would have to be made that a pension exchange would be preferable to just letting the CPPIB grow large.
The original CPP debates were spread out over several years in the 1960s. The discussions of reform in the 1990s also took years to reach completion. The prolonged debate in the current discussion on CPP expansion is not out of line. Statutorily, amending the CPP requires a double enhanced majority of two-thirds of the provinces with two-thirds of the population. Practically, the bar may be even higher, as leaving a large province unsatisfied on such an important item would create tensions for the federation and could risk the possibility of a province pulling out of the CPP. Such a strong consensus takes time to build.
It is worth taking the time to get this right. The CPP will pay out around $38 billion in benefits in 2013-14, and the CPPIB is set to overtake Quebec’s Caisse de dĂ©pĂ´t as the largest pool of investment funds in Canada. In addition to its financial size, the CPP also provides essential insurance to millions of Canadians. As the finance ministers move toward a CPP reform, clear thinking is required on the questions of how they want CPP expanded, what parts should be voluntary and what mandatory, and what role the CPPIB might take. The answers to these questions should provide guidance on the eventual form the CPP will take.
Photo:Â Cozine / Shutterstock
