The Canada Pension Plan (CPP) was designed in 1965 to replace 25 per cent of a person’s pensionable earnings in retirement, a figure that still holds true today. Enrolment is mandatory, with contributions made by both employees and employers, as well as self-employed workers.
The program has evolved over time and receives mixed reviews in regards to concerns about issues such as its sustainability and the possibility that increasing contribution rates will crowd out private savings. With an enhancement to CPP beginning in 2019, it’s worthwhile to review the value the plan brings to Canada’s overall retirement system. Have CPP contributions provided good bang for the buck to Canadian workers?
Get ready for increased contributions and benefits
Beginning in 2019, CPP contributions will increase gradually, such that the contribution rate in 2023 will be one per cent higher than it is today for both employees and employers. In 2024, an additional four per cent contribution will apply on earnings above the year’s maximum pensionable earnings up to a new projected upper limit, estimated to be $79,400. By 2025, the enhancements will be fully in place, with a target income replacement of 33 per cent of average work earnings.
The enhancements will also increase the post-retirement benefit, disability benefit and survivor’s pension.
With such significant changes coming over the next seven years, let’s look back and assess the value of a hypothetical employee’s contributions.
Putting CPP returns to the test
Richard retired on Dec. 31, 2017, after 40 years in the workforce. Starting in 1978, he made maximum annual employee CPP contributions. Richard wonders if he’d have fared better by investing those contributions himself.
To calculate a rate of return, let’s make the following assumptions:
- Richard has a life expectancy of 21 years from age 65.
- Inflation is two per cent over the long term.
- Richard makes the maximum annual employee CPP contribution for 40 years (from 1978 to 2017).
- He’ll be eligible for the maximum annual CPP retirement pension, indexed to inflation, throughout retirement ($13,610.04 starting in 2018).
Based on those assumptions, Richard would have needed a 7.78 per cent pre-tax annual return on his employee contributions to replicate the annual pension the CPP will provide him.
While that return may not seem high, consistently achieving it over a 61-year time horizon (Richard’s contributory period plus his retirement) is difficult. For example, U.S. investor returns on equity funds over the last 30 years (ending in 2016) averaged 3.98 per cent annually, Dalbar found in its 2017 report on investor behaviour. Asset allocation funds, which more accurately align with the CPP’s investment mandate, fared worse, with an annual average return of 1.85 per cent. The odds wouldn’t have been in Richard’s favour had he invested the contributions on his own.
Also note that, since Richard was an employee during his entire career, he made only employee CPP contributions. Being responsible for employer contributions as well — as self-employed people are — would reduce the overall return. However, business owners may still value in the predictable future source of retirement income, given the uncertainties they typically deal with.
One final note: One’s contribution period and projected CPP retirement pension benefit also affect the return. CPP contributions have increased significantly over time, so each contributor’s results could vary.
More to CPP than retirement benefit
In addition to providing a retirement pension, the CPP provides the following:
- Disability pension: A benefit for those who become disabled and unable to work regularly. The disability must be both “severe” and “prolonged,” and taxpayers must have made sufficient CPP contributions to be eligible.
- Survivor’s pension: A benefit available after the death of a spouse or common-law partner. The amount depends on age, whether the taxpayer receives a disability or retirement pension and the deceased person’s CPP contribution history.
- Children’s benefit: A benefit for dependants of disabled or deceased CPP contributors. A child must be either under age 18 or between 18 and 25 and attending a post-secondary school full-time. The benefit is payable until the child turns 18, stops attending post-secondary school between 18 and 25, is no longer under the custody of the disabled parent or dies. It also stops if the parent’s disability benefit ceases.
- Sustainability: The CPP’s fund value of $316.7 billion (as of March 31, 2017) is sustainable over a 75-year projection period. That should provide some peace of mind that CPP benefits will continue for years to come.
Considering all that the CPP provides in addition to a predictable retirement pension, while also taking historical investor returns into account, Canadians arguably receive value for their contributions. That value should give us all a solid foundation from which to build our retirement incomes. The upcoming enhancements should further cement CPP as a retirement income building block.
Curtis Davis is senior consultant for tax, retirement and estate planning services for retail markets at Manulife Financial Corp. This article originally appeared in the June edition of
Benefits Canada‘s companion publication, Advisor’s Edge.