Lately some politicians have been using a recent study by Broadbent Institute, which states that few Canadians have saved enough for retirement, to further discussion on enhancement to the Canadian Pension Plan (CPP). It is likely the upcoming federal budget will not contain any provisions to enhance CPP, however Finance Minister Bill Morneau has stated it is on the federal government’s agenda and he tends to consult with the provinces on the topic. In addition Ontario has already moved forward with their own provincial retirement plan.With potentially larger government pension plans on the horizon I thought it would be worthwhile to look at the value Canadians are getting for their CPP contributions.
Let’s use an example, Doug is 65. He started working 40 years ago and has always contributed the maximum to CPP. 40 years ago the annual maximum contribution was quite small, just $135, and the contribution rate was just 1.8%. However his employer would have also contributed to CPP and matched Doug’s $135contribution. Since that first contribution, the amount Doug added every year to CPP would have gone up because of inflation and larger contribution rates.Over 40 years Doug would have added $44,692 to CPP, his employer would have matched that, and today, having maximized his CPP contributions, Doug would be eligible for a pension of $1,092 per month.
One way to try and determine whether or not Doug got value for his money is to look at the equivalent lump sum needed to generate the same $1,092 of monthly income.Looking at current life annuity rates for 65 year old males Doug would need roughly $200,000 to generate the equivalent income. CPP does provide a spousal benefit, in Doug’s passing all or some of his CPP would be paid to his partner.If we were to try and incorporate that benefit he’d need a lump sum of roughly$250,000. Instead of contributing to CPP if Doug would have taken his annual contribution and the employer’s matching contribution and invested it over the last 40 years, he would have needed to achieve annual average rate of return of about 5.9% to have a $200,000 lump sum today or about 7.2% for $250,000. A 5.9%or 7.2% rate of return is decent value for your money. If Doug didn’t receive the employer’s matching contribution it would be very difficult to replicate the CPP monthly income.
The numbers mentioned above are made more attractive because of the small CPP contributions Doug made near the beginning of his career. In 2016 employees contribute not 1.8%,but 4.95% of their income. The maximum annual contribution is not $135, but$2,544. Doug’s larger CPP contribution impacts the value he gets from CPP. If we make assumptions about future contribution rates and inflation we can repeat the scenario above. In the next 40 years, because of the larger amount of money Doug has to pay into CPP, Doug would not need returns of 5.9% or 7.2%, but only2% to 3.5% to replicate the CPP monthly income. Not nearly as attractive. Similar to above if Doug didn’t receive the employer’s portion of the contributions it would be very difficult to replicate the monthly income.
The math for self-employed individuals is even less attractive as self-employed folks have to pay both the employee and employer contributions.
It is important to remember that once you start collecting CPP you have a guaranteed pay cheque for as long as you live. In addition CPP is indexed, provides some spousal benefits, disability benefits and death benefits. Not all those features are reflected in the math we did above. As well CPP acts as a means of forced savings, the math we did assumes that if the money was not contributed to CPP you would invest it, not spend it.
With the federal government and some provincial governments discussing changes to government pensions I believe it is important to analyze the pros and cons of enhanced government programs. Additionally if changes are made we will need to amend our retirement plans accordingly.
This information transmitted is intended to provide general guidance on matters of interest for the personal use of the reader who accepts full responsibility for its use, and is not to be considered a definitive analysis of the law and factual situation of any particular individual or entity. As such, it should not be used as a substitute for consultation with a professional accounting, tax, legal or other professional advisor. This commentary reflects my opinions alone, and may not reflect the views of National Bank Financial Group.