Canada's social security system:
the public system

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Canada's retirement-income system has two components: public and private. The public system is not a savings system but rather an income replacement system based on taxes. The public system is composed of Old Age Security (OAS), the Guaranteed Income Supplement (GIS), and the Canada and Quebec Pension Plans (CPP/QPP).

Old Age Security and the
Guaranteed Income Supplement

Old Age Security (OAS) came into effect in 1952, and introduced universal pensions for qualified Canadian residents. OAS is a flat benefit paid to all retirees regardless of their level of income or previous earnings; that is, recipients are not subject to a means-test and their previous employment income is not taken into account. OAS benefits are calculated as 15 percent of the average industrial wage (AIW) in Canada, which in 1999 provided a maximum benefit of $4,929 (Cooper 1999).

In 1967, Old Age Security was expanded to include a Guaranteed Income Supplement (GIS) for Canadians with low income.² GIS is a monthly benefit made available to OAS pensioners with limited income, separate and distinct from OAS benefits.

Changes to Old Age Security and
the Guaranteed Income Supplement

Beginning in 1972, OAS and GIS were indexed to reflect increases in the cost of living (inflation) as measured by the Canadian Consumer Price Index (CPI). In 1989, the federal government introduced a special "clawback" tax on OAS pension benefits (Canadian Institute of Actuaries 1995; and Human Resources Development Canada 1994). So, while both OAS and GIS are protected against inflation, OAS is now considered a taxable benefit while GIS remains exempt from taxation.

Canada Pension Plan and
Quebec Pension Plan

The second component of the public social security system comprises the Canada Pension Plan (CPP) and Quebec Pension Plan (QPP). The CPP and QPP were created in 1966 to provide a pension benefit based on past employment earnings. The CPP and QPP provide up to 25 percent of the average industrial wage (AIW) depending on past employment earnings. The maximum benefit per person provided by CPP in 1999 is $9,020 (Cooper 1999).

The CPP and QPP, combined with the universal OAS, provide up to 40 percent of the average industrial wage in pension benefits. For the average industrial worker, public pension benefits represent just over half, 53.3 percent, of the 75 percent of pre-retirement income needed to provide a reasonable standard of living in retirement (Canadian Institute of Actuaries 1993).

Contribution rates

Contributions to CPP and QPP are calculated based on the Year's Maximum Pensionable Earnings (YMPE). There is also an exemption for Canadians with low incomes. Thus, contributions are made on earnings above the Year's Basic Exemption (YBE) and below the Years' Maximum Pensionable Earnings (YMPE).

Prior to 1997, both the YMPE and YBE were indexed to wage growth, that is, they were adjusted each year to reflect increases in the average wage. The Year's Basic Exemption, which shields Canadians with low incomes from CPP and QPP contributions, was frozen as part of a larger reform package passed in 1997.

Between 1966 and 1986, the contribution rate for CPP and QPP was 3.6 percent of pensionable earnings, divided equally between employers and employees. The rate was increased by 0.2 percent each year until it reached 4.6 percent in 1991.

In the 1988 Statutory Actuarial Report on the CPP, it was revealed that this series of increases would not be sufficient to meet the long-term costs of the plan. Therefore, an adjusted schedule of future CPP contributions was proposed and adopted. This new schedule required that total contribution rates rise in annual increments of 0.2 percent (1992 to 1996), 0.25 percent (1997 to 2006) and 0.20 percent (2007 to 2016). Thus, by the year 2016, the combined employer and employee contribution rate was scheduled to be 10.1 percent of pensionable earnings (Office of the Superintendent of Financial Institutions, 1998).

Under federal-provincial reforms passed in 1997, the contribution rate is now set to rise from 5.6 percent to 9.9 percent in 2003 and then remain stable. (McCarthy 1998). In addition to the accelerated increase in contribution rates, several other changes were made to the CPP in 1997, including expanding the eligible investments to include stocks and bonds and a host of changes to marginal benefits and eligibility requirements. (For further information on the changes enacted to the Canada Pension Plan, see Appendix B.)

Rates of return on the CPP

The rate of return for the Canada Pension Plan³ is the amount of investment income required on contributions in order to pay for the promised benefits. From the point of view of the contributor, the rate of return is the yield on the investment (contribution) in the CPP or QPP as determined by the level of future benefits received.

Table 1 contains the Rate of Return for the CPP between 1966 and 2030.⁴ It is clear that those participating in the CPP in its early stages received enormous benefits relative to their contributions, while those participating later have received smaller relative benefits.

The rates of return are clearly decreasing over time from a relatively high rate of return for contributors born in 1922 to a relatively low rate of return for those born after 1952. These later nominal rates of return, once adjusted for inflation, are well below the real rates of return that could be earned in most private sector pension plans and individual Registered Retirement Saving Plans (RRSPs).

For instance, the long-term, real rate of return for contributors born after 1982, given the underlying assumptions, is approximately 1.5 percent (Canadian Institute of Actuaries 1993). This rate of return is below the real rates of return currently garnered in many private RRSPs and RPPs as well as below the Government of Canada's real return bond, which currently yields a nominal rate of 4.12 with inflation running at approximately 1.5 percent (Bank of Canada 1999).⁵

The information contained in table 2 suggests that elderly Canadians are increasingly relying on private sources of retirement income rather than public (government) sources. For instance, state-provided income relative to total income of retirees grew for men and women, between 1988 and 1996, by 7.1 percent and 11.7 percent, respectively. The increases for both men and women in the percentage of income provided by private pensions and Registered Retirement Saving Plans (RRSPs) significantly outpaced the growth of state-provided benefits. The increase in private benefits for men and women, between 1988 and 1996, were 41.9 percent and 60.7 percent, respectively, more than 5.9 times and 5.2 times the rate of growth of state-provided benefits. Retired Canadians are increasingly relying on private sources of retirement income.

Challenges to the public
social security system

Challenge 1: an aging population

The number of elderly people in Canada's population is increasing due to a number of factors including declining fertility rates, slow population growth, healthier life-styles, and advances in medical technology. Table 3 presents select data for two factors contributing to the aging of Canada's population, decreasing birth rates and increasing life expectancy.

The contrast between the assumptions used in creating the public social-security programs and the actual outcomes is stark. Birth rates declined by 54.1 percent between 1962 and 1996 while life expectancy increased by 10.1 percent during the same period. In 1966, the year the CPP was launched, there were 5.5 Canadians under the age of 20 for each Canadian over the age of 65. Today, there are 2.3 Canadians under the age of 20 for every retiree, and this is expected to further decrease to 1.1 by the year 2030 (Canadian Institute of Actuaries 1995).

A more alarming trend is the relationship between workers and retirees. In our pay-as-you-go system⁶ it is the income of current workers that provides the retirement benefits for current retirees. There is no fund of capital assets set aside for future payment of benefits. In 1992 [table 4], seniors represented 19.8 percent of the working age population. This is expected to increase dramatically to 38.9 percent by 2030 (table 4). In other words, the ratio of workers to retirees will fall from 4 to 1, to approximately 1.5 to 1 by the year 2030. These demographic changes have undermined the ability of the retirement income programs to provide the promised level of benefits in the future (Alexander and Emes 1998).

This phenomenon is not restricted to Canada. It is a problem confronting all the major developed countries. As Peter G. Peterson, Chairman of the Council on Foreign Relations notes:

Unlike with global warming, there can be little debate over whether or when global aging will manifest itself. And unlike with other challenges, even the struggle to preserve and strengthen unsteady new democracies, the cost of global aging will be far beyond the means of even the wealthiest nations--unless retirement benefit systems are radically reformed. Failure to do so, to prepare early and boldly enough, will spark economic crises that will dwarf the recent meltdowns in Asia and Russia. (Peterson 1999: 42-43).

In light of the changing demographics (low birth and death rates), lower levels of economic growth, and stagnant wage growth, the federal and provincial governments have collaboratively initiated some reforms, discussed in Appendix B: Changes to the Canada Pension Plan. These reforms, however, are not bold enough to cope with a problem of this magnitude.

Challenge 2: unfunded liabilities

Many programs in Canada--retirement income support plans like the CPP, QPP, OAS, and GIS as well as the health-care system--have unfunded liabilities, a deficit between the promised level of benefits and the resources provided to fund those benefits in the form of contributions and investment returns.

These programs represent government obligations, or promises to provide specific benefits in the future. They are not funded benefits because contributions are not placed in an account from which taxpayers may draw in retirement as is the case in Registered Retirement Saving Plans (RRSP). Rather, the current contributions are used to pay for the benefits currently consumed by others. It is in this sense that the OAS and CPP/QPP are pay-as-you-go income systems. Table 5 and figure 1 present the unfunded liabilities of Canada's two largest public-retirement income programs (OAS and CPP) and the medical system.⁷

Figure 1: Unfunded liabilities

Source: Alexander and Emes 1988.

Table 6 presents the gross and net transfers made to seniors in a single year, 1996, to illustrate the magnitude of resources already allotted to retirees in Canada and funded by payments from current workers.

In spite of these huge cost escalations, some policy makers subscribe to the view that the changes enacted to the social-security system over the past few years are adequate to deal with the growing costs associated with the aging of Canada's population. They also insist that economic growth will help Canada support an older population.

The Canadian economy did, indeed, grow in real terms at an average rate of 3.8 percent per annum over the last 35 years. Some of the factors contributing to this growth include:

1. working-age population increased by 2% per annum;
2. workforce participation rate (i.e., the work force as a percentage of the working age population) increased by 0.5% per annum;
3. real wages increased at the rate of 1.3% per annum.

During the next 35 years, however, the working age population will increase by less than 0.5 percent per annum. Labour-force participation rates may increase but not as fast as during the 1960s and the 1970s. In the most recent Annual Report for the Canada Pension Plan, real (inflation-adjusted) wages were assumed to increase at a rate of 1 percent per annum. Combining these factors, the economy might reasonably be expected to grow at about 2 percent per annum, half the average rate of the last 35 years (Hamilton 1995; Canadian Institute of Actuaries 1995) .

Policy alternatives

As the number of elderly in the Canadian population increases, the cost of Canada's social-security system will increase over the course of the next 30 years. The economic pressure of this increase coupled with the subsequent increased cost of social programs will force Canadians to choose among several options for the public social-security system:

1. an increase in general taxes;
2. a further increase in CPP and QPP contribution rates;
3. a reduction in social security benefits;
4. a combination of options 1, 2, and 3;
5. the privatizing of a portion or all of the current government social-security system.

Canadians appear to be concerned about the future of the social security programs. In fact, according to some surveys, less than 30 percent of Canadians under the age of 50 are confident that they will receive benefits from OAS and GIS programs and the CPP and QPP (Canadian Institute of Actuaries 1995). In other words, a large percentage of younger Canadians do not believe that there will be a government-funded safety net for them when they retire.

Some Canadians believe that the social security programs can be maintained in their current form by increasing the taxes required to support these programs gradually and that these increased costs will be borne by a population whose standard of living is improving. Table 7 presents Canada's comparative tax burden (figure 2), and the composition of taxes (figure 3) relative to a selected group of countries.

Figure 2: Comparative Tax Burden (percent of GDP)

Source: Emes and Walker 1999.

Figure 3: Composition of Taxes

Source: Emes and Walker 1999.

Raising either general taxes or specific taxes like the payroll tax seems unrealistic given the already high rates of taxation in Canada relative to our trading partners (table 7). High taxes also have an adverse impact on productivity and job growth, which could cause general economic stagnation or, at least, a reduction in economic growth rates and the standard of living of Canadians (OECD 1998; Gwartney and Lawson 1998; Law and Mihlar 1996; for further information see Appendix A).

It is clear that Canada's debt position (table 8) as illustrated in figure 4, coupled with its faltering productivity (Appendix A) and already high taxes (table 7 and figure 2) limit any type of adjustment or reform to the public social-security system based on increasing premiums or deficit financing.

Figure 4: Debt to GDP 1998

Source: Emes and Walker 1998.

A reduction in the benefits afforded under the social-security system is perhaps possible in the longer term but its political feasibility is suspect in the short term. As the population ages and older Canadians gain greater political leverage, it will become increasingly difficult to reform the social-security system provided by the state. For instance, the median age of the electorate is expected to increase from 42 years of age in 1995, to 49.5 years of age by 2030, an increase of 17.9 percent (Canadian Institute of Actuaries 1993).

It is not the intent of this paper, however, to assess and recommend proposals for reforming the public social security system⁸ but, rather, to examine the impact of the Foreign Property Rule on retirement income.

It is, however, critical to note that the social-security system offers a modest benefit depending on the level of pre-retirement income⁹ and that it is improbable that benefits will be expanded. The limitations on the public social-security system make the soundness of the private system that much more important for the future ability of retirees to maintain a reasonable standard of living.

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