Understanding CPP benefits and the dramatic decline in rates of return

The proposed expansion of the Canada Pension Plan (CPP) is expected to be front and centre at the upcoming meeting of the provincial finance ministers in June. Unfortunately, many of the arguments for expanding the CPP are either debatable or flat out incorrect.

One source of ongoing confusion regarding the CPP relates to the benefits provided by the program. Too many people conflate the returns earned by the CPP fund with the actual benefits received by Canadian retirees.

The CPP was overhauled in 1997 and one of the reforms was the creation of the CPP Investment Board (CPPIB), an independent organization tasked with investing the available funds from the CPP.

The CPPIB has performed well since 2000 when its mandate was broadened to allow for active investment. Over the last five years (2010-2015), for instance, its average rate of return (adjusted for inflation) was 11.4 per cent.

The strong performance of the CPPIB does not, however, directly influence the retirement benefit received by Canadian workers. CPP benefits are calculated based on the number of years worked, CPP contributions, and the age the worker retires. Nowhere in this calculation are the returns from the CPPIB included.

This is not to say that they have no influence. The high yields from the CPPIB lessen the need for further benefit reductions and/or contribution rate (i.e. tax rate) increases as were implemented in the 1997 reforms.

A recent paper calculated the actual returns received by Canadian workers from the CPP by analyzing contributions over their working lives and comparing them to the benefits received during retirement. The main conclusion is that the benefits received by Canadian workers in retirement vary considerably depending on when the worker was born and thus retired.

For instance, a worker born in 1905 who retired (at age 65) in 1970, one of the first years Canadians received CPP benefits, would have enjoyed a rate of return (adjusted for inflation) of 39.1 per cent. A worker born in 1950 who retired in 2015, on the other hand, would have received a return of 3.6 per cent. The rates decline further—those born after 1971 will receive a CPP benefit of 2.1 per cent.

The projected rates of return outlined above decline if certain assumptions are made less favourable. For instance, the calculations above assume that workers make no contributions to the CPP during the exemption period, which is roughly the eight years with the lowest earnings that are excluded from a person’s benefit calculation. If, however, we assume workers make contributions during these exempted years, which do not change their retirement benefits, then the rate of return for workers born in 1972 or later falls from 2.1 to 1.7 per cent.

There are two main reasons for the decline in the rates of return over time. The first is that the contributory period in the early years of the CPP (10 years) was much less than the current period of contributions (39 years). And second, the contribution or tax rate applied during those working years has increased from 3.6 per cent when the program was started in 1966 to 9.9 per cent currently.

A different way to think about the returns received by Canadian workers from their CPP benefits, particularly those born after 1971, is that contributions are made to a fund that must generate a 4.0 per cent real rate of return to provide a 2.1 per cent real rate of return to workers.

While the CPP in its current form is an important component of the overall retirement income system in Canada, it’s difficult to see how its proposed expansion can be justified on the basis of its rate of return to retirees. As we enter a pronounced period of debate on the costs and benefits of expanding the CPP, it’s critical to consider the rather meager rates of return offered to most current and future workers.