By Jean-Pierre Laporte
Special to the Financial Independence Hub
Much ink has already been spilled since Minister of Finance Oliver rose in the House of Commons on May 26th to announce that the federal government was open to the idea of allowing additional voluntary contributions to the Canada Pension Plan, in order to give Canadians yet another avenue to save for their retirement.
Pundits and pension experts have since wondered what this new policy initiative would look like when fully fleshed out. The details provided by the Hon. Oliver have been scant except to say that employers would not be forced to contribute to the Supplemental Canada Pension Plan (S/CPP for a lack of a better acronym).
The S/CPP policy announcement comes at critical time, as the Ontario government is refining its own proposed CPP expansion initiative known as the Ontario Retirement Pension Plan ( ORPP ). The ORPP is a mandatory extension of the CPP for all workers not otherwise exempted because they work for a federal employer, or participate in a ‘comparable’ pension plan like a defined benefit plan. The ORPP was Ontario’s reaction to the lack of willingness on the part of the Harper government to impose a mandatory increase to the basic CPP benefit.
Foundation laid in 2004
The foundations for a S/CPP solution can be traced back to an article published in the October 2004 issue of Benefits and Pensions Monitor (link : http://www.bpmmagazine.com/02_archives/2004/october/reforming_canada_pension.html). The core idea was simple. Since most Canadians already save through the Canada Pension Plan, why not give savers the opportunity to ‘top up’ their CPP savings with additional voluntary contributions that could then be invested by the professionals of the Canada Pension Plan Investment Board?
Employers would not be forced to contribute. However, where employers (as part of the terms of the employment contract) require employees to contribute to the S/CPP, the employers should be forced to make a matching contribution. The contributions would be collected by the Receiver General in the normal course, alongside the regular CPP remittances, but earmarked as supplemental assets. At retirement, the regular CPP benefit would be augmented by the benefits earned under the S/CPP.
A lot of the debate seems to center around whether the S/CPP should be a defined contribution (DC) scheme or a defined benefit (DB) scheme. This dichotomy underscores the lack of a firm grasp of pension law and principles. The other debate is whether it should be mandatory or voluntary. We review both below.
Defined Benefit or Defined Contribution?
First, let us be clear: the current CPP is a defined contribution plan in the sense that the contributions made by employers and employees are defined in advance, and that should there be insufficient assets in the pension fund to pay out promised benefits, there is no obligation on the parties (employers, employees or the government) to make up any shortfall.
This ability to “back stop” the promised and defined benefits is a characteristic of true “defined benefit plans.” Moreover, while the current CPP system does offer a “defined” benefit that can be calculated based on years of service and contributions made, it is not a classic Defined Benefit pension because it lacks some important attributes:
- there is no material death benefit payable as is the case under private pension legislation, where the commuted value of the pension is paid to the surviving spouse or designated beneficiaries. Instead a paltry benefit not exceeding $2500 is available.
- pensions received by a couple are partially offset in the case of a death. The survivor pension of a plan member whose spouse has died while in receipt of the pension, when added to the survivor’s pension cannot exceed a ceiling amount. Under a normal Defined Benefit pension, the survivor’s pension is not scaled back and is an independent right.
How S/CPP could transform into true DB plan
Secondly, now that we have a better sense that the current CPP is not a true Defined Benefit Plan, let us look at how the S/CPP could convert the defined contributions coming in, and transforming those into defined benefits. The solution is not very complicated and in fact was the norm with employer pension plans offered by life insurance companies during the 1940s, 1950s and 1960s. The insurer would receive the contributions and purchase deferred, partial annuities. When it came time to retire, these annuties would be combined to offer a guaranteed stream of pension income to the retiree.
Now, this solution requires the participation of Insurance companies, which is problematic for three reasons :
(1) most insurers withdrew from this form of pension product and only Industrial Alliance seems to be marketing it again.
(2) insurers must build in a profit margin in pricing these annuities such that the montly pension benefit cannot be as large as it ought to be.
(3) insurance companies are required to maintain regulatory capital before writing insurance. This also means not all of the contributions can be deployed to create a benefit. Mr. David Dodge, former Governor of the Bank of Canada, once remarked that if the S/CPP wishes to replicate what the insurers used to do to convert DC monies into DB pensions, it simply needed to self-annuitize. Since the S/CPP is not an insurance company, it need not maintain regulatory capital. As a non-profit entity, it does not need to retain assets to pay shareholders. This means more of the cash contributed can be converted to a stream of pension benefits.
The larger CPP pool subsidizes Disability payments
The final technical detail that many Canadians seem to forget is that their CPP contributions are not entirely devoted to create a fixed pension in retirement. Because the CPP also offers a disability pension, it is possible for someone to collect for much longer periods of time without making any corresponding contributions, if they qualify for a CPP disability payment. This suggests that one group of CPP contributors are subsidizing and in fact insuring another group, those who are eligible for the disability pension. While no one would oppose providing disability pensions to people who qualify, this special feature of the CPP necessarily implies that not 100% of CPP contributions go towards creating a benefit. This mathematically implies that but for this disability feature, Canadians could obtain higher pension benefits with the same level of contributions.
It would be possible for the government to specify that the S/CPP contributions be used strictly for maximizing the size of the retirement benefit offered by the voluntary contributions. In fact, maintaining a separate S/CPP account would allow the more generous private pension rules (relating to death benefits as discussed above) to apply to that pool of money.
Mandatory or Voluntary?
Those who dismiss a S/CPP solution are always quick to point out that voluntary solutions simply do not work. They will constantly remind people that there are billions of dollars of unused RRSP room that is accumulating and growing from year to year, which suggests Canadians are just incapable of saving.
Let us remember that saving can occur in many different ways. Purchasing a primary residence and paying down a mortgage is a form of savings. The sale of the house won’t trigger a capital gain, and while the equity in the home grows, it can also be turned into a stream of rental income. Moreover, by living in the house, the saver does not need to pay rent leaving more disposable income for other consumption items.
In an era of cheap credit, can one blame Canadians for refusing to keep their assets in a bank account where they will receive 0.5% when they see the price of houses raising by 5% or more every year? There are many other ways to save than to use RRSP contribution room: insured retirement plans, corporate class securities held corporately, mortgages, GICs, etc.
TFSA success is evidence Voluntary contributions can work
But what is the track record of purely voluntary measures? If one looks at the Tax Free Savings Account (no employer match, purely voluntary, no tax refund upon making a contribution, low limits on contributions) since their introduction, millions of Canadians have rushed to their financial institutions to open one, and billions of dollars have been transferred into them over the past few years. If Canadians cannot be trusted with saving and taking required action, how can one explain these facts?
The sad reality is that so-called pension experts truly believe they know best what is needed for Canadians, and that without a ‘forced saving’ strategy, most citizens will harm their own financial well-being because they are incapable of making efficient decisions.
When interest rates were in the double digit range in the early 1980s, the nation’s savings rate increased dramatically. Now that we are in a cheap credit era, Canadians are finding other uses for their money. By forcing someone with little disposable income to save in the CPP or ORPP (where they can hope to get a 5% return) instead of using that cash to pay down credit card interest being charged at 18%, are we really helping that person enhance their net worth? It is this type of economic absurdity that a forced savings strategy would impose on all Canadians, even those who are disciplined.
Tools to create S/CPP already exist
In summary, the idea of voluntarily enhancing the CPP is already a decade old. A lot of thinking has gone into turning it into a useful policy tool to assist all Canadians save for their retirement without creating new bureaucracies and without imposing payroll taxes on employers (especially those in the small private sector).
The tools to create the S/CPP already exist and have worked in the past. The only thing left to do is for the federal government to roll up its sleeves and consult those who can make it a reality.