Less Bang For Your CPP Buck?

Barbara Shecter of the National Post reports, Canadians shouldn’t confuse CPP investment gains with higher pensions:
The Canada Pension Plan’s investment arm may be racking up impressive gains, but Canadians are mistaken if they think the portion they will be getting in retirement is growing at the same rate, says a new paper from the Fraser Institute.

“Unlike individual RRSP, TFSA, or pension accounts, there is no direct relationship between the rates of return earned in the CPPIB (Canada Pension Plan Investment Board) and the benefits received by eligible retirees,” authors Jason Clement and Joel Emes say in the paper to be released Thursday.

The Canada Pension Plan Investment Board invests money that is not needed to pay current CPP benefits. As such, its returns will provide indirect benefits to individuals who will ultimately retire, such as by reducing the need to raise contribution rates to sustain the pension scheme, the paper says.

An individual’s annual retirement benefits, however, are calculated based on a complex formula that takes into account, among other things, the contributions each worker makes to the CPP over the course of their working life, from age 18 to 65. The benefits are also capped at an average income level below what many recipients earned during their working lives.

So while the CPPIB has performed “reasonably well,” reporting an average rate of return of 7.9 per cent since 2000, the authors calculate that someone born after 1955, and who retires in 2021 or later, will receive a “modest” annual return on their contributions of around three per cent.

Any CPP-eligible worker born after 1971, and retiring in 2037 or later, will receive an annual return of just 2.1 per cent in retirement, the paper says.

These returns are far lower than the CPP investment arm’s 10-year real rate of return of 6.2 per cent, after expenses, and also below the four per cent real rate of return the Chief Actuary of Canada says is necessary for the CPP to remain sustainable.

“It’s fairly easy for average Canadians to confuse the returns earned by the CPP Investment Board (CPPIB), which is tasked with actively investing the investable funds of the CPP, with what they themselves might actually earn from their contributions to the CPP in the form of retirement benefits,” the authors write.

“Indeed, some advocates for the expansion of the CPP have conflated, or at least not clearly differentiated between, the rates of return earned by the CPPIB and the actual returns received by individual Canadian workers in the form of CPP retirement benefits.”

The recently elected federal Liberal government of Justin Trudeau ran on a platform of enhancing the national pension program to ensure all Canadians have an adequate standard of living in retirement.

The maximum CPP retirement benefit for new recipients at age 65 is $1,092.50 a month. The benefit is meant to replace about 25 per cent of pre-retirement income but reaches a maximum around $12,000 a year.

The Trudeau victory kick-started talk about enhancing the Canada Pension Plan, which Ottawa and the provinces discussed seriously in 2010.

When an agreement could not be reached, the Conservative government of the day subsequently studied targeted voluntary contributions to CPP, adhering to the view that mandatory national expansion could hurt the economy by placing a burden on businesses that would be forced to contribute.

If the CPP program is not expanded by 2018, Ontario’s Liberal government has pledged to forge ahead with the creation of a separate provincial pension plan that would bolster the national scheme.

The Fraser Institute paper published this week is the latest from the think-tank to question the rationale for expanding the national pension scheme. Recent papers challenged the view that the Canada Pension Plan is a low-cost operation due to economies of scale, and suggested Canadians already save adequately for retirement.

In the review and analysis of returns on CPP contributions, this week’s paper found that older Canadians — those who reached retirement between 1970 and 1979 — did substantially better than more recent retirees.

Their contribution rates were lower and workers at that time were required to contribute to the program for a shorter period, allowing these retirees to enjoy a rate of return of 27.5 per cent, according to the paper’s authors.

The figures used to calculate returns don’t take into account payments received beyond base retirement benefits, such as survivor’s pension or death benefits.
You can read the full report by the Fraser Institute here. This report follows another one questioning the costs of running the CPP. I ripped into that report as did other pension experts who stated that study was deeply flawed.

Now we get another study from the Fraser Institute claiming Canadians don't really see the benefits of expanding the CPP. Let me briefly give you my thoughts on this study:
  • The first thing you should note is that the Fraser Institute is a right-wing think thank which is against "big government' and "big CPP". As such, you need to read all their studies bearing this in mind because they're funded by Canada's powerful financial services industry which doesn't want to see an expanded CPP (some bankers with a long term vision actually do see the benefits).
  • Second, and quite comically, the authors do admit the CPPIB has performed “reasonably well,” reporting an average rate of return of 7.9 per cent since 2000. Reasonably well? How many Canadian mutual funds can boast the same average annualized risk-adjusted return (after fees) as CPPIB and other large Canadian DB pensions since 2000? The answer is very few because unlike mutual funds, CPPIB and its large peers can invest across public and private markets as well as invest in the best hedge funds throughout the world. And they often invest directly in private markets, lowering the costs of their operations by foregoing fees to external managers.  
  • Third, CPPIB offers safe predictable returns that benefit all Canadians. Sure, unlike individual RRSP, TFSA, or pension accounts, there is no direct relationship between the rates of return earned in the CPPIB and the benefits received by eligible retirees, but the authors also miss an important point. Unlike TFSAs and RRSPs, your benefits from CPP are guaranteed for life (you won't run the risk of outliving your savings) and not subject to the vagaries of public markets. This means if you retire in a year like 2008 when stock markets got crushed, you won't have to worry about your CPP benefits. Also worth bearing mind, most Canadians don't invest enough in RRSPs or TFSAs and even when they do, they won't do a better job over the very long term than CPPIB (yeah, you might have outperformance in any given year but not over a long period, especially if you invest in mutual funds instead of exchange-traded funds as fees will eat away most your long term gains).
  • Fourth, CPPIB has one job: to maximize returns on contributions without taking undue risk. Period. If they keep up their stellar long term performance, it will allow the finance ministers of each province to sit down with their federal counterpart to discuss raising the benefits or lowering premiums. This last point was made by Ed Cass, Senior Vice President and Chief Investment Strategist at CPPIB, in my comment on building on CPPIB's success
  • Fifth, it doesn't surprise me that those born after 1971 are going to receive less annual return from the CPP than previous generations. Why? Well, for one thing, ultra low rates are here to stay and the Governor of the Bank of Canada even warned pensions to brace for the new normal of lower neutral rates citing the demographic pressures of the baby boom generation retiring in droves. In other words, given historic low rates and the fact that there will be more retired workers than active workers, many of whom are living longer, it's entirely logical that the current and future generations will receive less (proportionally) than previous generations. 
  • Sixth, and most importantly, given how brutal the investment environment is and will be over the next decade(s), I think now more than ever we need real change to Canada's pension plan by enhancing the CPP so more Canadians can retire in dignity and security. Studies by the Fraser Institute are grossly biased and never highlight the brutal truth on defined-contribution plans or how bolstering defined-benefit plans (like CPP) will bolster our economy providing it with solid long term benefits.
Having said all this, I will concede something to the authors of this latest Fraser Institute study, we need a lot more transparency on the way CPP benefits are determined (apart from a simple video) and there should be an open discussion on whether benefits should be increased or premiums reduced (of course, enhancing the CPP means higher premiums and higher benefits).

I believe in prudent management of the CPP, which basically means saving for a rainy day (and there will be plenty of them in the future), but I also believe in fairness and transparency. For example, if someone is working well past 65 years old and contributing to the CPP, why are their benefits capped and why shouldn't people who contribute more, receive more? These are all policy questions which need to be addressed by our provincial and federal governments, not the people managing the CPPIB.

I reached out to Bernard Dussault, Canada's former Chief Actuary, to get his views on this study. Bernard was kind enough to share this with me:
By definition, the rate of return in respect of a cohort of contributors is the discount rate that renders the present value of all contributions made for this cohort during its active life equal to the present value of all benefits paid to this cohort during its whole retirement benefits period (i.e. ending with the death of the last survivor of the cohort).

Generally speaking (e.g. assuming stabilized conditions), if a pension plan is financed on:
  • a fully funded basis, then thee rate of return corresponds to the average (over the period running from the first contribution made to the last pension benefit paid) rate of return on the concerned fund;
  • a partial funded basis, let say p% (for the CPP “p” is close to 15%), then the rate of return corresponds to [ (p)*i + (1-p)*e ], where:
  • “i” corresponds to the average (over the period running from the first contribution made to the last pension benefit paid) rate of return on the concerned “partial” fund;
  • “e” correspond to the average (over the active contribution period) rate of increase in the contributory employment earnings of the concerned cohort (i.e. the compounded increase of the salary and the population increase rates).
As indicated in Table 21 on page 49 of the 26th actuarial report on the CPP (http://www.osfi-bsif.gc.ca/Eng/Docs/cpp26.pdf), the nominal internal return for the cohort of CPP contributors born in 2010 amounts to 4.5%, while the nominal rate on the CPP fund is 6.2% (i.e. the sum of the 4% real rate plus the 2.2% inflation rate).

The 4.5% return on CPP contributions is obviously less than what it would be, i.e. 6.2%, if the CPP were fully funded. It is not because from 1966 to 1995 contributions to the CPP were made at a level lower than the CPP full cost rate, i.e. about 6%.

Besides, I consider that a lifetime guaranteed return of 4.5% is much appreciable:
  • not only because it applies to all members of the 2010 cohort taking into account the absence of longevity risk;
  • but also because few individuals (if any), irrespective of their investment expertise, would be in a position to achieve a 4.5% rate of return on average from age 18 to death.
I thank Bernard for sharing his expert insights with my readers.

Below, personal finance expert Preet Banerjee explains what happens when you take CPP payments before or after age 65. This is all part of the boomer’s dilemma which many people thinking of retiring early need to bear in mind. Listen to his comments carefully.