Double Blind

The government is bringing in some proposed amendments to the Canada Pension Plan. This will require a change in legislation, so it is most unlikely to pass because of the minority government situation. The changes are easy to analyze, and one of the changes (Change #4) will have a significant effect on when most Canadians will choose to take CPP (it will induce more people to take CPP later in life).

Change #1:

To remove the Work Cessation Test in 2012. Individuals would be able to take their benefit as early as age 60 without any work interruption or reduction in hours worked or earnings.

This is a logical amendment considering that most people were effectively not ceasing work before taking CPP. The definition of work cessation was also quite nebulous – you could take a leave of absence for two months and have that considered to be ceasing to work. It was a rule that has long since been depreciated in the modern workforce.

One advantage of taking CPP early is that if you planned on continuing to work, you would not have to pay CPP, in addition to receiving an extra source of income. This would no longer be the case after Change #3.

Change #2:

To increase the general drop-out:

* To 16 percent in 2012. This would allow a maximum of almost 7.5 years to be dropped.
* To 17 percent in 2014. This would allow a maximum of 8 years to be dropped.

This will positively affect people that have multiple years of low income years. In addition, since the average income for CPP purposes is calculated from the age of 18 and onwards, if people do end up working for 42 years before they take CPP at age 60, this will exclude 7 low-income years vs. 6 before this change. Since most people earn less money at the beginning of their careers, it will improve their average income for CPP purposes.

In addition, if you have a child, you can creatively use them to exclude 6 years of “CPP time” after they are born to optimize your or your spouse’s CPP benefit. In theory, if you have one child and take your CPP when you are 60 years old, you can exclude up to 13 years of a 42 year working period. If you had worked for those 13 years and had no children, you would have still received the same CPP benefit despite having contributed to the fund for that time!

Change #3:

To require individuals under the age of 65 who receive a CPP retirement benefit and work, as well as their employers, to make CPP contributions that will increase their CPP retirement benefit. This would be voluntary for individuals aged 65 or over, but employers of those opting to participate in the CPP would be required to also contribute.

* These contributions will result in increased retirement benefits, including persons already receiving the maximum pension amounts.
* The additional benefits would be earned at a rate of 1/40th of the maximum pension amount ($10,905 in 2009) per year of additional contributions. The exact amount of the additional benefit would depend on the earnings level of the contributor. The resulting pension could be above the maximum.

This change forces people that take early CPP to continue paying CPP contributions if they continue to work. However, unlike present, that amount enables people to increase the amount of CPP benefits they receive.

Using 2009 figures, if you took CPP at age 60 and continued to work and paid the full CPP premium amount ($2119 yearly for the employee) for five years, you would increase your monthly CPP benefit at age 65 by 12.5%, or about $1363 per year. The raw math is that you would contribute a net $10,595 over five years to the CPP (plus another $10,595 from the employer), and have an additional yearly return of $1363 per year when you turn 65. This works out to a pension with a 6.4% return on investment, ignoring time-value of money and other external factors. In low interest rate environments, you would ‘win’ with this, but in high-rate environments you would lose.

Coupled with Change #4, however, this change is a net loser for those that decide to take CPP early.

Change #4:

* To gradually restore the pension adjustments to their actuarially fair levels.
o The early pension reduction would be gradually increased to 0.6% per month for each month that the pension is taken before age 65. This would be done over a period of five years, starting in 2012.
o The late pension augmentation would be gradually increased to 0.7% per month for each month that the pension is taken after an individual’s 65th birthday, up to age 70. This would be done over a period of three years, starting in 2011.
* To require regular reporting on the actuarially fair level of the pension adjustments at least every nine years, starting in 2016. Finance Ministers will review these adjustments, based on an assessment by the Chief Actuary of the Plan, and recommend whether changes are needed.

Currently if you take CPP at age 60, you will receive 30% less than what you would be entitled to at age 65. Each year you wait, you would earn 6% more, relative to the age 65 level. If you waited until after age 65 to take CPP, you would earn 6% more per year over the age 65 pension level, up to a maximum of 30% extra for CPP when you turn age 70. The two decision-making variables are what your projected lifespan is, coupled with your cash flow requirements (and whether you think cash spent earlier at that time of life is more effectively spent than later in life). Taking CPP later than 65 years of life is currently a bad decision, and most people (especially men that have lower life expectancies, such as smokers or those with medically adverse family histories) have very good reasons for taking CPP as early as possible.

Mathematically, your “return on investment” for not taking CPP at 60 is incorrectly calculated by assuming the reward for waiting is 6% a year. Although the difference between taking CPP at the age of 60 vs. 61 is 6% different, it is the difference between -30% and -24%, which is actually 8.6%. From age 61 to 62, the return is 7.9%; 62 to 63 is 7.3%; 63 to 64 is 6.8%, and 64 to 65 is 6.4%.

If you think you can invest money better than a risk-free 8.6%, then taking CPP early at age 60 is a good decision.

What this change does is punishes people taking CPP early by increasing the risk-free amount they would have to earn for a break-even decision. This is a subtle change that reduces CPP benefits for those that want to retire early, and will induce more people to taking their CPP retirement later. In other words, it is a net actuarial gain for the CPP fund (and a reduction of benefits for future pensioners).

With a 0.6%/month decline in benefits for pensions taken earlier than age 65, the following are the risk-free amounts that must be earned in order to make early CPP a breakeven financial decision, compared to that of the old CPP system:

	Old System	Old System	Proposed	Proposed
	CPP Benefit	Risk-Free Return	CPP Benefit	Risk-Free Return
Age	Relative to Age 65	Required	Relative to Age 65	Required
60	70%		64%
61	76%	8.6%	71%	11.3%
62	82%	7.9%	78%	10.1%
63	88%	7.3%	86%	9.2%
64	94%	6.8%	93%	8.4%
65	100%	6.4%	100%	7.8%
66	106%	6.0%	108%	8.4%
67	112%	5.7%	117%	7.7%
68	118%	5.4%	125%	7.2%
69	124%	5.1%	134%	6.7%
70	130%	4.8%	142%	6.3%

 
Interestingly, there is a slight marginal benefit to wait until age 66 to claim your CPP as the proposed change increases the CPP benefit by 0.7% per month after 65, instead of 0.6%. If your risk-free threshold is 8%, then you will likely wait until you are about 66 years old before applying for CPP benefits.

Almost nobody will be able to get an 11.3% risk-free return at age 60, so it is very likely that most people will wait before collecting CPP. In the old system, the threshold is 8.6%.

In most cases, the net return of a working Canadian’s investment in CPP is significantly worse than if you managed your own retirement. If you can manage your own money in a tax-sheltered (RRSP or TFSA) account with a return of 4%, you will do significantly better than the CPP. There is also the distinct advantage of having full and free access to your capital during this period of time.

The Canada Pension Plan makes no distinction between contributions performed early in life vs. later in life – a Canadian contributing a full yearly CPP amount at age 59 is treated no differently than a Canadian with a full yearly CPP contribution at age 18. As a result, if one wishes to fully take advantage of the system with its present rules, it is only worth contributing to the CPP later in life than earlier. For example, somebody working between the ages of 18 to 38 will receive exactly the same amount from CPP as somebody that works from ages 38 to 58 (assuming the same salary, and both people taking CPP at the same time). It is correct to say that the Canada Pension Plan amounts to a wealth transfer mechanism from younger workers to older ones.

This entry was posted on Tuesday, May 26th, 2009 and is filed under Best Of, Finance. 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.