Canadian federal and provincial finance ministers met in Charlottetown in June 2010 and moved a few steps closer to reaching agreement on the expansion of benefits payable from the Canada Pension Plan (CPP). The objective of CPP enhancements is to provide increased pension coverage for millions of working Canadians, albeit with increased payroll taxes on employees and employers. While a definitive direction for CPP changes may yet lie in the future, the Ministers’ initiative does raise the question as to how some of the proposed changes would affect current public and private sector pension plans.
Currently, CPP provides a maximum benefit of $934 per month at age 65 to participants who have contributed the maximum amount for all or most of their career (certain periods of non-contribution or lower contributions are excluded when determining benefits payable). Members may receive their inflation-adjusted CPP benefit on a reduced basis as early as age 60. CPP also provide pre-retirement disability and death benefits and post-retirement survivor pension benefits to eligible participants. The Quebec Pension Plan provides comparable benefits and is sponsored by the province of Quebec.
The options
While the degree to which the CPP might get expanded remains to be seen, there are two basic approaches being discussed publicly. One option is to adjust the earnings limit applicable to benefit calculations as well as employee and employer contributions. In 2010, CPP contributions and benefits are determined by reference to a $47,200 wage limit. An increase to the wage limit will cause employees and employers (self-employed individuals pay for both) to contribute more and accrue a greater amount of CPP benefit. This would provide enhanced CPP benefits to employees who earn more than the current CPP wage limit but would have no effect on employees earning less than the current wage limit.
Another option is to increase the accrual rate itself. Today’s CPP provides a maximum target benefit equal to 25% of the average CPP wage limit in the five years prior to commencement—an increase to the target benefit would provide all CPP contributors, regardless of level of employment income, with a larger pension.
Regular actuarial valuations are performed triennially by the CPP’s Chief Actuary in order to conclude whether the CPP is sustainable for the next 75 years. As a result, it is improbable that CPP reforms can be implemented on a retrospective basis. Rather, one can expect reforms to be on a prospective basis where the changes in earnings limit or the benefit accrual rate, and in particular, the increase in employee and employer contributions, would only apply to future periods.
Canadian public- and private-sector pension plans have a long history of integrating the benefits they provide with the CPP. Integration is often present for determining the employee contributions to the plan. When the CPP was introduced in 1966, a number of plans were designed with explicit integration (e.g., 2% of earnings less CPP benefits). Over time, many plan sponsors have restructured their accrual formulae to indirectly integrate with the CPP (e.g., 1.3% of earnings up to the CPP wage limit and 2% of earnings above). This indirect integration provides for somewhat simpler administration and reduces administrative challenges whenever CPP is amended. From the sponsor’s perspective, indirect integration minimizes the risk that a reduction in CPP benefits would cause an immediate increase in benefits payable from the plan.
Private sector reaction
How are plan sponsors likely to react in this era of high pension costs and difficult economic climate? Let’s start by looking at how plan sponsors typically design their defined benefit (DB) pension plans. In most cases, DB design starts with a plan sponsor assessing the total retirement income level, or target benefit, that should be received for a full-career so a retiree can maintain a reasonable standard of living. Design of defined contribution plans, on the other hand, generally focuses on the total level of company and member contributions, rather than the target benefit payable. Once a target has been established, the sponsor assesses the proportion of the target benefit that should be provided from three sources, namely: (i) government programs, such as the CPP and Old Age Security (OAS); (ii) company programs, such as the pension plan; and (iii) personal savings by the employee, whether in a company plan or through individual savings.
While opinions on the required level of replacement income vary, many plan sponsors view replacement of 50% to 70% of pre-retirement income as a reasonable benchmark for their employees. The final design will generally balance the competing challenges of providing sufficient income to employees and ensuring the plan is affordable to the sponsor. Based on the benefits provided by the CPP, OAS, and employer-sponsored plan, employees need to make the necessary savings to provide the total desired income. Employers may assess that if more of the target benefit is provided by government programs, less of the target benefit needs to be provided by company pensions.
Given the current economic climate, it is unlikely that members of pension plans will see much increase in total pensions if the CPP is augmented. For affected employees who are not able to increase the total amount of income set aside for retirement, the higher employee contributions necessitated by an amended CPP will presumably come out of other current savings the employee is making. For employers who cannot afford the cost increase in their business, increased contributions to CPP may cause them to consider commensurate changes in their pension plans to carve out the additional CPP benefits from their plan, mitigating the cost impact. In short, the cost impact of extending CPP may come at the expense of other savings by employees and reduced levels of pension or other benefits provided by employers.
It is unclear whether the CPP changes will be extended on a voluntary (i.e., sponsors can opt-in or opt-out if certain conditions are made) basis or whether participation will be mandatory for all employees and employers. If the changes are provided on a voluntary basis, most plan sponsors will likely consider the costs of participation and the demographics of their workforce, and will make the choice which best benefits them financially. If, however, one of the goals in implementing the CPP changes is to ensure equitable treatment for all employees, then mitigating the potential impact of opt-outs will add another challenge to be addressed.
Finally, some employers may take adoption of an extended CPP as the catalyst to re-open the design of their pension plans which may in some cases provide the opportunity to adopt cost-cutting or risk-reducing alternatives to help the organization meet its broader financial objectives. If this were to occur, the affected plan members may find that their future retirement savings will not have been further secured, but instead increasingly their responsibility along with the risks that come with it. While the finance ministers have started down the path of potentially enhancing CPP benefits for all Canadians, there is a real chance that the goal of enhanced coverage may be achieved at the price not only of a higher payroll tax on employers without pension plans, with the resulting potential for job losses, but potentially also lower ultimate pensions for those in pension plans today.