Office of the Superintendent of Financial Institutions
Good afternoon. It is my pleasure to be here to talk about measuring and reporting of actuarial obligations of the Canada Pension Plan.
About the speaker (Slide 2)
Let me introduced myself. I am Jean-Claude Ménard, Chief Actuary of the Office of the Chief Actuary (OCA) which is a part of the Office of Superintendent of Financial Institutions in Canada. Our office is responsible for preparing the actuarial reports of the Canada Pension Plan, the Old Age Security, Employment Insurance and Canada Student Loans Programs, and pension and benefits plans covering members of the federal Public Service, the Canadian Forces, the Royal Canadian Mounted Police, federal judges and Members of Parliament.
Canadian Retirement Income Security System: Not all eggs in the same basket! (Slide 3)
Let me start by giving you a brief overview of the Canadian retirement income system. At retirement, most Canadians will receive an income from one or more of the three tiers of our system: Old Age Security program, Canada/Quebec pension plans and occupational pension plan or dedicated individual pension savings plans.
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".
Financing the CPP (Steady-State Funding) (Slide 4)
The Canada Pension Plan – CPP – is a part of the second pillar. It is financed on a steady-state basis which is a partial funding approach aimed at stabilizing the asset to expenditure ratio. At the same time, improved or new benefits are required to be fully funded.
The two main sources of CPP financing are employer/employee contributions and investment income. The chart presented on this slide shows that while the importance of the investment income as a source of revenues increases over time in line with the overall growth in the CPP assets, contributions are projected to remain the main source of revenues for the Plan. According to the projections of the 27th CPP Actuarial Report, contributions are expected to represent about 65% of total CPP revenues over the long term.
So let me emphasize that the Canada Pension Plan was never intended to be fully funded, in a sense that the invested assets are sufficient to cover accrued-to-date benefits. Further, the Plan was never subsidized by the Government, and its financing and governance structure ensures that no subsidies will ever be needed.
The key concepts of financing objectives of the Plan are sufficiency and stability of contribution rates, and long-term nature of the plan.
Evolution of Asset/Expenditure Ratio (Slide 5)
In line with the financing objectives of the Plan, the steady‑state financing was introduced in the mid-1990s to build a greater reserve of assets over time. Investment earnings on this pool of assets in turn help to stabilize the contribution rate and asset/expenditure ratio (the ratio of assets at the end of one year to the expenditures of the next year). The key legislatively prescribed measure for evaluating the Canada Pension Plan is the steady-state contribution rate defined as the lowest constant contribution rate that results in the projected asset/expenditure ratio of the Plan being the same in the 13th and 63th years following the date of the actuarial valuation.
Under the assumptions of the 27th CPP Actuarial Report and the legislated rate of 9.9%, the A/E ratio is projected to be stable up to 2030, and then to increase over the next two decades reaching 7.3 in 2050. The A/E ratio determined using the minimum rate of 9.79% (dotted line) is below the one using the legislated rate (solid line) and slightly decreases between 2017 and 2030 due to the retirement of the baby boom generation.
Under the legislated contribution rate of 9.9%, the Plan's assets are expected to reach $476 billion by the end of 2025.
CPP assets and obligations (Slide 6)
As I stated, the sufficiency and stability of the CPP contribution rate is the main measure of its financial health. However, other measures such as relative size of assets and obligations of the CPP may provide meaningful indications when examining the financial state of the Plan.
Assets and obligations may be measured using three main approaches.
Under the closed group without future accruals approach, no new entrants are permitted, and current plan participants who are not receiving benefits at the valuation date are assumed to make no further contributions, and hence no further benefits accrue. Since there will be no future contributions, the assets of the plan correspond to the invested assets. The obligations correspond to the projection of future benefits of current contributors for past service and the future benefits of current pensioners.
Under the closed group with future accruals approach there are no new entrants. However, current contributors are assumed to continue contributing to the plan. Therefore, the assets correspond to the sum of the invested assets and the future contributions from current contributors. Accordingly, the future benefits of current contributors in respect to the past and future service are considered in the determination of the obligations as well as future benefits of current pensioners.
The open group approach includes all current and future participants of a plan since the plan is considered to be ongoing into the future. Therefore, the assets include future contributions from the current and future contributors and the future benefits of current and future participants are included in the obligations.
Social security pension system's balance sheet should reflect the system's financing approach and its membership (Slide 7)
So which methodology is appropriate to 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. This is supported by the actuarial standards of practice of the Canadian Institute of Actuaries.
For fully funded systems, i.e. systems which are expected to have invested assets sufficient to pay for all accrued-to-date benefits of current participants at any given date, the accrued obligations are assumed to be funded in advance. Therefore, balance sheets determined under a closed group without future accruals approach are appropriate for such plans.
The balance sheets under a closed group with future accruals approach correspond to the situation when, for example, a social security system is closed to new entrants and allows future accruals to current participants. In such situations, the system would rely on the existing invested assets and future contributions of current participants to pay for their current and future benefits.
On the other hand, pay-as-you-go and partially funded systems represent social contracts with current contributors allowing 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 open group approach accounts explicitly for these claims by considering the benefits and contributions of both current and future plan participants.
CPP groups with or without future benefit accruals – Balance sheet at 31 December 2015 (Slide 8)
This slide compares the CPP balance sheets under a closed group without future accruals, and closed and open groups with future accruals approaches.
Compared to the open group, the asset shortfall for the closed groups is larger since these approaches do not fully account for future contributions as a major source of financing for the Plan.
Valuing the Plan on an open group basis shows that the Plan is able to meet its financial obligations and is sustainable over the long term. This result is consistent with the results produced by the legislated steady-state methodology.
If the CPP financial sustainability is to be measured using balance sheet, it should be done on an open-group basis that reflects the partially funded nature of the CPP (Slide 9)
To reiterate, the CPP is intended to be long-term and enduring in nature. Therefore, if the Plan's financial sustainability is to be measured based on its asset excess or shortfall, it should be done on an open group basis that reflects the partially funded nature of the Plan, that is, its reliance on both future contributions and invested assets as means of financing its future expenditures. The closed group methodologies do not fully account for future contributions as a major source of financing for the Plan.
The inclusion of future contributions and benefits with respect to both current and future participants in the assessment of the Plan's financial state confirms that the Plan is able to meet its financial obligations and is sustainable over the long term.
Open Group Modified Balance Sheet – Description and Purpose (Slide 10)
The balance sheet for the open group may be presented in a modified way so that the assets and obligations of the pay-as-you-go and funded components are shown separately. Under the pay-as-you-go component, contributions always exactly equal expenditures in any given year. Contributions for the funded component exist as long as the current year's contributions exceed the same year's expenditures. These excess contributions are added to the Plan's invested assets, while expenditures in excess of contributions create the funded component's obligations.
By modifying the balance sheet in this way, the hybrid nature of the steady-state partial funding of the Plan is highlighted. This modification also allows for a clearer understanding of how the Plan's future expenditures are financed.
Open-Group Modified Balance Sheet (Slide 11)
The open-group modified balance sheet could be built in two steps. As shown in this slide, the present values of the contributions and expenditures on the assets and obligations sides of the balance sheet are separated out.
On the left, the assets are split in three parts: the present value of future contributions that cover future expenditures (yellow bar), the present value of future contributions in excess of future expenditures (orange bar), and the current assets as at the end of 2015 (purple bar).
On the right, the obligations are split into two parts: the present value of future expenditures covered by future contributions (yellow bar), and the present value of future expenditures not covered by future contributions (orange bar).
Open-Group Modified Balance Sheet (Slide 12)
The second step consists of regrouping the present values of the future contributions and expenditures into the pay-as-you-go and funded components. The chart clearly shows that no asset excess or shortfall exists with respect to the pay‑as‑you‑go component.
Under pay‑as‑you‑go financing, while both the present values of the assets and obligations could vary depending on past experience and future actuarial assumptions, they will always remain equal. Under the funded component, an asset excess results when the total assets, consisting of the current invested assets and the present value of future contributions in excess of future expenditures, are more than sufficient to pay the future expenditures not covered by future contributions. In the case of the open group under the best‑estimate scenario, the asset excess is $1 billion as at 31 December 2015.
The closed group approach does not provide any information regarding the changing cost of the CPP when fertility expectations change (Slide 13)
Over the next few slides, I will discuss how balance sheets prepared under open group and closed group without future accruals approaches react to alternative economic and demographic expectations.
Let's start with fertility. The higher total fertility rate leads to an increase in the number of contributors in the medium and long term and eventually to an increase in the amount of benefits paid in the long term. Under the steady-state methodology, higher fertility rate assumptions results in a lower contribution rate. The CPP balance sheet under the open group approach produces an asset excess of $139 billion which is higher than the $1 billion under the best-estimate assumptions. This is consistent with results obtained using the steady-state methodology. The situation is reverse for lower fertility rate assumptions.
The balance sheet under the closed group approach does not provide any information regarding the changing cost of the CPP under the alternative total fertility rate assumptions: both the asset shortfall of $886 billion and assets as a percentage of obligations of 24.4% remain unchanged. This is a direct result of the backward-looking nature of the closed group methodology, which does not reflect the reliance of the Plan on future contributions as a major source of financing. The same conclusion could be reached with respect to any other assumption that impacts only future participants, such as the net migration rate.
The younger generations who are affected the most by the changes in future mortality are either not included at all under the closed-group or have low accrued-to-date benefits (Slide 14)
Another very important demographic assumption is mortality. Under the higher mortality rates scenario, fewer individuals reach retirement age leading to lower expenditures mainly due to shorter durations of benefit payments. In contrast, the lower mortality rates scenario leads to higher life expectancies at age 65, and, therefore to higher expenditures.
Contrary to the total fertility rate scenarios, the CPP balance sheet under the closed group approach is impacted by changes in the level of mortality. However, the impacts are much lower than those emerging under the open group approach since younger generations who are affected the most by the changes in future mortality are either not included at all in the valuation or have low accrued-to-date benefits.
Contrary to the statutory methodology, the closed group assessment under higher wage increases results in higher cost of the CPP (Slide 15)
Under the higher real wage increase scenario, higher earnings lead to higher contributions and eventually to higher benefits being paid. However, higher contributions outweighs higher expenditures, and the MCR is lower than under the best-estimate assumptions.
The impacts of changes in the real wage increase on the financial state of the CPP as measured under the open group approach are consistent with the changes in the MCR determined under the statutory steady-state methodology. Under the higher real wage increase assumption, the increase in assets outpaces the increase in obligations. Under the lower real wage increase assumption, the assets decrease more than the obligations.
However, under the closed group methodology, higher contributions are not reflected in the assets. Therefore, if the financial state of the CPP is assessed using the closed group approach, the change in the real wage increase expectations leads to conclusions that are opposite to those reached using the statutory steady-state methodology.
Main sources of reporting on the financial state of the CPP (Slide 16)
Consistent financial and actuarial reporting is important. This slide shows the main sources where financial information on the Canada Pension Plan can be found.
The first one is the statutory triennial actuarial report prepared by the OCA that provides detailed information on the long-term sustainability of the CPP. These reports include a comprehensive actuarial assessment of the financial state of the Plan, a detailed projections of the Plan's future cash flows, the minimum contribution rates, as well as an extensive discussion on the uncertainty of results.
The other two are the Public Accounts of Canada and the Annual Report of the CPP. Both of these sources present consolidated financial statements of the Plan and information on its long-term sustainability.
CPP Consolidated Financial Statements provide multiple disclosures (Slide 17)
The CPP consolidated financial statements include two notes that address the financial state of the CPP.
The first more detailed note, talks about the long-term financial sustainability of CPP. It discusses its financing approach, summarizes the main findings of the latest actuarial report and provides sensitivity analysis.
The second note presents the balance sheets of the CPP under the open and closed group approaches.
The decision to include multiple disclosures in the CPP consolidated financial statements serves the objective of educating readers by providing meaningful information and explaining how different measures should be interpreted. It was felt such multiple disclosures will help informed decisions to be made.
Public Accounts of Canada favour the open group approach (Slide 18)
While both closed and open group balance sheets are presented, the Public Accounts of Canada favour open group. They state that: "if the CPP's financial sustainability is to be measured based on its asset excess or shortfall, it should be done on an open group basis that reflects the partially funded nature of the CPP, that is, its reliance on both future contributions and invested assets as a means of financing its future expenditures."
The key to good disclosure is the cooperation between professions (Slide 19)
I should say that the journey to develop the notes to the CPP consolidated financial statements was long and not always smooth. What was the key to the eventual success was the willingness of members of the "triple "A" team" - actuaries, accountants and auditors - to cooperate and understand each other's position. Other countries will include other professionals, but in many instances, these three professions are the key players.
Even if we are very proud of these disclosures, the search for perfection is endless. Each year we revisit these notes and try to make them more complete, more transparent, and, just, better.
To conclude… (Slide 20)
A social security pay-as-you-go or partially funded systems create claims for current and past contributors to contributions of future contributors. Therefore, it should be assessed using the open group approach, which accounts explicitly for these claims.
Given the long‑term nature of the CPP and its financing approach, it is unlikely that the Plan would become insolvent. The inclusion of future contributions and benefits with respect to both current and future contributors in the assessment of the Plan's financial state shows that the Plan is able to meet its financial obligations and is sustainable over the long term.
The communication of financial information should be relevant, clear, complete and internally consistent. One of the answers may be the use of multiple disclosures – the way chosen in Canada. The search for perfection regarding disclosures is endless.
The actuarial community is and will continue to be committed to work with all interested parties such as international organizations, accounting bodies, and Governments to develop the reporting requirements that will provide meaningful and complete information to users.
Thank you for your attention. I will be happy to answer any questions that you have.