Office of the Superintendent of Financial Institutions
Jean-Claude Ménard and Assia Billig, Office of the Chief Actuary, Office of the Superintendent of Financial Institutions, Canada23-24 February 2013
This paper examines the intergenerational aspects of the components of the Canadian retirement income system.
Canada’s retirement income system is based on a diversified approach to savings, in terms of the sources (private and public), coverage (mandatory and voluntary), and the financing methodology (pay-as-you-go, partial funding, or full funding). Pay-as-you-go financing means that expenditures are covered only when they arise. Partial funding means that a certain portion of expenditures is funded in advance of being paid. Lastly, full funding means that all expenditures are funded in advance.
The Canadian system rests upon three pillars. Pillar one is the Old Age Security (OAS) Program that provides a universal basic benefit payable at age 65 based on citizenship and years of residence. The OAS Program is financed on a pure pay-as-you-go basis from general tax revenues.
The second mandatory pillar consists of the Canada and Québec Pension Plans (CPP and QPP). The CPP and QPP are sister plans that both came into effect on January 1, 1966 and are deemed to be equivalent. Both plans provide a basic retirement pension to all workers, and are financed by employer and employee contributions, and also by investment earnings. These plans also provide disability, death, survivor, and children’s benefits. The Canada Pension Plan covers virtually all Canadians between the ages of 18 and 70 working outside of the province of Québec, while those working in Québec are covered by the Québec Pension Plan. For both plans, funds not immediately required to pay benefits are invested in the markets by the respective plans’ fund managers – the CPP Investment Board and the Caisse de Dépôt et Placement du Québec. Therefore, these plans are partially funded.
In Canada, the first two pillars replace about 40% of pre-retirement earnings for individuals with earnings at the average level. Such replacement rate is consistent with the goal set in the International Labour Organization Convention No.102.
The third pillar consists of voluntary private savings, which are generally fully funded. It includes tax-deferred savings in employer-sponsored Registered Pension Plans (RPPs) and individual Registered Retirement Savings Plans (RRSPs). RPPs and RRSPs permit Canadians to save on a tax-assisted (tax-deferred) basis to supplement public pensions (OAS and CPP/QPP) in order to meet their retirement income goals. The Tax-Free Savings Account (TFSA – available since 2009) is a general purpose tax-assisted (tax pre-paid) savings vehicle that may also be used for retirement saving. Governments are also moving ahead to introduce frameworks for Pooled Registered Pension Plans (PRPPs), a new large-scale, low-cost pension option that will be available to employers, employees and the self-employed.
The diversification of the Canadian system through its mix of public and private pensions and different financing approaches mitigates the multitude of risks to which the system and individuals’ retirement incomes are exposed. As stated in the editorial of the Organization of Economic Cooperation and Development’s Pension at a Glance 2011 publication: “Taking the long view, a diversified pension system – mixing public and private provision, and pay-as-you-go and pre-funding as sources of finances – is not only the most realistic prospect but the best policy” (OECD, 2011).
Measuring the intergenerational equity of a program can depend on several factors. What are the goals of this program: protecting from poverty, providing adequate retirement income, and /or minimizing the inequality of income in retirement? How is the program financed? Who bears the main burden of financing? Is it mandatory or voluntary? This list of questions could be extended further.
Finally, one can investigate the intergenerational balance of the retirement income system as a whole. Is the low-income level of the elderly population stable in relation to the low-income level of the general population? Is the society giving equal means to all cohorts to accumulate sufficient retirement resources?
In this paper, we will look at each of the three pillars of the Canadian system and try to identify intergenerational balance measures appropriate for each pillar. We conclude with a brief overview of the Canadian retirement income system as a whole.
The Old Age Security (OAS) Program is the first pillar of the Canadian retirement income system and provides a quasi-universal basic benefit (Basic OAS) currently payable at age 65. This benefit is based on citizenship and years of residence. An income-tested Guaranteed Income Supplement (GIS) is also payable to those who receive a basic OAS pension and who have little or no other income. All OAS Program benefits are indexed to inflation. Currently, about 97% of the Canadian population aged 65 and over receives the Basic OAS, and around 34% receives the GIS. The OAS is financed on a pay-as-you-go basis from general tax revenues.
The OAS benefits are relatively modest. For example, the maximum annual Basic OAS benefit in 2013 is $6,650 or approximately 13% of the average earningsFootnote 1. For single beneficiaries in 2013, the maximum annual GIS benefit is $8,890, which includes the maximum annual GIS top-up benefit of $610. However, since the GIS benefit is income-tested, the average payable GIS benefit (including top-up) was significantly lower at $5,900 per year in 2012. In 2013, OAS benefits are reduced for beneficiaries with earnings exceeding $70,950 and totally eliminated for beneficiaries with earnings exceeding $114,640.
In assessing the intergenerational balance of the OAS, it should not be forgotten that the goal of the OAS, as the first pillar of the Canadian retirement income system, is to reduce poverty. It is also important to remember that it provides Canadians with the minimum guaranteed income in the case of unexpected future events that could reduce their income from private retirement savings (such as unanticipated longevity, investment risk, and employer solvency risk associated with defined benefit pensions). The universality of the OAS Program allows aging Canadians to maintain their human dignity. Therefore, the steward of the OAS, i.e. the federal government, should balance the program’s paternalistic philosophy and its financial affordability.
As mentioned earlier, the OAS program is financed from general government revenues on a pay-as-you-go basis. As such, we consider that the stability of the level of expenditures is the best measure to assess the financial burden on different generations of taxpayers. To relate this measure to Canada’s economic growth, we express OAS expenditures as a percentage of the Canadian Gross Domestic Product (GDP).
Chart 1 shows the projected OAS expenditures as a percentage of GDP, as presented in the statutory triennial 9th Actuarial Report on the Old Age Security as at 31 December 2009 (the 9th OAS Report) (OSFI, 2011a). It can be seen that the ratio of expenditures to GDP was projected to be 2.3% in 2010, which is similar to what the ratio was in 1980 (not shown). After 2010, the ratio was projected to reach a high of 3.1% in 2030. This level is somewhat higher than the previous peak of 2.7% in the early 1990s. The dollar value of this increase is about $70 billion, from $37 billion in 2010 to $108 billion by 2030. The expected impact of inflation is responsible for 27% of this increase. The remaining two main contributing factors to the projected increase in costs over the 20-year period are the retirement of baby boomers (41% of the increase) and longevity improvements (32% of the increase).
After reaching a peak of 3.1% in 2030, the ratio of expenditures to GDP is projected to decrease to a level of 2.6% by 2050. This reduction is attributable to expected slower inflation growth compared to GDP growth and higher projected incomes of new retirees, resulting in lower GIS benefits. At the same time, the number of benefit recipients increases throughout the projection period ending in 2060.
Source: The 9th Actuarial Report on the Old Age Security Program as at 31 December 2009 (OSFI, 2011a)
In the two-year period following the tabling of the 9th OAS Report, the government enacted two sets of changes to the OAS Program. Firstly, in June 2011, the targeted increase in GIS benefits (GIS top-up) for the most vulnerable seniors was introduced. Similar to GIS benefits, the GIS top-up benefit is income-tested. The introduction of the GIS top-up is consistent with the main goal of the OAS Program – poverty reduction among seniors.
Next, the increase in the level of projected OAS expenditures by 2030, which is a reflection of the aging of the Canadian population, has prompted the Canadian government to make further changes to the OAS Program. In June 2012, the Canadian Parliament passed legislation increasing the OAS Program eligibility age from 65 to 67. The gradual increase will start in April 2023 with full implementation by January 2029. These increases do not affect Canadians who were older than 54 years as at March 31, 2012, and provides the rest of the population with a reasonable amount of time to adjust retirement planning behaviour. In addition, starting from July 2013, the OAS will allow for late retirement with actuarially adjusted benefits. Adjustment factors are designed to be actuarially neutral.
Chart 2 compares the evolution of the projected OAS expenditures before and after Program changes. The introduction of the targeted GIS top-up benefit increases the cost of the OAS Program; however, due to the modest size of this benefit and a limited number of eligible beneficiaries, the increase in the cost is small. On the other hand, the eligibility age increase significantly reduces the cost of the OAS Program. Both measures combined are expected to reduce the cost of the Program from $108 billion to $98 billion, a net reduction of $10 billion in 2030. It can be seen that the curve for the amended OAS is much flatter between 2023 (the beginning of the implementation of the eligibility age increase) and 2035. After that, it decreases at the same pace as the curve before the amendments.
Source: The 9th Actuarial Report on the Old Age Security Program as at 31 December 2009(OSFI, 2011a), and the 10th and 11th Actuarial Reports Supplementing the Actuarial Report on the Old Age Security Program as at 31 December 2009 (OSFI, 2011b and 2012a)
So what does this mean from the intergenerational balance point of view? The OAS Program is perceived as a fair program by Canadians because it gives all Canadians a minimum amount at retirement. While the cost of the OAS Program as a percentage of the GDP seems modest compared to other OECD countries, international comparisons need to be made carefully as there can be significant differences, both between the countries’ retirement income systems and between social programs providing support for seniors (e.g., in some cases, these programs are funded from a mix between government revenues and contributions). Also, it is not clear whether an international comparison could take into account all sources of government support, including tax assistance, provincial and municipal support (which exists in most jurisdictions in Canada, including through in-kind benefits), etc.
The planned eligibility age increase moderates the intergenerational transfer to the baby boomers generation because it reduces the overall cost of the program, therefore reducing the financial burden for younger cohorts. In addition, it addresses the costs associated with improving life expectancy by reducing the benefit payment period. Still, even with the increase in the eligibility age from 65 to 67, it is projected that future beneficiaries starting to receive benefits in 2030 will receive it for a longer period of time than their predecessors who started their benefits during the first decade of the 21st century.
The Canada Pension Plan (CPP) as well the Québec Pension Plan (QPP) came into effect on 1 January 1966 as earnings-related plans to provide working Canadians with retirement, disability, death, survivor and child benefits. These plans were established primarily to assist with income replacement upon retirement. The CPP covers virtually all Canadian workers outside the province of Québec, and is jointly administered by federal, provincial and territorial ministers of finance.
The CPP benefits are financed by employer and employee contributions, and it is projected that investment earnings will be used to pay a part of expenditures after 2021. Employers and employees share the cost equally at 4.95% of earnings above the Year’s Basic Exemption (YBE) (for low income earners), and up to a limit of the Year’s Maximum Pensionable Earnings (YMPE) which approximates the average earnings in Canada. The self-employed pay the full 9.9% on the same contributory earnings. The maximum contributory period is forty-seven years; that is, from age 18 to 65. The YBE has been fixed at $3,500 since 1997, whereas the YMPE increases each year in line with the percentage increase in the average weekly earnings as published by Statistics Canada, and is equal to $51,100 in 2013.
Some periods of low earnings may be excluded from the benefit calculation by reason of pensions commencing after age 65, disability, child rearing for a child less than seven years of age, and general drop-out provisions. The retirement pension is equal to 25% of career average earnings indexed to wage increases. The retirement pension is payable at age 65, but may be received as early as age 60 or as late as age 70, subject to a permanent actuarial adjustment. The CPP also provides disability, death, survivor, and children’s benefits. All CPP benefits are indexed to inflation. The 2013 maximum annual CPP retirement pension at age 65 is $12,150. However, the majority of beneficiaries do not receive the maximum amount. For example, in 2012, the average payable retirement CPP pension at age 65 was about 55% of the maximum.
The CPP was initially established as a pay-as-you-go plan with a small reserve and an initial combined employer-employee contribution rate of 3.6%. The CPP (and QPP) became the second pillar of Canada’s retirement income system.
At the time of its inception, the CPP design contained several features that affected the intergenerational equity of the Plan. First, the transition period for eligibility for the full retirement pension was set to 10 years. This transition period combined with the fact that the start of the contributory period was the later of either January 1, 1966 or contributor’s age 18, meant that all participants who were over age 18 at the inception date were eligible to receive the full CPP retirement pension after January 1, 1976, even if they contributed for less than the full 47 years contributory period. It should be noted, that the length of the transition period was a topic of extensive debates between the provinces. Several provinces and business organizations were pressing for a transition period of 20 years or even longer. However, the federal government, supported by unions, argued that the new plan should provide meaningful benefits for people close to retirement at the time of inception.
In addition, at that time, it was recognized that the contribution rate of 3.6% was expected to increase in the future. The Canada Pension Plan Actuarial Report produced in 1964 provided a range of long-term projections for scenarios assuming 3% and 4% annual increases in earnings (Department of National Health and Welfare, 1964). Both scenarios anticipated an increase in the contribution rate. For example, if a 4% increase in earnings was assumed (the more optimistic scenario), the combined contribution rate was projected to be between 4.1% and 5.2% in 2010, and between 4.3% and 7.1% by 2030.
The combination of low contribution rates and generous transition provisions resulted in much higher returns on contributions for earlier cohorts of beneficiaries than for the later ones.
The CPP was introduced with the goal of improving the adequacy of retirement income. At that time, a large number of Canadian workers were facing a sharp reduction in living standards upon retirement. Private pension plans, while growing in coverage, benefited only a limited percentage of the population. In addition, the lack of “portability” features of these private plans resulted in the loss of pension entitlement for employees who terminated employment before becoming vested. As such, the goal of a relatively quick reduction of poverty among seniors was more important at the time than the achievement of intergenerational equity.
The CPP and QPP in combination with the OAS were very successful in reducing poverty amongst seniors. The low-income rate among seniors was 37% in 1971 (compared to 16% for the overall population) and had decreased to 22% by 1981 (12% for the overall population)Footnote 2. Currently, Canada enjoys one of the lowest old-age low-income rates compared to other OECD countries (6% in 2008 compared to 11% for the overall populationFootnote 3).
Demographic and economic conditions in the 1960s were characterized by a younger population owing to higher fertility rates and lower life expectancies, rapid growth in wages and labour force participation, and low rates of return on investments. These conditions made prefunding of the Plan unattractive and a pay-as-you-go scheme more appropriate. Growth in total earnings of the workforce and thus contributions were sufficient to cover growing expenditures, even if some increases in the contribution rate were anticipated. The assets of the Plan were invested primarily in long-term non-marketable securities issued by the provincial governments at lower than market rates, thus providing the provinces with a relatively inexpensive source of capital to develop needed infrastructure.
However, changing conditions over time including lower birth rates, increased life expectancies and higher market returns led to increasing Plan costs and made fuller funding more attractive and appropriate. By the mid-1980s, the net cash flows (contributions less expenditures) had turned negative and part of the Plan’s investment earnings were required to meet the shortfall. The shortfall continued to grow and eventually caused the assets to start decreasing by the mid-1990s. The fall in the level of assets resulted in a portion of the reserve being required to cover expenditures. The contribution rate remained fixed at 3.6% up to the mid-1980s, and then was gradually increased, reaching 5.0% by 1993 and 5.6% by 1996.
In the December 1993 (15th) Actuarial Report on the CPP (OSFI, 1995), the Chief Actuary projected that the pay-as-you-go contribution rate (expenditures as a percentage of contributory earnings) would increase to 14.2% by 2030. It was further projected that if changes were not made to the Plan, the reserve fund would be exhausted by 2015. The Chief Actuary identified four factors responsible for the increasing Plan costs, namely: lower birth rates and higher life expectancies than expected, lower productivity, benefit enrichments and increased numbers of Canadians claiming disability benefits for longer periods. It was clear that the intergenerational equity was compromised with younger workers required to pay increasing contributions without guarantee that they would receive their own benefits.
The projected increasing financial burden on workers to financially maintain the Plan led to the federal, provincial, and territorial governments’ decision to consult with Canadians in a review of the Plan and to restore its long-term financial sustainability. Following the cross-country consultations held in 1996, the federal, provincial, and territorial governments agreed to amend the Plan (changes to the CPP require the approval of at least 2/3 of Canadian provinces representing at least 2/3 of the country’s population). Guiding principles developed for that purpose stated in particular that the solutions to the CPP’s problems must be fair across generations and between men and women (Finance Canada, 1996).
The changes to restore the financial sustainability of the CPP were legislated in 1997 and became effective on 1 January 1998Footnote 4. The 1997 changes were based on the principles of increasing the level of funding in order to stabilize the contribution rate, improving intergenerational equity, and securing the financial status of the Plan over the long term. Key changes included:
A major change was to modify the financing approach from a pay-as-you-go basis to a hybrid of pay-as-you-go financing and full funding, called “steady-state funding”. Steady-state funding is a partial funding approach under which the level of prefunding depends on the best-estimate assumptions, and the main goal is the stabilization of the ratio of assets to expenditures (A/E ratio) over time.
Steady-state funding involves a steady-state contribution rate that is the lowest rate sufficient to ensure the long-term financial sustainability of the Plan without recourse to further rate increases. This rate is calculated by the Chief Actuary based on legislated regulations and is part of each triennial actuarial valuation of the Plan. The steady-state contribution rate ensures the stabilization of the A/E ratio over time. Specifically, the legislation requires that the steady-state contribution rate be the lowest rate such that the A/E ratios in the 10th and 60th year following the 3rd year of the most recent review period be the same.
The steady-state methodology results in a stable contribution rate over the long term and helps to improve intergenerational equity. When the CPP financing methodology was examined in 1997, intergenerational equity was one of the primary concerns. Maintaining a pure pay-as-you-go approach would have resulted in significant increases in the contribution rate over time to provide the same benefits. On the other hand, moving to a full funding approach would also have created unfairness across generations, as some generations would have been required to pay higher contributions than others to cover both their own past unfunded liability as well as the past unfunded liability of current retirees. Thus, the financing of the CPP was moved from a pay-as-you-go approach to partial funding, which resulted, in particular, in building a much larger fund than the one before the amendments. The partial funding approach provides a balance between pay-as-you-go and full funding and contributes to the diversification of the financing of Canada’s retirement income system. This diversification of financing approaches, in turn, strengthens the system against possible fluctuations in demographic, economic, and financial market conditions.
At the time of the 1997 amendments, the steady-state contribution rate was determined to be 9.9% for the year 2003 and thereafter as shown in the September 1997 (16th) Actuarial Report on the CPP (OSFI, 1997). The legislated contribution rate was thus scheduled to increase incrementally from 5.6% in 1996 to 9.9% in 2003 and to remain at that level thereafter. The legislated rate has remained at 9.9% in accordance with the schedule.
In addition, incremental full funding was introduced in order to require that changes to the CPP that either improve or add new benefits be fully funded. That is, the costs of these benefits must be paid as the benefit is earned, and any costs associated with benefits that have already been earned must be amortized and paid for over a defined period of time consistent with common actuarial practice. These additional costs may take the form of temporary and/or permanent contribution rate increases. The steady-state rate is determined independently of the incremental rate. As such, the Plan is financed on a dual basis – the steady-state rate applies only to the basic Plan, whereas the incremental rate applies to new or improved benefits since 1997. The resulting sum of the steady-state and incremental rates is the minimum contribution rate of the Plan.
Both of these funding objectives were introduced to improve fairness and equity across generations, as well as to improve the long-term financial sustainability of the Plan. The move to steady-state funding eases some of the contribution burden on future generations. Under incremental full funding, each generation that will receive benefit enrichments is more likely to pay for it in full so that its costs are not passed onto future generations.
The 1997 amendments also strengthened stewardship and accountability to Canadians in order to avoid future situations similar to the one that arose during the 1990s. Specifically, the frequency of statutory periodic reviews of the CPP by the federal and provincial finance ministers was increased from once every five years to every three years. During such reviews, ministers of finance examine the financial status of the Plan and make recommendations as to whether benefits or contribution rates, or both, should be changed. If a triennial review reveals that major Plan changes are required, Canadians must be informed prior to any such changes being made.
The actuarial reports on the CPP produced by the Chief Actuary are one of the main sources of information used for these reviews. Further to the changes of 1997, the federal, provincial and territorial finance ministers took additional steps in 1999 to strengthen the transparency and accountability of actuarial reporting on the CPP. They endorsed regular independent peer reviews of actuarial reports and consultations by the Chief Actuary with experts on the assumptions to be used in such reports.
The actuarial reports on the CPP contain information on the minimum contribution rate, as well as projections of the Plan contributions, expenditures and assets. They present detailed analyses of the demographic and economic factors that impact the financial status of the CPP. The main results of the reports are based on best-estimate assumptions without any provisions for adverse deviation, in order to avoid bias with respect to either current or future generations. However, the actuarial reports also contain a section on the uncertainty of results, where alternative scenarios are explored. This section provides decision makers with insights on how specific demographic and economic factors could impact the financial status of the CPP.
The CPP actuarial reports are tabled in Parliament and are published on the Office of the Chief Actuary’s website. Following the tabling, these reports are reviewed by an independent panel of Canadian actuaries. This panel is chosen by the UK Government Actuary's Department which, in addition, provides its opinion on the independent review report at the end of the process. To ensure the transparency, press releases are issued at each step of the review process, and the final independent review report is made public. The most recent fifth independent review of the statutory actuarial report on the CPP confirmed that the work of the Chief Actuary meets professional standards of actuarial practice and is of sound quality (Andrews, Brown and McGillivray, 2011). To ensure the quality of future actuarial reports, the Chief Actuary continues to consult with experts in the fields of long-term demographic and economic projections.
Lastly, the insufficient rates provisions, a form of self-sustaining provision, were also put in place to safeguard the Plan in the event that the minimum contribution rate exceeds the legislated contribution rate and that no recommendation is made by the federal and provincial Ministers of Finance with respect to the changes to contributions and/or benefits. The insufficient rates provisions cause an automatic increase in the legislated contribution rate to be phased-in within three years and benefits to possibly be frozen (i.e., no indexation to inflation) until the next review. Whether or not freezing of benefits occurs under the insufficient rates provision depends on the values of the steady-state, incremental, and legislated contribution rates. In this way, the CPP insufficient rates provisions share the cost between generations, i.e. between contributors and beneficiaries.
It was argued in actuarial literature (Andrews, 2009; Monk and Sass, 2009) that the CPP insufficient rate provision allocates higher burdens to beneficiaries. However, the degree of the cost sharing depends in part on the magnitude of the increase in the minimum contribution rate relative to the legislated rate: the greater the increase, the greater the proportion of the costs borne by contributors. It also depends on the length of time that benefits are frozen. In addition, it should be taken into account that when this policy was formulated, the general societal sentiment was that the current beneficiaries had made smaller contributions to the CPP, so it would be fair for them to bear a higher burden for the adjustment (Little, 2008). Of course, this sentiment disappears over time.
However, the most important reason for the current CPP insufficient rate provision design is that it is not really expected to be applied. This design provides the system with a safety net without diminishing responsibility of the CPP stewards for the Plan’s soundness.
It should be noted that the Canada Pension Plan legislation permits the federal and provincial governments to maintain the legislated contribution rate below the level necessary to meet the Plan’s financing provision – at least for the near term. Such a decision to maintain the rate can be appropriate given the prevailing conditions surrounding the Plan around the time of a review. However, the transparency of the CPP financial reporting and its frequency ensure that, firstly, the stewards of the Plan are informed in a timely manner of any forthcoming long-term problems, and, secondly, that the Canadian public has a chance to have its say on the decisions made by CPP stewards.
In summary, the financial sustainability and intergeneration equity of the Plan are being closely monitored. The discussed measures ensure strengthened stewardship, accountability and transparency regarding the Plan and its finances.
The Canada Pension Plan is an evolving program that adapts to changing economic and demographic conditions. In this subsection, we will discuss recent changes introduced to the CPP which, in our opinion, serve to strengthen the intergenerational fairness of the Plan.
The first change is restoring the CPP pension adjustment factors to their actuarially fair value. Originally, flexible retirement provisions were introduced to the CPP in 1987 to allow individuals to start receiving an actuarially adjusted retirement pension as early as age 60 and as late as age 70. Since then, the retirement pension was permanently adjusted downward or upward by 0.5% for each month between age 65 and the age at which the pension commences. The adjustment is required to take into account the fact that, in the case of early benefit uptake, fewer years of contributions will be made and more years of benefits will be received, and that the opposite occurs in the case of retirement benefit uptake after the normal retirement age of 65.
However, since 1987, there have been significant demographic and economic changes affecting the level of the pension adjustment factors. As a result, the pension adjustment factor of 0.5% per month became too generous for contributors who elected to start their retirement benefit before age 65; that is, early benefit uptake was subsidized. Conversely, the adjustment factor for contributors who elected to start their retirement benefit after age 65 was not generous enough; that is, late benefit uptake is penalized. As a result, it was decided in 2009 to gradually restore the pension adjustment factors to their actuarially fair values of 0.6% per month for retirement before age 65, and to 0.7% per month for retirements after age 65 (for future retirement beneficiaries).
This amendment further requires the Chief Actuary to report on the actuarially fair level of the pension adjustment factors in at least every third triennial actuarial report (i.e. at least every 9 years) starting in 2016. Finance Ministers will review these pension adjustment factors based on the assessments of the Chief Actuary and recommend whether any changes are needed.
Another set of changes to the CPP were also made in 2009 in response to changing patterns of how Canadians retire. As shown by Chart 3, the number of CPP beneficiaries who combine pension and work has increased dramatically during the last decade. However, prior to the changes, such individuals could not contribute to the CPP on any future earnings from employment once the benefit started being paid. As a result, these participants were not able to continue to build their CPP pension, and the Plan was not fully benefiting from the increase in labour force participation for the age groups 60 and over.
To rectify this situation, it was decided to amend the Plan to require individuals under the age of 65 who both receive a CPP retirement benefit and continue to work, as well as their employers, to make CPP contributions. Working beneficiaries aged 65 to 69 are not required to contribute to the Plan, but employers of those opting to do so are required to contribute. The contributions paid provide for a post-retirement benefit earned at a rate of 1/40th of the maximum CPP retirement pension per year of additional contributions and is adjusted for the earnings level and age of the contributor. The resulting total pension may be greater than the maximum pension.
The amendments discussed above are good examples of how the CPP governance framework results in the strengthening of its intergenerational balance in changing economic and demographic environments.
The three measures that we consider appropriate for assessing the intergeneration status of the CPP are the evolution of the asset/expenditure ratio (i.e. stability of the contributions rate), the internal rate of return for different cohorts, and the actuarial balance sheet position of the Plan. All measures discussed below assume that both the current legislated contribution rate of 9.9% and current benefits will remain unchanged.
Stability of the contribution rate
The stability of the contribution rate is the main objective of the steady-state financing methodology. The legislated employer/employee contribution rate of 9.9% has remained unchanged since 2003. At the same time, the CPP actuarial reports produced during the last decade estimated the minimum contribution rate being slightly lower than the legislated contribution rate. Under the most recent 25th Actuarial Report on the Canada Pension Plan as at 31 December 2009 the steady-state contribution rate was determined to be 9.84% and the minimum contribution rate to be 9.86%Footnote 5 (OSFI, 2010). Table 1 presents the projected financial status of the CPP based on the 25th CPP report. It can be seen that a substantial increase in benefits paid is projected as a result of the aging population. However, even if the net cash flow (contributions minus expenditures) of the Plan becomes negative, the assets are projected to grow.
(1) Investment income includes both realized and unrealized gains and losses.
(2) As at September 30, 2012, the investment portfolio of the CPP totalled C$170.1 billion, and 60% of the portfolio was invested outside of Canada.
Source: Table 1 is an extract of Table 11 in the 25th CPP Actuarial Report (OSFI, 2010).
Under this report, with the legislated rate of 9.9%, the A/E ratio is expected to grow to 4.7 by 2020 and 5.2 by 2050.
Source Chart 4 corresponds to Chart 2 of the 25th CPP Actuarial Report (OSFI, 2010).
In summary, the results of the 25th CPP Report show that under the current contribution rate of 9.9% and assuming no reduction in future benefits, the CPP is expected to meet its obligations throughout the projection period and remain financially sustainable over the long term.
Internal rate of return
The internal rate of return is, with respect to a group of CPP participants born in a given year (i.e. a cohort), the unique interest rate resulting from the equality of:
Accordingly, actual internal rates of return cannot be determined until the last member of the cohort has died. However, they can be estimated based on the historical and projected experience of the cohort. Internal rates of return are dependent on many assumptions as to future experience, such as those regarding the age at pension take-up, life expectancy, the actuarial adjustment factor applied to the pension, etc. The internal rates of return presented in Table 2 are calculated on the basis of the best-estimate assumptions of the 25th CPP Actuarial Report and using the legislated contribution rate of 9.9%.
These rates are based solely on contributions paid and benefits received; that is, administrative expenses associated with each cohort are excluded. Results are shown on two bases, as both nominal and real internal rates of return. To determine the real internal rates of return, both contributions and benefits were first adjusted to remove the impact of price increases.
Source: Table 3 corresponds to Table 34 of the 25th CPP Actuarial Report (OSFI, 2010).
The differences in rates provide an indication of the degree of intergenerational transfer present in the Plan. The higher internal rates of return of the earlier cohorts mean that they are expected to receive better value from the CPP than those who follow. This is not surprising given transitional measures at the Plan’s inception, as discussed earlier in this paper. However, the internal rates of return stabilize for cohorts born after 1970, i.e. cohorts who paid higher contributions.
Actuarial balance sheet of the CPP
The choice of the methodology used to produce a social security pension system’s balance sheet is mainly determined by the system’s financing approach. For fully funded systems, the accrued liabilities are assumed to be funded in advance; therefore, balance sheets under closed groups with or without future accruals are appropriate for such plans. On the other hand, pay-as-you-go and partially funded systems represent social contracts where, in any given year, current contributors allow the use of their contributions to pay current beneficiaries’ benefits. As a result, such social contracts create a claim for current and past contributors to contributions of future contributors. The proper assessment of the financial sustainability of a social security pay-as-you-go or partially funded system by means of its balance sheet should take these claims into account. The traditional closed group methodologies do not reflect these claims since only current participants are considered. In comparison, the open group approach accounts explicitly for these claims by considering the benefits and contributions of both current and future plan participants. Thus, the open group valuation that emphasises the long-term nature of the CPP is deemed to be the most appropriate.
An open group is defined as one that includes all current and future participants of a plan, where the plan is considered to be ongoing into the future; that is, over an extended time horizon. This means that future contributions of current and new participants and their associated benefits are included in order to determine whether current assets and future contributions will be sufficient to pay for all future expenditures.
Another important element of the methodology used to determine the components of the CPP balance sheets is the length of the projection period. The CPP legislation requires the Chief Actuary to present financial information for at least a 75-year period following the valuation date. At the same time, limiting of the projection period to 75 years for the open group balance sheet excludes from the liabilities part of the future expenditures for cohorts that will enter the labour force during the projection period. However, most of the contributions for these cohorts are included in the assets. Therefore, we use the projected cash flows over an extended time period of 150 years. It should be noted that, while enhancing the assessment of the financial sustainability and the intergenerational equity of the Plan, increasing the length of the projection period also increases the uncertainty of projections.
To determine the actuarial liability of the Plan under the open group approach, future expenditures with respect to current and future Plan participants are first projected using the best-estimate assumptions of the 25th CPP Actuarial Report. Next, these total projected expenditures are discounted using the expected nominal rate of return on CPP assets to determine their present value. This is the actuarial liability under the open group approach.
To determine the assets of the Plan under the open group approach, future contributions of current and future contributors are projected using the best-estimate assumptions of the 25th CPP Actuarial Report and the legislated rate of 9.9%. These total projected contributions are then discounted using the expected nominal rate of return on current CPP assets to determine their present value. This present value is added to the Plan’s current assets to obtain the total assets of the Plan. Table 3 presents the CPP open group balance sheets as at December 31, 2009 and 2019.
(1) Liabilities include administrative expenses.
Source: Table 4 is an extract from Table 5 in Actuarial Study no. 10 (OSFI, 2012a).
The asset shortfall under the open group methodology as at 31 December 2009 is $7 billion and the total assets covers 99.7% of the actuarial liabilities. Given the extended projection period and the associated uncertainty, it confirms that future CPP beneficiaries will receive promised benefits with a stable contribution rate.
The third pillar of the Canadian retirement income system consists of tax-assisted voluntary private savings, which are fully funded or are intended to be fully funded. These savings are held principally in employer-sponsored Registered Pension Plans (RPPs) and individual Registered Retirement Savings Plans (RRSPs). RPPs are governed by federal or provincial pension legislation with the goal of setting minimum benefits standards and protecting pension rights. RPPs include both Defined Benefit (DB) and Defined Contribution (DC) plans, as well a variety of hybrid designs. RPPs and RRSPs are also governed by the federal Income Tax Act (the ITA), which sets out specified rules and limits for such plans, and must be registered with the Canada Revenue Agency. A deferral of tax is provided on savings in RPPs and RRSPs: contributions and investment earnings are not taxable; however, the benefits payments are.
The Tax-Free Savings Account (TFSA – available since 2009) is a general purpose, tax-assisted, registered savings vehicle that may be used for any savings objective, including retirement saving. Contributions to a TFSA are made from after-tax income (they are not deductible), but investment earnings and withdrawals are not taxable. While the response to TFSAs has been extremely positive since its implementation in 2009 – the number of Canadians with a TFSA increased from 4.9 million in 2009 to 8.2 million in 2011, close to a 70% increase – it remains to be seen to what extent TFSA savings will be used for retirement income needs.
Assessing the intergenerational equity of the third pillar is complicated for several reasons. Firstly, the third pillar, being a voluntary one, is often fragmented. It includes arrangements representing a wide variety of design, and does not necessarily cover the whole population. Secondly, even if the full funding of the third pillar’s programs implies that each cohort is paying for its own benefits, the external environment can impact the value of benefits for different cohorts within the same arrangement. The economic and financial crisis of the 2008-2009 serves as a good example. For all participants of DC plans, account balances and, therefore, future benefits were eroded. However, the magnitude of this erosion was much higher and much more important for people nearing retirement. As a result, different cohorts contributing the same amount will receive different benefits. While there is no direct intergenerational transfer within a DC plan, the indirect transfer can occur due to a higher reliance of affected cohorts on the first and second pillars of the retirement income system.
For DB plans, external shocks as well as ongoing factors such as a low interest environment can lead to funding shortfalls and thus the necessity to cover those shortfalls (excess of accrued pension liabilities over the existing pension assets). The answer to the question of how this shortfall burden could be shared between employer, current contributors and current beneficiaries could affect the intergenerational balance of a DB plan. For example, the quite obvious approach for plans that provide inflation protection after retirement would be to temporarily reduce such protection for current retirees, as well as increase contributions for current contributors. While some Canadian plans are starting to adopt this approach, the situation is complicated by the fact that Canadian pension legislations protect accrued benefits; therefore, if a DB plan wishes to introduce some form of the “conditional” indexation protection, it could only be done for future service. As such, even if DB plans are starting on the road of managing intergenerational transfers, it will take quite some time for the full impact of recent changes to materialize.
Countries that enjoy a significant replacement rate from mandatory schemes (both public and private) often do not have, and probably do not need, a well-developed system of private voluntary pension schemes. However, this is not the case in Canada. As mentioned in the beginning of this paper, the gross replacement rate for an average earner from the CPP and OAS is around 40%. Therefore, it is important to provide a favourable and equitable saving environment for each generation of Canadians.
Intergenerational equity for the third pillar also depends on how each generation diversify their savings amongst various savings instruments (such as RPPs, RRSPs and TFSAs) and the availability of such instruments over time. As such, to arrive at a complete picture, non-third pillar savings (such as housing and unregistered financial assets) would also need to be taken into account.
In the beginning of the 1990s, the Canadian tax rules were changed to create a level saving playing field for Canadians independent of their participation in registered employer-sponsored pension plans. While these reforms addressed the intra-generational balance, they did not result in increased coverage of Canadians by RPPs and RRSPs.
The total number of active RPP members as a percentage of the labour force declined from 34% in 2000 to 32% in 2010. The RPP coverage in the public sector remained relatively constant around 87% of public sector employees from 2000 to 2010, while the RPP coverage in the private sector decreased from 28% to 24% of private sector employees. Further, the share of tax filers contributing to a RRSP also decreased from 29% to 24% between 2000 and 2010. (OSFI, 2012c).
In addition to the decline in RPP coverage, there has been a shift from Defined Benefit (DB) to Defined Contribution (DC) plans and other plans. Overall, the proportion of active RPP members in DB plans declined from 84% to 74% over the last ten years. While the reduction in DB coverage was significant in the private sector (from 76% to 52%), it did not occurred in the public sector (stable at 94%) (OSFI, 2012c).
These trends have prompted the Canadian government to examine the retirement savings behaviour of Canadians and to decide on the steps that need to be taken to address the risk of under-saving for retirement. The public debates were mainly focused on two possibilities: expanding the CPP and expanding coverage by RPPs.
The option of expanding the Canada Pension Plan would result in strengthening of the mandatory part of the Canadian retirement income system. The discussions were focused on a modest, fully funded and phased-in expansion. The proponents for this approach are arguing that the CPP provides secure and portable benefits delivered with low-cost administrative and investment fees. The opponents were concerned by the burden that additional contributions could put on businesses. To date, the possible expansion of the CPP remains under discussion.
At the same time, the government took concrete steps aimed at expanding the coverage of the Canadian labour force by RPPs. The Pooled Registered Pension Plans (PRPP) legislation was adopted in the summer of 2012. The PRPP allow for the pooling of DC plans and are expected to result in low administrative and investment costs. Furthermore, the benefits will be fully portable. Another attractive feature of the PRPP for small businesses is that it transfers fiduciary responsibility for the plan from the employer to the plan’s provider (e.g. an insurance company). The particulars, such as mandatory versus voluntary participation, minimum employer/employee contributions, annuitization of benefits, etc. will be legislated by each province for plans offered within a particular jurisdiction. It remains to be seen how popular the PRPP will be with employers and workers, and what impact they will have on the adequacy of Pillar 3 benefits.
The Canadian retirement income system generally performs quite well from the intergenerational balance point of view. Chart 5 shows that from the beginning of the 1990s, the relationship between the elderly low-income rate and the general population low-income rate is quite stable; that is, there are no apparent intergenerational subsidies.
Data Source: LIS Cross-National Data Center in Luxembourg, http://www.lisdatacenter.org/lis-ikf-webapp/app/search-ikf-figures
The Canadian retirement income system is an evolving structure and the emerging intergenerational imbalances are corrected periodically. The 1997 amendments to the CPP are an excellent example of problems identified and corrected. Given the strong governance framework for the CPP as well as the CPP insufficient rate provisions, it is unlikely that problems of this magnitude will arise in future. The 2012 amendments to the OAS Program are another example of corrective actions.
Source: This is an extract of Table 1 in the 25th CPP Actuarial Report (OSFI, 2010).
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Report Abu Dhabi and Dubai separately from other members of United
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