Presentation at the Finance Circle of Quebec - Conference on retirement, institutional investment and personal finances: Canada Pension Plan Enhancement. Jean-Claude Ménard, Chief Actuary, Office of the Chief Actuary, OSFI, Quebec City, 8 November 2016

Good afternoon. Thank you for inviting me here today to talk about a very exciting development in the Canadian retirement landscape – the enhancement of the Canada Pension Plan.

Office of the Chief Actuary (Slide2)

Let me introduce myself. I am the Chief Actuary of the Office of the Chief Actuary (OCA) of the Office of the Superintendent Financial Institutions. The mandate of my office is to conduct statutory actuarial valuations of social insurance programs such as the Canada Pension Plan (CPP), the Old Age Security (OAS) program, Employment Insurance (EI) program, and the Canada Student Loans Program (CSLP), as well as of the federal public sector employee pension and benefits plans. All statutory actuarial reports that we prepare are tabled before Parliament by appropriate ministers.

As you can see, we are responsible for plans and programs that have impacts on almost every single Canadian.

Today, I will be talking about the enhancement to the CPP that is the result of the agreement in principle reached by nine provinces on June 20, 2016 in Vancouver. Let me emphasize, that my presentation reflects solely the views of the Office of the Chief Actuary.

CPP27: the Plan is expected to be able to meet its obligations over long term (Slide 3)

I would like to start by assuring you that the Canada Pension Plan is in a good financial health. The 27th CPP Actuarial Report as at 31 December 2015, tabled in Parliament on September 27, 2016, found that the minimum contribution rate needed to sustain the Plan is 9.79% of contributory earnings for the year 2019 and thereafter. This rate is below the legislated contribution rate of 9.9%.

The report also found that under the 9.9% contribution rate, the annual contributions are projected to cover annual expenditures up to 2020. Further, the assets are projected to grow to almost half of trillion by the end of 2025. However, even with the projected growth in assets, contributions are and will remain the main source of revenues for the CPP. In 2050, it is projected that the contributions and investment income will represent 67% and 33% of total revenues, respectively.

Bill C-26 amends the Canada Pension Plan, the Canada Pension Plan Investment Board Act and the Income Tax Act (Slide 4)

Bill C-26 which formalized the federal-provincial agreement in principle was tabled in Parliament on 6 October 2016.

Under this Bill, the amount of retirement pension is increased to provide a replacement rate of 33% compared to the current replacement rate of 25%, and the range of covered earnings is increased to 114% of the Year’s Maximum Pensionable Earnings (YMPE). The additional benefits are financed by additional contributions equal to 2% of earnings up to the YMPE, and 8% of earnings between the YMPE and 114% of the YMPE. Further, the expansion is phased-in over the period of seven years.

Finally, to help offset CPP contributions for eligible low-income workers, Bill C-26 includes provisions that both employee and employer contributions to the additional CPP would be tax deductible, and that the Working Income Tax Benefit would be increased.

Additional CPP strengthens link between contributions and benefits (Slide 5)

Bill C-26 sets out the financing objective for the additional CPP:  to have constant contribution rates that result in projected contributions and investment income that are sufficient to fully pay the projected expenditures of the additional CPP over the long term.

This financing objective is consistent with the gradual accrual of additional benefits, and the fact that no past service liability is created at the time the additional Plan is introduced. Both the financing of the additional Plan and its benefits design strengthen the link between contributions and benefits.

Insufficient rates provision of the current CPP serves as a safety net (Slide 6)

One of the most important elements of the base CPP governance is the insufficient rate provision. This provision prescribes how the contributions and benefits are modified in the case the contribution rate needed to sustain the base Plan is higher than the legislated rate. However, this provision is activated only in the case the CPP stewards (federal and provincial Ministers of Finance) do not agree on what needs to be done. That is, the primary responsibility with respect to the CPP financial health remains with the Ministers.

Bill C-26 introduced the analogous provisions for the additional CPP. As for the base CPP, every time when some actions are required, the first priority is given to the recommendations of Ministers. However there is an important difference with the base CPP: the provisions will be activated if additional contribution rates fall outside specified ranges, that is, the additional contribution rates may be lower than the legislated rates to trigger adjustments. Once again, such structure is consistent with the financing objective of the additional CPP, as well as with the wish to maintain the intergenerational equity.

Prescribed actions with respect to the benefits and contributions will be defined in future regulations.

The 28th CPP Report was tabled in Parliament on 28 October 2016 (Slide 7)

As required by the CPP legislation, the OCA has prepared the 28th CPP Actuarial Report which provides cost estimates with respect to the additional Plan. This report was tabled in Parliament on 28 October 2016.

The report found that the minimum constant first and second additional contribution rates needed to fulfil the additional Plan financing objective are 1.93% and 7.72%, respectively. These rates are lower than the legislated rates of 2% and 8%. Under these rates, future projected contributions and investment income are sufficient to cover the future expenditures, as shown by the open group balance sheet. The slide also shows that the ratio of additional assets to the following year’s expenditures stabilises at the level of 25 over the long term, thus ensuring the stability of the contribution rates.

For the additional CPP, investment income is the major source of revenues (Slide 8)

The gradual accrual of the additional benefits will result in about 40 years of positive cash flows to the additional CPP, and in the accumulation of sizable assets. As shown on the slide, by mid 2050s the additional CPP assets are projected to exceed the base CPP assets and will continue to grow.  It is projected that the additional assets will reach $1.3 trillion by 2050.

As discussed earlier, the financing approach of the base CPP implies that the contributions are and will remain the major source of the base Plan revenues. The adopted financing approach for the additional Plan results in the investment income being the major source of revenues. This will make the additional Plan more sensitive to investment environments as illustrated on the next slide.

Additional CPP will be sensitive to investment environments (Slide 9)

The 28th CPP Report assumes that the additional CPP assets mix is equivalent to a portfolio invested 50% in equities and 50% in fixed income securities. This portfolio volatility is 9.2% which is lower than the volatility of 11.4% of the assumed base CPP portfolio. The reduced volatility translates to a lower expected real of return on the additional assets (a difference of 40 basis points between the base and additional CPP assumptions).

The higher reliance of the additional Plan on investment income results in higher volatility of the minimum additional rates to changes in the investment environment. For example, a decrease in the best-estimate rate of return of 1% results in about 30% increase in the minimum additional contribution rates compared to about 8% increase in the minimum contribution rate for the base CPP.

Do persistent low-income workers benefit from CPP enhancement? (Slide 10)

I would like spend the remainder of my time by discussing the rationales of why the additional CPP covers earnings starting from the first dollar.

The main goal of the enhanced CPP is to improve the retirement preparedness of Canadians. At the same time, concerns were raised that the CPP enhancement is not necessary for low-income workers due to their entitlement to the GIS benefits.

So let’s look at whether persistent low-income workers benefit from the enhancement. We define persistent low-income workers as those who have at least 10 years of earnings between 10% and 50% of the YMPE.  Out of the CPP contributors’ cohort aged 65-69 in 2014, 50% or 0.7 million could be qualified as persistent low-income workers (green and blue shares of the pie).

The necessary condition to benefit from the CPP enhancement is the participation in the labour force. Thus, we should look only at persistent low-income individuals with sufficient labour force attachment, that is those who have less than 20 years absence from the labour force (blue share of the pie). It may surprise you, but out of this group more than 75% were not receiving GIS in 2014 and thus would fully benefit from the CPP expansion. Due to the family nature of the GIS benefit, this percentage is even higher for women.

Increasing lower earnings threshold would reduce replacement rates (Slide 11)

Excluding earnings up to a certain threshold (for example 50% of the YMPE) from the expansion would reduce the ability of the expansion to close retirement savings gap. As shown on this slide, an individual earning 50% of the YMPE throughout his/her career would not benefit from the expansion at all if the only the earnings over the 50% of the YMPE are covered by the expansion. Further, for an individual earning 100% of the YMPE, the total replacement rate would reduce from 32% to 28%.

Increasing the lower limit of covered earnings excludes some middle income workers from the enhancement (Slide 12)

Each year about 30% of CPP contributors have multiple employments during the year. Some of these individuals do not contribute sufficient amount to the CPP due to the fact that the basic exemption (YBE) is applied by each employer. Such contributors are given the option to cover both employer and employee portions of the contribution shortfall.

If the exemption is set at 50% of the YMPE, one quarter (almost 1 million in 2014) of such individuals as well as their employers would not make sufficient contributions to the enhancement and will end up with a lower retirement benefit than the one they would be entitled to if contributions were paid on total earnings from all jobs.

Thank you for your attention and I am happy to answer your questions.