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.