Canadians are often told they need to save more for retirement and to start saving sooner. Life expectancy is increasing and investment returns are low, so the cost of providing retirement income is much more than it used to be. Saving more seems like the prudent thing to do.
But for many low- and middle-income Canadians, contributing more to a pension plan or RRSP is not prudent at all—simply because of the way our tax system works.
Conventional wisdom is that retirees pay tax at lower rates than they did when working. But for many retirees with pension or RRSP savings, the opposite is true. Consider the example of an Ontario worker earning $30,000 who retires at age 65 in 2012 with $100,000 in registered retirement income fund (RRIF) savings. She expects RRIF income of $6,200 annually, average Canada Pension Plan (CPP) benefits of $6,347 and maximum Old Age Security (OAS) benefits of $6,540. Her taxable income will be $19,087, on which she will pay an average income tax rate of 2.56% ($489). The Guaranteed Income Supplement (GIS) pays a maximum annual amount of $8,868, but the GIS she receives will be reduced by 50% of her CPP benefits to $5,694 and further reduced by 50% of her RRIF income to $2,594.
Income tax and GIS clawbacks mean our retiree loses GIS benefits of $6,274 and pays an “effective” tax rate of 52.46% on her CPP and RRIF income, more than the highest federal-provincial marginal tax rate on regular income. The top Ontario rate is 47.97% on income above $500,000.
PRPPs won’t help
Finance Canada recently released draft regulations for pooled registered pension plans (PRPPs). As of the middle of August, the federal government was promoting PRPPs as a way to “bridge existing gaps in the retirement system.” Where are these gaps in the federal government’s estimation?
In his February 2012 remarks to the House of Commons Standing Committee on Finance, Ted Menzies, minister of state for finance, promoted PRPPs as “an effective and appropriate way to target those modest- and middle-income individuals who may not be saving enough.”
But as currently proposed, PRPPs will serve many low- and middle-income Canadians badly because they will lead to punitive effective taxes. If these workers save for retirement, many would be better off doing so outside a PRPP, RRSP or pension plan.
With PRPP contributions to be based on RRSP limits, Canadians with upper-middle incomes won’t get a level playing field with career members’ DB pension plans, who can and often do receive four to five times more retirement income than those who save in RRSPs. Like RRSPs and DC pension plans, PRPPs won’t be “real” pension plans because they won’t pay pensions, leaving PRPP retirees to manage their funds through retirement, when many will face increasing physical and mental infirmities.
With the exceptions of relief from payroll taxes on contributions, a reduced administrative burden for participating employers and potentially lower fees through asset pooling, PRPPs add little to the mix of existing retirement savings options. And, if low- and middle-income workers contribute to them, they may actually be harmful by increasing their effective tax rates, as mentioned above.
Federal PRPP legislation was drafted in the hope that provincial governments would adopt the PRPP model for provincially regulated workers. Before following the federal lead, provincial governments may want to ask themselves this question: Should we encourage saving that will reduce federally funded benefits paid to our elderly residents?
How to make PRPPs work
The proposed PRPP model can be made much better by adding tax-free pension accounts to PRPPs that would allow low- and middle-income workers to save without reducing their elderly benefits. Upper-middle-income workers need more saving room, so PRPPs should allow members to save under the same rules that apply to federal government workers and other DB plan members, or by implementing uniform lifetime accumulation limits for all pension and RRSP saving, in tax-free and tax-deferred accounts. Finally, PRPPs should be allowed to pay benefits in the form of lifetime pensions.
Is a big CPP the answer?
Introduction of the PRPP model has divided many pension reform advocates into two camps: those who prefer private solutions, such as the PRPP, and those who promote public solutions, such as expansion of the CPP. What is often not discussed in the debate is the different tax treatment of employees’ pension and RRSP contributions and their CPP contributions. The table below shows the difference for an Ontario employee earning the CPP maximum pensionable earnings of $50,100 in 2012:
|Contribution||Refund Rate||Tax Saved|
As noted above, CPP income is taxable and reduces elderly benefits. This means that if current CPP refund rates apply to increased employee contributions, CPP expansion could be worse for many low- and middle-income workers than saving in an RRSP, pension plan or PRPP. In itself, this does not mean CPP expansion is a bad idea, but if CPP expansion is to help future retirees, then changes to refund rates for CPP contributions and to the clawback rate for elderly benefits on CPP income will need to be considered.
Whether it happens through new private options or expansion of public plans such as the CPP, getting pension reform right means making future retirees better off, not worse. Fortunately, there is much governments can do to make both public and private retirement saving better—if they are willing to take up the challenge.