Canada’s retirement income system is sometimes referred to as a three-legged stool:
- Old Age Security (OAS) – provides universal income to all Canadians subject to residency and income tests.
- Canada Pension Plan (CPP) – an employment-based pension funded by employee and employer contributions.
- Private savings – the government provides tax assistance to Registered Pension Plans as well as RRSPs and TFSAs.
The sustainability of the first two legs is critical because many Canadians rely on OAS and CPP, which provide up to $2,000 per month in inflation-protected income.
Occasionally, the first two pillars become the subject of political debate or controversy, shaking public confidence in these programs. There are also persistent myths about public pensions that cast unnecessary doubts on their sustainability.
In this note we outline why cynical views about the integrity of Canada’s public pension system are largely unjustified. But Canadian public pensions aren’t ironclad guarantees either. They may need to be adjusted modestly lower to keep up with prevailing demographic and economic trends.
OLD AGE SECURITY
The OAS program is considered the first leg of the three-legged stool because of its universal eligibility. OAS pensions start at age 65 but can be deferred by up to five years in exchange for higher monthly income, potentially a wise strategy to hedge longevity risk. The maximum monthly pension for a 65-year-old in the fourth quarter of 2023 is $707.68.
Population aging will cause program expenditures to double (in real terms) from 1.5% of GDP in 1966 to over 3% of GDP by 2031. Costs will gradually decline to 2.6% of GDP by 2060 as baby boomers pass away and immigration bolsters the tax base. These factors suggest that program costs will be contained in the long term. Nevertheless, the OAS program cost $68 billion in 2023, funded entirely from current revenues (“pay as you go” funding). Due to the high and rising cost, there will be an ongoing temptation to reduce benefits.
A trending solution among OECD countries to address rising costs is to index the retirement age to increases in longevity. Stephen Harper’s 2012 budget took this approach by increasing the OAS eligibility age from 65 to 67. This change was overturned by Justin Trudeau in 2016. Furthermore, in 2022, the Trudeau government increased pensions for all seniors after they turn 75.
Canadians shouldn’t be surprised if a future government extends eligibility or reduces benefits to fall in line with international trends. However, precedent suggests seniors and people in their last decade of work needn’t worry. The Harper government’s 2012 amendments were to begin in 2023, a full decade of notice, and with gradual implementation through 2029.
CANADA PENSION PLAN
The CPP was designed to replace 25% of a contributor’s pre-retirement income up to the program’s earnings limit1. Pensions start at age 65 but can begin as early as age 60 or be deferred to age 70, with corresponding benefit reductions or increases. The maximum monthly pension for a 65-year-old in 2023 is $1,306.57.
Like OAS, CPP was originally designed for pay-as-you-go funding. The initial contribution rates were 3.6%, split evenly between employee and employer. Such low contribution rates were unsustainable in a world with declining fertility rates and rising life expectancies. Demographics, as they say, are destiny.
In his 1993 report, Canada’s Chief Actuary Bernard Dussault sounded the alarm that CPP’s reserve fund would be depleted by 2015 and contributions would have to soar to 14.2% by 2030. In 1997, cooperation between the federal and provincial governments put the CPP on a sustainable path by:
- Slashing expensive disability benefits;
- Gradually increasing contribution rates to a sustainable rate of 9.9% by 2003;
- Creating the CPP Investment Board to invest surplus assets in a globally diversified portfolio (instead of exclusively in provincial bonds); and
- Establishing triennial reviews to continually assess the sustainability of the program.
Despite the success of these measures, one of the most persistent myths about the CPP is that it is perpetually on the brink of insolvency. This is simply not true.
But the situation isn’t as rosy as it could be. The Alberta government recently proposed to withdraw from the CPP and replace it with the Alberta Pension Plan (APP). There are potential benefits to an Alberta-only plan because a younger population translates into lower costs. But, according to University of Calgary economics professor Trevor Tombe, “The benefits of such a plan are arguably relatively modest, and the goals of the Alberta government to increase benefits and reduce contribution rates may be challenging to fulfill.”
At the heart of the controversy is the division of the CPP’s assets. The LifeWorks 2023 report commissioned by the Alberta government suggests that the APP would be entitled to 53% of the CPP’s assets, worth about $300 billion. Tombe highlights a critical shortcoming of the 53% estimate: if BC, Alberta and Ontario all used the same asset transfer methodology, they would collectively be entitled to receive 128% of the CPP fund. Such an absurd conclusion suggests a flawed premise. An asset transfer of closer to 20-25% would be more appropriate, according to Tombe’s analysis. Given the wide range of possibilities, it’s hard to see how there could be a solution agreeable to all parties involved.
If the APP were to receive 20% of CPP assets, Tombe’s baseline scenario, he estimates that the APP’s minimum sustainable contribution rate would be 8.2%, a clear advantage for Albertans. But splitting up the CPP is at best a zero-sum game. Any gains for Alberta would be losses for the rest of Canada. According to Tombe, if the asset transfer to Alberta were $300 billion (which he considers unlikely), the CPP’s minimum sustainable contribution rate would rise to 10.5%, above the current legislated rate of 9.9%. If you live in a losing province, it’s possible that benefits or contributions under the CPP would need to be modified to absorb roughly 10% higher costs. Finally, there is no guarantee that an APP Investment Board could replicate the success of the CPP Investment Board; therefore it’s possible that everyone is worse off if Alberta withdraws from the CPP.
RETIREMENT PLANNING
Pensions from the CPP and OAS might need to be revised lower someday to account for previously unanticipated demographic and economic trends. There could be additional cost pressures on the CPP if Alberta withdraws. But Canadians shouldn’t be overly concerned about any of these possibilities. If changes were to be announced, they would likely be minor adjustments, not dramatic cuts. Furthermore, seniors currently receiving benefits and people near retirement would be unlikely to see any changes to their benefits.
If you are under age 55 and pessimistic about the future of Canada’s public pensions, you might consider a planning scenario in which you receive 10-15% less from these programs than your base plan. Please talk to your Investment Counsellor to discuss this further.
1The CPP was enhanced starting in 2019 to provide additional benefits.
