(As published in November 2016 Smart BIZ)
At least that has been the conventional wisdom. The federal and provincial finance ministers recently announced a deal to reform the Canada Pension Plan and save us all from a retirement of penury, I looked into what it would mean for financial planning. You may be surprised to hear that CPP Reform may not be such a good deal .
The deal will raise CPP contribution rates from 4.95% for each of employer and employee (call it 10%), to more like 15%. They will raise the contribution salary from $53,600 (2015) to $82,700 (subject to inflation I’m sure). That means a middle class worker at the limits will go from “saving” a little short of $450/month to about $1000/month. And what will he get for that? The pension at age 65 after 40 years of working life will rise from about $1100/month to $2275/month, from a 25% pension on $53,600 to a 33% pension on $82,700. $2275 after making $6891 would still seem like penury to me. In short, the reform deal will not solve the problem of senior poverty. The CPP reform agreed in Vancouver is another poor deal for tax-payers.
A financial planner starts by setting the retirement income goal. Let’s call it $50,000 a year or a little over $4000 a month. Based on the saver’s risk tolerance, and probable returns, we can calculate the needed contribution level to achieve the client’s capital accumulation needed to produce the retirement income goal. A balanced portfolio of 50/50 fixed assets and equities should average 5% a year over the long term, net of fees, plus inflation. Contributing 10% of the $50,000 income, the same as required now by employer and employee into CPP, would be just over $400/month for forty years. That level of contribution and return would grow to about $600,000 by the time she reaches 65. At the same conservative balanced investments, that “pension” portfolio should give her an income of more than $48,000* a year. Ms. Taxpayer could receive close to a 100% pension on forty year average earnings, at the current contribution rates! So why are we reforming CPP? It would be interesting to calculate how much Ms. Taxpayer would be better off just contributing the increase in the planned CPP premiums into a defined contribution plan!
One explanation /excuse is that CPP is a defined benefit plan, managed under very conservative assumptions. I don’t buy it. The conventional wisdom is that Defined Benefit plans are GOOD, Defined Contribution plans are BAD. It may be time to challenge that assumption. The difference between a defined benefit pension of $2275 a month and a defined contribution pension of $4000 a month for the same contributions is simply not worth the marginal security of knowing one will receive exactly $2275. I would rather gamble on a pension that may only be $3800 a month but could as well be $4200 a month. And if certainty is really your only criterion, use your contribution pension to buy a defined guaranteed pension from an insurance company.
In the “END OF WORK – financial planning for people with better things to do” I explain investing basics in terms of building a balanced, well-diversified portfolio with consistent contributions. Then chapter eight gives an example of just such a portfolio – the Canada Pension Plan! Surprised? Twenty years ago, the CPP was rapidly going broke. That is because, even though the funds are independent of government’s consolidated revenue fund, it was still a slush fund for cheap government money. Its portfolio was 100% government bonds returning maybe the rate of inflation, if that. CPP was going broke and the politicians were sure to get blamed! So they created the CPP Investment Board, to manage Canadians’ money. The CPPIB has done very well for us. It took the first ten years to shift out of government bonds to create a balanced diversified portfolio. For the past ten years, the CPPIB has averaged 6.8% net of costs. That covers my 5% projection as well as 1.8% margin for inflation (which actually averaged 1.2% from 2005 to 2015). Admittedly, there is some volatility in its returns. Last year (to March 31, 2016) it only made 3.4%. Mind you, in the same period, the TSX lost 10%. I’ll take that. The five year average return has been 10.6%.
In THE END OF WORK I lament that one cannot voluntarily invest in the CPP, so one can only use it as a model when working with an advisor in selecting investments to mirror the CPP like a surrogate ETF. Now I am thinking that the only reform that the CPP needs is to change it from a defined benefit plan to a defined contribution plan, with individual accounts – at current contribution rates. It might then allow additional voluntary contributions by employees, and whatever they can negotiate from their employers. Bill Morneau is a pension expert. Please tell me where I am wrong?
I ran this draft by the Globe’s Rob Garrick and he replied: “Factually, can’t argue with what you’re saying”.
The politicians have assumed that increasing contributions is the only way to solve senior poverty. Instead, while we can keep contributions mandatory, start running it like a real pension plan. You do not need to increase contributions, just increase benefits!
“The uncreative mind can spot wrong answers, but it takes a creative mind to spot wrong questions.”
Fredrick Petrie, B. Comm. (Hons.), author of “THE END OF WORK: financial planning for people with better things to do”, practices financial planning at Mortgage Logic, 1793 Portage Ave., Winnipeg, MB. (204) 298-2900
“THE END OF WORK: Financial Planning for People with Better Things to Do” is available on Amazon Kindle
* Each $100,000 of capital invested at 5% average would produce $8000 a year income for twenty years, about life expectancy for 65 year olds, using up the capital. I also use this formula in reverse to determine the insurance required for capital replacement of income for dependency period needs.