Thank Your Paper Carrier—She Just Saved the Canada Pension Plan

Jason Clemens and Joel Emes

The recently enacted changes to the Canada Pension Plan (CPP) have been heralded by federal Finance Minister Paul Martin as a "step forward" that "will ensure the plan's financial sustainability and make it fairer and more affordable for future generations of Canadians." (footnote 1) The changes to the CPP have created a `savings' of 4 percent for future contributors, reducing the maximum expected contribution rate from 13.9 percent to 9.9 percent.

Some of the problems of the previous CPP have been notably, but still only partially addressed by the reforms. For instance, increasing the contribution rates decreases the inter-generational inequality, and thus increases the program's fairness since there is a closer relationship between the benefits received by certain generations and the amount each contributes. Similarly, the changes made to the investment policy should increase the return gained from the surplus funds.

Assuming that the CPP is not replaced by a more effective private system of retirement savings, (footnote 2) the plan appears to be both prudent and fair. However, a closer examination of the changes reveals that the single largest source of savings is accomplished at the expense of those earning about 10 percent of the average industrial wage—about $3,500 a year. Who earns that income level? CPP supporters should thank their neighbourhood newspaper carrier, or the high school student who works during the summer, or the elderly person who works part-time to earn extra money, because it is exactly these people who will contribute the most to the savings generated by the reform package.

As with any pension, the reform possibilities were limited to three areas: revenues, expenses (benefits) and fund management. The new plan includes changes to all three areas: increases to the contribution rate, changes in the investment policy, and adjustments to some of the benefits. The main benefits of the plan and the eligibility criteria have not been changed. For instance, although life expectancy has increased from roughly 69 years since the inception of the CPP, to 76 years in 1990, and is expected to further increase to nearly 81 years by 2020, the age of eligibility has remained constant at 65. (footnote 3)  Similarly, the target benefit of 25 percent of the average industrial wage remains unaffected.

Although all three areas of reform will contribute to the savings, it is the acceleration of the increase in the contribution rate which has garnered the lion's share of public attention. The new plan calls for the contribution rate to increase to 9.9 percent of the average industrial wage (AIW) 12 years ahead of the schedule present under the old plan. The previous agreement called for a rate of 9.9 percent by the year 2015 and a maximum rate of 13.9 percent in 2030. Unfortunately, there is no guarantee that the new reduced maximum rate will fare any better than the original maximum rate of 5.11 percent established in 1964. If the accelerated contribution rate were implemented in isolation, that is, if it were the only aspect of the new plan implemented, total savings would be 0.5 percent rather than 4 percent. (footnote 4)

The new plan also changes the investment policy from passive investment in provincial bonds to a more pro-active strategy which includes stocks, higher-yielding government and corporate bonds, and some foreign investments.  (footnote 5) If the new plan only included changes in the investment policy, the savings would be 0.3 percent.

Coupling the accelerated increase in the contribution rate with the new investment policy is expected to yield greater savings. The combined effect is projected to yield savings of 1.5 percent, almost double the rate of savings expected if the reforms had been introduced in isolation. The reason the savings are increased when the two changes are implemented in concert relates to their complementary nature. By deducting more sooner, and at the same time investing the subsequent funds in a more pro-active manner, the CPP is able to amplify the total earnings of the fund and thus generate a greater level of overall savings.

A host of marginal changes have been implemented regarding the benefits available under the CPP. Six areas have been reformed: eligibility requirements for disability benefits, administration of disability benefits, conversion calculation from disability to retirement benefits, limitations on combined pensions, limits on the death benefit, and the calculation of the earnings index. In all, these changes generate 1.1 percent of the total 4 percent savings.

The change that has the single largest impact has also received the least attention. Freezing the Year's Basic Exemption (YBE) is responsible for 35 percent of the total savings. Under the previous plan, no one had to pay CPP premiums on the first $3,500 of income. For instance, if an individual earned $40,000 in 1996, he or she would only pay CPP premiums on the amount above the YBE ($3,500) and below the Years' Maximum Pensionable Earnings (YMPE) of $35,400.

The aim of the exemption was to exclude individuals whose earnings were deemed minimal from having to bear the cost of CPP deductions. Under the old plan, the YBE and the YMPE were adjusted each year in order to reflect changes in the level of average wages. The new plan freezes the level of the exemption at its current level of $3,500. This change will effectively decrease the value of the exemption at the rate at which industrial wages increase, thereby providing less and less protection for very low-income workers.

For instance, suppose the local paper carrier or the part-time grocery clerk earned $3,500 in 1997 and received a 5 percent wage increase to $3,675 in 1998. Suppose further that total wages, upon which the YMPE and the YBE were calculated also increased by 5 percent over the course of the year. Under the previous guidelines, the person would not be subject to any CPP deductions since his or her wage would be equal to the exemption. However, with the exemption frozen, the individual will now be required to pay CPP premiums on the income ($175) above the exemption. Granted, there will only be a negligible impact this year and each of the next few years, but eventually the value of the exemption will be completely eroded by wage inflation.

The September 1997 actuarial report on the proposed reforms described the change as follows:

Freezing the YBE is expected to reduce the stable contribution rate by 1.4 percentage points but does not materially affect the amount of contributions as it produces a gradual compensatory increase in the contributory base... (footnote 6)

What this accounting jargon means is simple: more people will be included in the pool of individuals who contribute to the CPP. Including people who earn in and around 10 percent of the average industrial wage is reprehensible. The local paper carrier, the high school student working during the summer, elderly people employed part-time trying to supplement their fixed income, and all those earning an absolute minimum income should be exempt from CPP deductions.

The fact that the single largest source of savings is achieved at the expense of very low income workers is further evidence that tinkering or making marginal changes to a fundamentally unfair and expensive program can do nothing to eliminate the inherent problems of a state-run, pay-as-you-go retirement system. It is time that all political party leaders, social institutions, and community organizations, as well as the parents of the next generation of Canadians begin to discuss what type of retirement income system Canada needs.

Footnotes

1. "Ottawa to rule CPP fortune," Globe and Mail, Shawn McCarthy quoting Finance Minister Paul Martin in the House of Commons during the tabling of reform legislation, September 26, 1997.  Back to paragraph 1
2. Countries including Australia, Chile, and the United Kingdom have reformed their state pensions through privatization initiatives with tremendous success. For survey data on reforms undertaken around the world see the National Center for Policy Analysis (NCPA) paper, Private Alternatives to Social Security in Other Countries, available on the web at www.ncpa.org. For information on the basic essentials of a retirement income system, see the Association of Canadian Pension Management (ACPM) paper, A Retirement Income Strategy for Canada: Creating the Best Retirement Income System in the World, available on the web at www.benefitscanada.org. Back to paragraph 3
3. United Nations, World Population Prospects, 1992. Back to paragraph 4
4. Office of the Superintendent of Financial Institutions, CPP: Sixteenth Actuarial Report, September 1997, p. 5. All figures regarding the savings generated by reforms were taken or derived from this report. Back to paragraph 5
5. For more information on the change in the investment policy, see the article, "In the New CPP, Will Environmentalists Finance Resource Exploration?" by these authors in the January 1998 edition of Fraser Forum. Back to paragraph 6
6. Office of the Superintendent of Financial Institutions, CPP: Sixteenth Actuarial Report, September 1997, p. 5. Back to paragraph 12

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