We might be on the verge of a major development in pension reform, since we have witnessed several events over the last few months focusing on improvements for our retirement income system. Governments need to consider carefully the implications of a possible C/QPP expansion, but might wish to examine simpler solutions as well.
First let us recap significant events that happened recently:
- July: All Canadian Premiers continued discussions to enhance our public and private pension system;
- August/September: Quebec’s public finance committee held a consultation on major recommendations made by the D’Amours committee last spring, including an innovative public program called the “longevity pension”, and then a consultation on the proposed VRSP rules (comparable to PRPPs elsewhere in Canada);
- September: PEI’s finance minister circulated a detailed new CPP expansion proposal;
- October: Ontario’s Premier visited a few other Premiers to promote a CPP expansion and announced that otherwise, she would consider an Ontario-only alternative;
- November 1: Provincial and territorial finance ministers met in Toronto to consider a CPP/QPP expansion, issuing a statement that defined four objectives that should guide future discussions, namely that any expansion should:
- Be responsible and fully funded and focus on today’s workers;
- Moderate the short-term effects on businesses, families, and the economy;
- Improve the future retirement incomes of middle-income earners; and
- Protect lower-income workers.
The first objective is meant to avoid another intergenerational transfer of wealth so any fresh expansion would be prospective only. It would not provide a windfall for baby boomers, some of whom might therefore need to retire a bit later than expected.
The second objective acknowledges the warnings from business groups that any quick and significant increase in payroll taxes could damage the current slow economic recovery. This could be addressed by reducing concurrently other payroll taxes. Nevertheless, it should be realized that any action aimed at redressing a perceived lack of savings is bound to imply that additional sums will need to be saved, and while savings reduce immediate consumption, they generate capital for current investments and lead to future consumption.
The third objective recognizes the fact that middle-income earners are not very well protected by the current public system and that a majority of them do not even participate in a private pension plan. Basically, this defines the biggest issue with our current retirement income system.
The fourth objective implies that lower-income earners, who are already very well protected by the current system, would end up losing half of those sums if and when they eventually receive GIS benefits, since these would be clawed back at 50%.
It is interesting to note that all of the above concerns were voiced by various stakeholders during the recent Quebec hearings on the D’Amours Report, in addition to the concern that the Quebec proposal to implement a new longevity pension should be coordinated with a potential CPP expansion by the rest of Canada.
PEI proposal for CPP expansion
It is interesting to note that the specific CPP expansion proposal recently unveiled by PEI’s finance minister seems to address directly those four objectives, as can be summarized as follows:
- Be fully funded: additional benefits of 15% of earnings would apply only to service after the implementation date and would be financed by additional contributions of 3.1% (shared equally between employees and employers, at 1.55% each) of the covered earnings. Although we have not seen on what basis that 3.1% might suffice to finance a benefit level of 15%, it is well known that the current CPP contribution of 9.9% finances not only a benefit level of 25%, but also windfalls granted to previous generations, so the proposed 3.1% might be sufficient to finance fully the new benefit;
- Moderate short term effects: the changes would be delayed about two years and then would be phased in over about three years. So the contribution rates would not change right away and then would increase annually by only approximately 0.5% of earnings for each party, which likely represents only a fraction of expected annual salary increases;
- Improve pension of middle-income earners: the new benefits and contributions would apply to earnings between approximately $25,000 and $100,000 (the current CPP earnings ceiling is $51,100);
- Protect lower-income earners: by excluding the first $25,000 of earnings for the new benefits and contributions, the potential impact on future GIS benefits would be greatly reduced. In addition, this partial exclusion would reduce the impact of the new contributions as a percentage of total earnings; for example, someone earning $50,000 would pay the new contributions on just half of total earnings, so that the annual contribution increase of 0.5% would represent only 0.25% of total earnings (which would also be diluted by the income tax deduction).
The impact can be summarized as follows at different salary levels:
These tables show that for higher-income earners, this expansion would produce an increase of approximately 50% in contributions and almost 90% in benefits, while for middle-income earners, it would represent an increase of approximately 20% to 30% in contributions and 30% to 60% in benefits. This would probably go a long way to improve their retirement security, but only after a phase-in period of about 40 years, in order to satisfy the full funding objective.
Other Considerations Related to Stated Objectives
As the finance ministers and premiers examine closely such a proposal, they may wish to consider carefully the following potential implications related to their stated objectives:
For The Objective Related to The Protection of Low-Income Earners:
While it may be true that additional contributions would likely end up reducing their future GIS benefits by 50% (meaning they get their own contributions back, but not their employer’s), this is already true of their current CPP contributions. One difference is that the CPP expansion would cost less than the current CPP, which includes the cost of past inter-generational transfers.
On the one hand, do governments wish to maintain their current “unrewarding” contributions and simply not exacerbate that problem with a CPP expansion, or else do they wish to attempt to rectify what is already counterproductive? On the other hand, do governments wish that low earners continue relying in the future on benefits funded solely by general tax revenues supported by future taxpayers?
If they wish to redress the current problem, one approach might be to exempt a significant first layer of earnings, such as $15,000 or $25,000, and by applying that exemption not only for contributions (as is the case with the current basic exemption of $3,500) but also for benefits; however this would have a substantial effect on the appropriate contribution rate needed to maintain the current level of CPP funding, and also on the future costs of the GIS program. Another approach might be to find some compromise by applying a less severe clawback formula for CPP benefits (maybe only up to a certain level, such as half the maximum CPP benefit), or by considering the CPP expansion as a tax free savings account, which is not counted for GIS calculations.
For The Objective Related to The Improvement of The Pension for Middle-Income Earners:
Depending on what is the targeted level of middle-income where the current lack of savings may be most acute, is it appropriate to spread a CPP expansion gradually all the way up to earnings of $100,000, or should the improvements be more concentrated in the range up to $75,000? Some stakeholders may feel that public plans should focus on those who need the most assistance, while those who are better off could be left to handle their own affairs.
For example, instead of new rates of 3.1% and 15% being applied between $25,000 and $100,000, new rates of 5% and 25% could be applied between $25,000 and $75,000, which would produce very comparable results for high earners but much more impact for middle earners. The following tables illustrate how this alternative would affect different salary levels:
For The Objective Related to Moderating The Short Term Effects on The Economy:
Although it may be justified to pay attention to short term effects, it would be wise to consider also medium and long term effects. For example, the current system was structured by creating different sources of retirement savings (the so-called “three pillars”), and leaving a significant part to be played by private plans, including workplace plans and personal plans. The gist of today’s problem is that only a smallish percentage of private sector workers participate in private plans. Any expansion of the public plans is bound to push those workers who already participate in private plans (or their employer) to reduce their contributions to those private plans. This may very well produce a vast displacement of investments from private to public funds.
For example, it was estimated that the Quebec proposal for a new longevity pension would produce annual contributions totalling about $4 billion, but that this would be offset by reductions of about $2 billion in private plans. A rough estimate of the impact of a CPP expansion might be to triple those numbers for the rest of Canada.
Such a displacement helps to reduce the net short term impact on the economy, but requires private plans to implement the adjustment. This implementation should be pretty straightforward for a defined contribution plan, e.g. if you were used to paying 5% of salary and now you are asked to pay 3% into a new plan, you can simply reduce your existing contribution to 2%. But for defined benefit plans, the appropriate offset may not be as easily determined, especially if the public plan expansion is phased in over three years. So this adjustment in private plans may require significant effort and administrative expenses.
If we look into the long term, it should be realized that the displacement of contributions will produce huge sums going from private financial institutions to some public body; this may have some advantages, but also some disadvantages, which should be carefully considered by governments now.
Alternative approach: a targeted PRPP solution
While any alternative that might be considered involves certain advantages and disadvantages, it can be useful to remind ourselves of the problem that needs to be addressed and then to attempt devising a solution that focuses on that problem as much as possible, while minimizing collateral impacts where there is no problem.
If we try to keep that in mind, another approach may be to focus the changes on workers who do not already participate in private plans, so that the new public plan simply complements what has already been established, rather than displace it.
Over the last couple of years, finance ministers have pursued a parallel track to reinforce the private plans by developing new rules for PRPPs (or VRSPs in Quebec). While this new vehicle might help to cover some of the workers who are not covered currently by one of the existing private plans, if their employer (or themselves) take advantage of that new vehicle, it is hard to imagine that this new vehicle will have a widespread impact if the rules make it totally voluntary. And this seems to be one reason why the finance ministers are trying to do more than their recent PRPP initiative.
But the strategy now being planned by finance ministers for expanding the public plan could be revised so as to dovetail into their PRPP initiative. Here is a broad outline of a targeted solution that could be based on a public PRPP.
- When taxpayers file their tax returns, determine whether they have accumulated a certain minimum target level of retirement savings in the last year; if not, then impose a contribution into a public pension plan.
- This test could be based on whether they have either an RRSP deduction or a Pension Adjustment (which is reported as a result of their participation in their employer’s pension plan, including a new PRPP). If this approach were considered, it might be preferable to ensure that the reported retirement savings really end up providing retirement income, so the current rules on locking-in might need to be reinforced.
- For example, if the alternative now being considered were new CPP contributions of 3% on earnings between $25,000 and $100,000, someone who earns $75,000 would be expected to contribute (in combination with the employer) an amount of $1,500 toward retirement savings in one form or another (in addition to the current CPP). On his tax return, if he reported at least $1,500 in RRSP contribution or in a PA, then he would not need to make any additional contribution; but if he reported less, then he would need to contribute (through a tax-administered assessment) such missing retirement savings into the new public pension plan. To avoid an immediate cash outlay, this lack of savings could be spread over the coming year.
- The way to link this approach to the new PRPP rules would be for governments to set up their new public pension plan as a PRPP for this purpose, or even select a PRPP set up by a financial institution, possibly from a short list offered to each taxpayer to select on his tax return (if he doesn’t have enough being saved in his RRSP or employer pension plan).
- We could even envisage several provincial PRPPs (one being in existence already in Saskatchewan). This would certainly help those PRPPs achieve very rapidly the economies of scale that help to keep administrative costs at a very low level, which is one of the main objectives of the PRPP rules.
While there would still be several details to analyze before setting up such an approach, this targeted public PRPP solution may offer a lot of advantages.
So as politicians prepare to make some important decisions on a possible expansion to CPP/QPP, let us hope they will weigh in the above considerations and alternatives.