The June 20 announcement that federal, provincial and territorial ministers of finance have reached an agreement on enhancing the Canada Pension Plan (CPP) brings an interim and partial conclusion to a lengthy decision-making process. The debate started in June of 2009, when the finance ministers of the day launched a review of retirement income adequacy in Canada. A year later, the federal and Ontario finance ministers endorsed the idea of implementing a modest increase in CPP retirement benefits, with the apparent support of all of provinces except Alberta and Quebec.

CPP expansion talks were cancelled in 2013, however, after several years of stalling by the federal government. During the last election the Liberals campaigned on a promise to revive the discussions with the provinces, and they confirmed this commitment in the budget speech in March 2016. The June 20 announcement is a step toward fulfilling the commitment.

What is clear from the announcement is that the CPP benefit rate will increase from 25 to 33 percent of pensionable earnings, and the maximum level of earnings covered by the CPP for contribution and benefit purposes will increase by roughly 14 percent from a current level of about $54,900 to $62,586, if it was fully implemented today (or roughly $82,700 in 2025). The increase in the benefit rate will be phased in between 2019 and 2023. The higher contributory earnings level will be phased in over the following two years. Fully phased in, the CPP will provide a benefit of 33 percent on earnings up to the new yearly maximum pensionable earnings (YMPE). The ministers have also said that the benefit improvements would be paid for by a one- percentage-point increase in the contributions required from employers and employees.

The following commentary provides some critical perspectives on the June 20 announcement. Nevertheless, the fact that finance ministers finally agreed on a CPP expansion, after decades of steadfast campaigning by proponents of a benefit rate increase and opposition by its opponents, should not be underestimated as a political milestone.

Alternatives on the path to June 20

Over the past six years, two formal proposals for pension reform have been put forward. One, known as the PEI proposal, seemed to have the support of a majority of provinces in 2013. The other is the proposal for an Ontario retirement pension plan (ORPP), introduced by Ontario in 2014 after the federal government shut down discussions on the CPP.

The PEI proposal was designed to replace an additional 15 percent of preretirement earnings between $25,000 and $100,000, raising the benefit rate to 40 percent. The proposed ORPP had the same target benefit rate as the PEI proposal, but would have applied to a wider range of earnings at the lower end, starting at $3,500 (the minimum eligible earnings under the existing CPP) and up to $90,000. The ORPP also differed from the PEI proposal in another important respect: members of workplace pension plans that provide comparable benefits would not have been required to participate.

When we compare it with these earlier proposals, the June 20 agreement is similar in direction but more modest in the benefit rate and the upper limit on covered earnings. Also, there is nothing that would indicate that an ORPP-type exemption of participants in comparable workplace pension plans is being considered.

Some unresolved questions

It is an axiom of pension finance that the more certainty there is in benefit payments, the less certainty there will be in the contributions required. The opposite is also true. Pure defined benefit (DB) plans place all of the financial risk on the contribution rate, and pure defined contribution (DC) plans place all of the financial risk on the benefits. This axiomatic relationship can become problematic in a plan that has a precise funding target and whose benefit promises are backed by risky assets.

No public information has been provided as to how the financial risk in the new tranche of CPP benefits will be allocated between contribution-rate and benefit-rate adjustments.

It is worth noting, however, that amendments to the CPP in 1997 ended the pure DB character of the benefits in place at that time. According to these new rules, the benefits in place in 1997 continued to be partially funded, and the indexation of benefits could be suspended under specified financial conditions. These amendments also specified that any future enhancement to benefits would have to be fully funded, implying these benefits would be pure DB. In effect, two distinct sets of financing arrangements were provided for: one for existing benefits and one for new benefits. Ever since, the requirement that new benefits be fully funded seems to have been accepted – somewhat uncritically – by the two levels of government.

In a fully funded regime backed by financial assets, returns on the assets inevitably ebb and flow. Finance ministers will have to offer an explanation on whether the ebb and flow will cause contributions or benefits to vary over time.

Blinkers on the process

Canada’s retirement income system (RIS) has many components, some of which interact with each other and with the personal income tax (PIT). As a consequence, what results from an adjustment to one part of the system cannot be fully understood until all of the interactions with other components of the RIS and the PIT are taken into account. This is particularly important for Canadians with low earnings.

Canada’s RIS includes the Guaranteed Income Supplement (GIS) which, together with Old Age Security (OAS), provides a minimum-income guarantee for Canadians 65 and over. Under the GIS the amount of benefit paid is reduced by 50 cents for every dollar of income received from sources other than the OAS. That 50 percent tax-back rate applies to income generated by the CPP. In addition, the GIS includes “top-ups” for individuals with very low levels of income, and these top-ups have a 25 percent tax-back rate on top of the 50 percent rate. These GIS tax-backs also overlap with tax-backs on other provincial income-tested benefits. Moreover, at the upper end of the income range at which GIS is payable ($25,000 for a single person), the GIS tax-back overlaps with the PIT.

The net effect of these overlapping tax-backs and tax rates is that the advantage of an increase in CPP benefits is largely lost for people with low incomes. This problem seems to have been recognized by the ministers in their June 20 announcement, to a certain extent. They propose to offer financial relief to low-income CPP contributors through the Working Income Tax Benefit. The need to offer relief, and the related costs, could have been avoided, however, had the minimum earnings level at which the new CPP rate applies been set higher, as it was in the PEI proposal, and as Quebec is considering doing.

The failure to take an integrated view of the RIS in the current pension reform debate has yet another consequence. Analysts have long predicted peoples’ ability to maintain their standard of living in retirement would deteriorate over time. Predominant among the reasons they cite is the decline in the value of OAS benefits relative to average wages and salaries. This, they argue, is because OAS and GIS benefits are indexed to price changes while, in the future, wages and salaries are expected to grow faster than prices. Although the OAS plays an important role in helping people — especially lower earners — maintain their standard of living in retirement, it is mostly ignored in discussions of earnings replacement, including by finance ministers. Ironically, if the assumption about real wage and salary growth proves correct, the loss in the relative value of the OAS might  offset a significant part of the gain from CPP enhancement in earnings replacement — especially among those with low earnings.

The implications of the requirement that new benefits be fully funded are also missing in current discussions. That position, which continues to be endorsed by recent finance ministers and most observers, seems based on the somewhat narrow argument that each generation has to pay its own way in order to make the CPP intergenerationally fair. The consequence, which also seems to be widely accepted, is that enhanced benefits should be phased in over a full lifetime of work – about 40 years.

If pension reform were being assessed in isolation from all other public and private initiatives that have intergenerational impacts, this view would be understandable. But it is not at all clear that a pension reform that transfers wealth to older generations is unfair if it occurs along with initiatives that transfer wealth to younger generations, for instance through tax-financed initiatives related to education, the environment and infrastructure.

Concluding thoughts

The finance ministers’ agreement on CPP expansion is a long-awaited development and is politically historic. And while the usual opponents of CPP expansion were quick to decry the move, there is strong analytical support for it. Even among supporters of CPP expansion, however, there is plenty of room for disagreement on the details, which can be very important. I would prefer a reform that only applies to earnings above $25,000 to $30,000, and is only compulsory for those who don’t belong to a workplace pension plan that meets certain standards. A higher contribution and benefit rate might have been more acceptable if the improvements had been targeted in this way.

As a practical matter, the benefit enhancement will have little to no effect for people with very low earnings: most of the benefit will be lost in tax-back and tax rates. As one moves up the earnings scale toward the current YMPE, one should expect about 4 to 6 percentage points of the 8 percentage point increase in the benefit rate to contribute to a higher income net of taxes. The biggest change will apply to earners in the narrow earnings range from $54,000 to $62,586 as a result of the proposed 14 per cent increase in the YMPE. For someone at the new upper limit of $62,586, the CPP replacement rate will double from 18 to 33 per cent. Half to three quarters of this gain will remain net of taxes for most beneficiaries.

The lack of a holistic view of the RIS during discussions of CPP reform is only one of a number of problems in the governance and management of the public component of Canada’s retirement income system. Others include the lack of transparency in decision-making; the failure to take account of emerging social, economic and demographic trends; gaps in data and analytical tools; and the fact there is no regular assessment of the income situation of the current and future elderly. I will address these issues in a future paper for the IRPP. While we can do better than we have done, the decision by finance ministers on CPP expansion is nevertheless a step forward.

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Bob Baldwin is an Ottawa-based consultant who has worked on pension policy and pension management issues for more than 35 years. He has been an adviser to governments and to individual pension plans, has written many research papers on the topic and is a frequent conference speaker.

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