CPP: A good bang for the buck?

The Canada Pension Plan (CPP) was designed in 1965 to replace 25% of a person’s pensionable earnings in retirement, a figure that still holds true today. Enrolment is mandatory and contributions are made by both employees and employers, as well as the self-employed.

The program has evolved over time (the CPP Investment Board was created in 1996) and receives mixed reviews (concerns about its sustainability, for example, or 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 increased benefits

Beginning in 2019, CPP contributions will increase gradually, such that the contribution rate in 2023 will be 1% higher than it is today for both employees and employers (to 5.95% from 4.95% of the year’s maximum pensionable earnings, or YMPE). In 2024, an additional 4% contribution will apply on earnings above YMPE up to a new projected upper limit, estimated to be $79,400. By 2025 the enhancements will be fully implemented, with a target income replacement of 33% 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, we will make the following assumptions:

• Richard has a life expectancy of 21 years from age 65.
• Inflation is 2% over the long term.
• Richard makes the maximum annual employee CPP contribution for 40 years (1978 to 2017).
• He will be eligible for the maximum annual CPP retirement pension, indexed to inflation, throughout retirement ($13,610.04 starting in 2018).

Based on these assumptions, Richard would have needed a 7.78% pre-tax annual return on his employee contributions to replicate the annual pension that CPP will provide him.

While this 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% annually, Dalbar found in its 2017 report on investor behaviour. Asset allocation funds, which more accurately align with CPP’s investment mandate, fared worse, with an annual average return of 1.85%. The odds would not have been in Richard’s favour had he invested the contributions on his own.

Also note that, since Richard was an employee his entire career, he made only employee CPP contributions. Being responsible for employer contributions as well—as the self-employed are—would reduce the overall return. However, business owners may still value 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 impact the return as well. CPP contributions have increased significantly over time, so each CPP contributor’s results could vary.

More to CPP than retirement benefit

In addition to providing a retirement pension, CPP provides the following:

• Disability pension—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. The CPP disability pension isn’t income-tested, and a person can purchase additional disability benefits through group or private plans.
• Survivor’s pension—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’s CPP contribution history.
• Children’s 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 paid 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—CPP’s fund value of $316.7 billion (as of March 31, 2017) is sustainable over a 75-year projection period. This should provide some peace of mind that CPP benefits will continue for years to come.

Considering all that CPP provides in addition to a predictable retirement pension, while also considering historical investor returns, Canadians arguably receive value for their contributions. This 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

Tax & Estate

Curtis Davis, FCSI, CFP, TEP, is director for tax, retirement and estate planning services, retail markets at Manulife Investment Management.