Double Blind

We are all invested in the stock market, whether you know it or not. Whenever you earn money through employment, 4.95% of that goes to the Canadian Pension Plan. Whoever is hiring you will have to chip in another 4.95%. If your income source is from self-employment, you have the privilege of paying both!

The Canadian Pension Plan took an 8.5% hit between July 1 and September 30 this year. Most of this was due to a $10.9 billion investment loss for the quarter. The CPP had net assets of approximately $117 billion at the end of September.

About $40 billion of this is invested in publicly traded equities.

According to the financial statements, the CPP board has added approximately $22.7 billion in value since their inception – the other $94.7 billion came directly through CPP contributions.

When the CPP was created, pension payments were funded by existing taxpayers. It was decided by the government (Chretien era) that assets should be accumulated to pay for future CPP payments, instead of the pension liability being strictly funded by existing taxpayers. The decision to double CPP premiums was controversial, but is turning out to be a good long term decision.

In theory, in about 10 years, the CPP fund should have about $300 billion in assets, which can be used to pay out the increasing number of people that will be collecting CPP benefits in the near future. This assumes that the markets will actually be able to deliver positive returns on the future – something that doesn’t seem like a given at present!

Assuming that you pay fully into the CPP for your working career (40 of 47 years), you will receive a CPP benefit of approximately $885 per month (inflation-adjusted) when you turn 65.

The only problem is that when you add up the employee and employer contributions to CPP, it doesn’t make much sense. For example, if you work from 2008 to 2047, and contribute the maximum to CPP, you will have contributed $164,000 in 2008 (inflation-adjusted) dollars, for a $10,600 yearly benefit once you turn 65. Note that the $10,600 is considered to be taxable income, and there are various rules concerning the taxation of income when you turn 65 that essentially taxes CPP money at around 70% (via the GIS clawback, and reduction of income-tested benefits such as MSP premium payments).

Now, if you would have taken those yearly $4,100 CPP contributions and put them in an RRSP or TFSP (either one works, although the TFSP is much, much better if you can take the initial tax hit), and compound the investment at 4% a year (a very conservative number; right now 3.7% is the 10-year Canada government bond yield), you will end up with $390,000 in a bank account after 40 years.

You can take 4% out of this account indefinitely after for a $15,600 income – far better than the $10,600 given by the CPP. If this money is from the TFSP, it will be tax-free.

The mathematical break-even point is 3.3% – if you can do better than 3.3%, then you should invest outside the CPP. If you project less than a 3.3% return, then you should invest in the CPP.

Finally, while the CPP is indexed to the CPI (Consumer Price Index), changes in interest rates in the market should offer some sort of inflation protection.

The other advantage of “do it yourself” is that if you so happen to die, the money will still be there. Also, you can structure your income to be advantageous with respect to income taxes (whatever the rates so happen to be in 40 years).

These are probably the best arguments why if you can avoid paying CPP premiums, you should do so. The only way one can realistically do this is by structuring their income through a small business corporation and pay dividends, opposed to employment income.

This entry was posted on Wednesday, November 12th, 2008 and is filed under Commentary. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.