Sounding Board: Factoring CPP, inflation in retirement plan design
Inflation must be taken into account when designing both plan sponsor and government retirement programs because, over time, it will undermine purchasing power.
In terms of recruiting and retaining employees, workplace retirement plans are important, but they also represent a significant cost for employers. Inflation-adjusted government pension programs can help lower these costs. But plan sponsors and their members should also be aware of the shortcomings of the Canada Pension Plan and old-age security, both of which are critical components of employees’ retirement income.
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What is the CPP?
All Canadians, no matter where they live, are eligible for the CPP, a retirement income plan provided by the federal and provincial governments. It’s funded by equal contributions from employees and their employer (currently at 9.9 per cent). However, if an employee is earning less than $3,500 annually, no contribution is required. The CPP earns revenue by pooling contributions into investments, which are managed by the Canada Pension Plan Investment Board. It currently manages about $320 billion.
One common question around the CPP is when to take it. If a retiree takes CPP before age 65, their monthly CPP will be reduced, but the total amount they’re likely to receive over their retirement will be greater than the amount they lose each month.
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Canadians can start receiving CPP when they turn 60, or defer it to age 70 (more than two-thirds of Canadians take it before 65). But there’s a penalty for taking it early: for each month of CPP taken before age 65, there’s a 0.6 per cent reduction. So for an individual taking CPP at age 60, their monthly payment would be 32.4 per cent less than if they’d waited until age 65. Another option is to gamble — anticipating a longer life expectancy — and increase monthly CPP by 42 per cent by delaying it until age 70.
Some argue that CPP should be more inclusive, since many people don’t qualify for it. Paul Owens, Alberta’s deputy superintendent of pensions, concluded that CPP, OAS and the guaranteed income supplement aren’t sufficient to retire comfortably. Not surprising, since the average CPP payout is about $550 a month.
CPI adjustments
The CPP is adjusted annually based on the consumer price index, which is intended to offset inflation. However, CPI excludes some important costs incurred by Canadians. Most people are aware that the cost of food, energy and housing are increasing at a higher rate than CPI.
Many items included in a typical Canadian ‘shopping cart’ aren’t part of CPI. For example, between 1997 and 2011, household spending increased by 3.4 per cent while CPI only increased by two per cent. During retirement, a relatively small difference like this results in a significant shortfall in CPP benefits — i.e., 1.4 per cent difference compounded over 25 years results in about a 40 per cent shortfall in retirement purchasing power.
Indexing is a critical component of CPP due to the impact of this compounding. But a critical aspect of the CPP promise is that an inflation adjustment should maintain purchasing power.
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Some Canadians are fortunate enough to have indexed, employer-provided defined benefit plans and significant savings, in addition to CPP and OAS. For example, the pension payments for retirees and their spouses in public service DB plans are adjusted annually based on CPI (1.6 per cent for 2018). However, many private sector DB plans and defined contribution or other capital accumulation plans, aren’t automatically adjusted for inflation.
OAS is also adjusted for inflation. It’s reviewed quarterly and may be adjusted for inflation based on CPI. The purpose is to address any major changes in CPI faster than for CPP. The OAS clawback upper and lower limits are also adjusted by CPI each year.
Survey of household spending
The federal government’s survey of household spending, which is used to calculate GDP and to develop social and economic policies, is a more inclusive indicator of retail spending and inflation. In addition, it would be a better benchmark for adjusting CPP annually, but it isn’t without its shortcomings.
For example, both the survey and CPI exclude the costs associated with indigenous reserves, military camps, seniors in residences, permanent school residents and communal colonies. These areas represent about 2.5 per cent of the Canadian population. Further distortion occurs because the survey uses longer reference periods for measuring the cost of goods and services that are more expensive or purchased irregularly.
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However, the biggest difference between the survey and CPI is the measurement of ‘shelter costs,’ which represent 27 per cent of the CPI basket. While the survey includes mortgage payment principal, land costs, renovations, condo fees, indirect taxes and many costs associated with second residences, CPI excludes them. CPI also treats homeownership as if owners are renting their homes, and it accounts for ‘shelter’ by using a long-term housing depreciation estimate versus acquisition cost. As result, there’s a much lower cost allocation to CPI’s shelter component — and skyrocketing housing and land prices are understated in CPI.
Change requires action
The annual CPP adjustment clearly understates the reality of Canadian spending inflation. As a result, the average household is subjected to an unrelenting erosion of one to two per cent annually in purchasing power. Many Canadians depend primarily on CPP and OAS for their retirement income and are finding it difficult to make ends meet.
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But who would pay for a higher CPP inflation adjustment? The annualized returns on CPP investments over the last 10 years, five years and for fiscal 2018 are eight per cent, 12.1 per cent and 11.6 per cent, respectively. In addition, CPP is projected to be self-sustaining for at least 75 years. An increase of 0.5 to one per cent in CPP benefits for inflation could be covered by investment returns at no additional cost to the government or significant risk to the CPP funded status. It could also help to reduce the pressure on pension plan sponsors to increase their retirement savings programs and control their costs.
CPP and OAS benefits are also taxable — i.e., the government would recoup a portion of CPP increases. If there’s concern about the current level of CPP funding, another approach would be to increase OAS, which is more inclusive compared to CPP, and would benefit those most in need of assistance.
Canadians are forced to pay into CPP and are entitled to a fair benefit in return. It should reflect a realistic measure of CPI that maintains purchasing power over time.
Gerry Wahl is managing director of the PensionAdvisor.