Thursday, March 17, 2016

CPP Forgiveness or Unfairness

A friend I’ll call Bill recently began receiving Canada Pension Plan benefits. He was telling me that the return he’s getting on his premiums doesn’t seem all that good. He paid the maximum for almost all of his 43 years of working and the payout is less than he expected. The reasons have to do with inflation and some of CPP’s forgiveness rules.

Bill’s benefits will increase with inflation for the rest of his life. This has to be factored into any computation of his return, but that’s not the only reason his return seems low.

If Bill hadn’t worked for 7 years he wouldn’t have made any CPP contributions during that time, but he would still be getting the same CPP benefits today. This is because when we calculate CPP benefits we get to drop out the 17% of months where we earned the least. If Bill had been the primary caregiver of his children when they were under 7 years old, he could have dropped out another 7 years as well.

On the surface, this seems very generous. You get to raise kids and have a few bad earning years and you still get the same pension. However, there’s a flip side. To give more money to some, you have to give less to others. People like Bill get lower returns on their contributions because they have little use for the dropout periods.

Some may suggest that maybe the dropouts give some people more without punishing anyone else. This isn’t possible. We can’t summon value out of thin air. If CPP is self-sustaining, then whatever extra we give to some people must be taken from others. The only alternative is that CPP isn’t self-sustaining and has to draw from tax revenues, which we all pay for. No matter how you slice it, the dropouts take money from those who don’t use them.

Don’t mistake this explanation as a condemnation of how CPP works. It may well be sensible public policy to have these dropout periods. But the inevitable side effect is that Bill’s rate of return on his contributions is lower than the return seen by those who use the dropouts.

21 comments:

  1. I guess you could sum it up as "Who's going to pay for that free lunch?" I really like this post because it's a good example of a common problem in government and pension trade offs. I think you deftly avoided value judgements... unlike me, who just called the dropout period a free lunch.

    ReplyDelete
    Replies
    1. @Gene: I'm on the fence about whether these dropouts are justified, but I agree that they are a free lunch. But we give away far more free lunches every day when the public service fails to lay off employees who can't or won't do their jobs. I know many public servants who are good at their jobs, and they can give egregious examples of other workers who shouldn't be there.

      Delete
    2. I'm also on the fence, but probably a bit more lenient when it comes to the "taking from those who have worked all the way through" part. That's part of living in this Canadian society -- we lower the highest bar and raise the lowest bar, which, hopefully, creates a more sound(?) society. Of course we could rip apart the fiscal and physical operations of such public policy entities like CPP and health care, but that's just complaining.

      I agree heavily on the public service free lunches. What grinds my gears more than poor PS employees who are still employed, is that fact that after they retire they will continue to benefit with (most likely) a pension; thus, it's possible for a poor PS employee to get a free lunch which lasts decades.

      (As an aside, I've thought about the public service employee situation in a private sector setting. The private sector doesn't just house the very best entities, it's the entire spectrum. For instance, I could open a burger joint and sell crappy burgers for the next 30 years. I'll never be as successful as McDonalds and my clientele could be comprised of a very narrow sector (e.g. locals), but I'd still be in business. The differentiation which PS eliminates is putting all entities on the same profitless point (e.g. ALL Level 1 workers are paid $XX/hr), which means if I were a crappy gov't burger joint, I'd be guaranteed to make just as much as the McDonalds franchise nextdoor. I guess there's a little bit of Communism in every government.)

      Delete
    3. @SST: You make a good point that CPP does a reasonable job of giving some extra to those who have very little.

      However, with the public service there are terrible employees keeping their jobs with well above median pay in Canada. It makes no sense to have a charity system that launches people above median pay. I don't begrudge the strong PS workers their pay, but getting rid of the incompetent ones is the path to saving taxpayers money.

      Delete
  2. There is a way for Bill to increase his total return...live a very long time. ;)

    ReplyDelete
    Replies
    1. @Garth: I like it. If Bill is competitive, he can plan to live much longer than those who make good use of dropout periods. For myself, when it comes time to retire, I'll be happy to let others have whatever they've got and just concern myself with enjoying life.

      Delete
  3. If Bill is already retired then he is of the age that gets a relative boost in his returns on CPP compared to those younger than him. Because CPP was pay-as-you-go and underfunded for most of the early baby boomer's working life, if he's around 65 years old today he can expect about 1.4 times more back from CPP than the value of what he contributed, not factoring in what he has to pay extra for those who benefit more from drop out periods. People 55 years old today pretty much break even. People 30 and under can expect at most 2/3 of the value the should get from their CPP contributions.

    I've come to think of CPP as a tax for a social program, not an investment. You don't get a fair return on investment from it, but you do get a society where seniors who don't have the discipline to save during their working life (or have bad luck in some extreme cases) get a decent life. That's a good thing, but I'm not in favor of expanding the CPP. We've got to leave the opportunity for motivated people to save and invest for themselves.

    ReplyDelete
    Replies
    1. @Greg: You're right that there are other subsidies buried in CPP that lead to less money for those who don't get these subsidies. Bill is not 65, so he doesn't get the full benefit of what you describe, but he gets some of it. I wouldn't object to a modest expansion of CPP, but the details matter greatly.

      Delete
  4. If the CPP assets are invested,I assume there would be capital gain to cover at least some of the short fall in contributions.

    ReplyDelete
    Replies
    1. @Robert: Your comment seems to imply that the contributors should just get their contributions back and government can just do as they please with the gains. To a first approximation, the capital gains, dividends, and interest generated by CPP assets belong to the contributors in proportion to their contributions amounts. Any other distribution is a form of favouritism, whose merits we can debate but is favouritism nonetheless.

      Delete
  5. You know there are some days I just get angry when I read some of your topics... The sad thing is yes, we that are responsible and plan for our futures, are in varying degrees better off. How much better off, sometimes may be questionable. What I don't like is the responsible people are the ones getting many of of the raw deals and targeted for more and more tax money to throw down a hole somewhere else and waste. For trying to not be a burden on others we simply get penalized. Gives credence to today's title.

    Imagine one day down the road if our government continues its irresponsible path of more and more debt, they want to nationalize all pensions like in some other countries? They will advertise it as a good thing for everyone...

    ReplyDelete
    Replies
    1. @Paul: It always sounds good to say that we're going to help out those who've had a few rough earning years or who raised children, but the unsaid part is that we're going to take from those who worked all the way through.

      Delete
  6. It would be interesting to know the "breakeven" age for Bill compared to someone who got to take advantage of the dropouts... My guess is that it would be only a few years??

    ReplyDelete
    Replies
    1. @Garth: It would depend greatly on the degree to which someone benefited from the dropouts. If a person earned no income at all for the maximum period permitted, Bill would have to live decades longer to get the same return. But few people get that much benefit from the dropouts.

      Delete
  7. I certainly get frustrated with PS workers who really don't seem to get how lucky they are when I see the other ones who work so hard. And their pensions do seem a bit too much in some ways.

    On the other hand my body is breaking down and I'm hoping to never have to go on disability. My hope is to retire early or at least semi-retire and live on what savings I have tucked away until CPP, etc begins thus I would be making use of a non working period.

    Yes, I feel guilty especially after reading this (though glad I read it anyway) but maybe I can find a mentally stressful job instead one day to balance things out. Sigh.

    Ron B

    ReplyDelete
    Replies
    1. @Ron: PS workers cover a very wide spectrum of people. It's true that many are ungrateful for their good luck, but that's true anywhere and it's human nature. I know PS workers who definitely appreciate the stability of their jobs.

      I'm sorry to hear that you're having physical troubles. I never blame people for using a system as it's designed. You shouldn't feel guilty about using the dropouts. If I retire before I'm 60, I'll use the dropouts too. There's no point in trying to balance karma by finding a stressful job. Enjoy your life as best you can.

      Delete
    2. Makes sense to me but I'm still going to hold out for 60 if I can, not sure my body likes that but I'll see.
      Ron B

      Delete
  8. Wouldn't Bill also be able to take advantage of excluding his lowest 17% of months? Surely he had some low income months along the way. Does everyone automatically get the lowest 17% of months dropped?

    ReplyDelete
    Replies
    1. @David: Bill paid the CPP maximum in almost every year of his 43 years working. When he was short, it wasn't by much. So he got almost no benefit from the dropout rules.

      My understanding of the rules is that everyone gets the lowest 17% of months dropped.

      Delete
  9. I think you're forgetting one thing: the amount of unpaid labour that stay at home parents and caregivers (for elderly parents, spouses, etc) provide. Consider the cost if the government had to pay for more subsidized child care and eldercare. Society already financially penalizes people who take time off to care for others -- and people want to make that burden heavier?

    For women, who already earn less than men to begin with and are more likely to face poverty in their final years, this drop out can make a big difference in the long run. When their former bread-winning spouse dies, they only receive a fraction of that person's pension as a spousal benefit.

    I don't have kids, but I have absolutely no objection to people (men or women) who can benefit from the "drop out" because they are raising the next generation or caring for those who need it -- because ultimately, that benefits us all.

    ReplyDelete
    Replies
    1. @BB: I happen to be in favour of subsidizing the raising of children. I'm not sure that CPP is the right place to do it, but that's another discussion. The point I was making here is that CPP benefits for those who don't make much use of the dropouts will be lower because others use the dropouts. Even if we decide that this is exactly how we want the system to work, it doesn't change the fact that people like Bill get less money.

      Delete