Monday, February 21, 2011

Why CPP is not a good investment

This is a post that I have been trying to write for the better part of the last 3 months. Every time I see a comment from Jack Layton about how we should increase the CPP contributions and double the maximum benefit. Every time I see an op-ed from a union boss saying the same thing. Every time I see these things, it doesn't sit right with me because I know it's the wrong thing to do. It doesn't sit right with me because it transfers more money to past generations at the expense of the current and future generations. It forces me to pay for the short-sightedness of my parent's generations (Dad was at the beginning of WWII, Mom was the first year of baby boomers).

In order to understand why I think the CPP is a bad idea, it's useful to understand how it was funded in the past, and is currently funded now (from wikipedia):

At its inception, the prescribed CPP contribution rate was 1.8% of an employee's gross income up to an annual maximum. Over time, the contribution rate was increased slowly. However, by the 1990s, it was concluded that the "pay-as-you-go" structure would lead to excessively high contribution rates within 20 years or so, due to Canada's changing demographics, increased life expectancy of Canadians, a changing economy, benefit improvements and increased usage of disability benefits (all as referenced in the Chief Actuary's study of April 2007, noted above). The same study reports that the reserve fund was expected to run out by 2015. This impending pension crisis sparked an extensive review by the federal and provincial governments in 1996. As a part of the major review process, the federal government actively conducted consultations with the Canadian public to solicit suggestions, recommendations, and proposals on how the CPP could be restructured to achieve sustainability once again. As a direct result of this public consultation process and internal review of the CPP, the following key changes were proposed and jointly approved by the Federal and provincial governments in 1997:

* Total CPP contribution rates (employer/employee combined) were increased annually from 6% of pensionable earnings in 1997 to 9.9% by 2003.
* Continuously seek out ways to reduce CPP administration and operating costs.
* Move towards a hybrid structure to take advantage of investment earnings on accumulated assets. Instead of a "pay-as-you-go" structure, the CPP is expected to be 20% funded by 2014, such funding ratio to constantly increase thereafter towards 30% by 2075 (that is, the CPP Reserve Fund will equal 30% of the "liabilities" - or accrued pension obligations).
* Creation of the CPP Investment Board (CPPIB).
* Review the CPP and CPPIB every 3 years.

I'm going to paraphrase that so that my point is clear. Until 1996, the CPP was a government ponzii scheme. In fact, in 1996, according to these two documents (Contributions (Page 16) and Payments(Page 7), archived from the StatsCan website here), the plan had been paying out more than was contributed for 12 solid years. The cumulative effect was that by 2000, the first year when contributions again exceeded benefit payments, total CPP payments had exceeded the total contributions made in the entire history of the plan. The only saving grace for the CPP at that point was that interest rates had been high for a large part of the 70s and 80s, giving the fund some breathing room to keep a nest egg.

I ran my own data back to 1994, the beginning of my working life.  Specifically, I had data back to 1999 and estimated my prior contributions.  I then took the information on current maximums and projected out what I will pay over the remaining 30 years of my working life.  Since I am self-employed, that is accurate to say "I PAY" because it's all coming from the same pocket.  Not only did I project out what I will pay, but I also projected out what those contributions would be worth when grown through normal investing.

From that total, I also projected out what the CPP maximum benefit would be when I begin to collect in 2041.  To make that projection I used an average inflation rate of 2.5%, a rate that has held fairly steady over the past 15 years.  The number I arrived at was slightly more than $2000 a month (2014/month).

Now here's where it gets interesting.  Assuming these numbers are correct, the CPPIB would only need to average 3.89% from 1994 until I die in order to pay me the maximum benefit.  This assumes that I live to age 88 - a full 15 years after the expected life span of a male my age when I was born.  Even if I lived to age 100, the CPPIB would only have to average 4.8% during that same span in order to pay me a maximum benefit.

Indeed, if I lived to age 88, the CPPIB would have to average 6.01% in order to pay me DOUBLE the maximum benefit from age 65 until I die.

Now, that last bit is important for 2 reasons.  The first reason, is that if I DON'T live to age 88, the remainder of my accumulated contributions are property of the CPPIB and do not accrue any benefits to my spouse unless she is younger than age 65 (assumption is that she will receive SOME CPP benefit when she turns 65, and thus would be cut out of a survivor pension from me).  The second reason is because currently, most money managers are using 6% as their assumption of what the market will yield over the next few decades.  Point of fact, the market HAS yielded approximately 8% over the past 100 years, despite certain notable Black periods such as the one beginning in 1929.

The essence is that if the CPPIB earns more than 3.89% at current benefit levels, or if I die between age 65 and age 88, the CPP will not have benefited me as contributor.  Further, even if I died prior to age 65, the CPP will not pay out to my surviving spouse or children in survivor benefits even as much as I contributed during my lifetime.

The importance of that knowledge  leads me to make one further question - if the CPPIB has to average slightly less than 2/3rds of the projected market yield in order to sustain current benefits, and it has to yield what the market it projected to yield in order to pay out double the maximum benefits, then why do contribution rates need to be increased?

Personally, what I would like to see in pension reform is a system where there is eventually no CPPIB.  I would like to see OAS GIS augmented to absorb the current CPP beneficiaries, and the current reserve apportioned to contributors based on their accumulated contributions.  In the meantime, the requirement for a CPP contribution would not go away, it would merely take the form of a mandated matched contribution to a locked in RRSP account which can not be accessed except on retirement (at age 65), disability or death.  The retirement account would be portable in that it moves with the individual, and like an RRSP, it would roll to your spouse tax-free upon death.  Most importantly, the individual would be responsible for investing the money and for determining their own annual income levels on retirement.

No, my reforms would not be fair for those people who didn't contribute enough during their lifetimes.  No, my reforms would not protect the individuals from market fluctuations (unless those individuals bought government T-Bills 5-7 years before they were due to retire).  What my reforms WOULD do is help nay FORCE individuals to create their own wealth for retirement and destroy the reliance not just on the government to provide for the poor, but destroy the current system which borrows from current generations to fund the short-sightedness of past generations.

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