Wednesday, June 16, 2010

Retirement Dreams Clash with Economic Reality

Canadian Financial DIY had a thoughtful piece about pension reform and what retirees need that will resonate with many Canadians. An important consideration for any such plan is whether it is economically viable.

The plan calls for replacing 40-45% of pre-retirement income adjusted for inflation for the rest of the retiree’s life. This is a significant increase over the existing Canada Pension Plan benefits. Let's assume that this change in benefits will be achieved by expanding CPP and that it will be fully funded by sufficiently large deductions from everyone's pay cheques to pay for these retirement benefits.

I'm assuming that the 40-45% replacement figure is intended to apply to your income in the last few years of working, which is generally more than the average income over your working life (even adjusted for inflation). So, let's say that your yearly retirement benefits will be 50% of your average lifetime inflation-adjusted income.

Let's also assume that the average Canadian works for 40 years and is retired for 20 years. Then you need to save enough in two years of working to pay for one year of retirement income. This means that CPP contributions will need to be half of the retirement benefit, or 25% of income. Income taxes complicate this calculation. In reality, CPP contributions may only need to be about 20% of your gross income.

Currently, the total of the CPP contributions you and your employer make are only just under 10% of your gross income, and this is only for income below the current cap. This cap would have to rise to give any real meaning to the 50% replacement figure, and now we're talking about doubling CPP contributions for low-income Canadians and more than doubling them for middle- and higher-income Canadians.

All this may well be sensible, but it won't be cheap.

Another thing to consider in this discussion is that if we adopt a system with higher CPP contributions and benefits, the higher benefits would only apply to people who pay the higher CPP contributions for their entire working lives. If these plans were adopted today, current retirees would get nothing extra and those close to retirement would get little extra.

Any plan that gives current retirees and those near retirement significantly higher benefits must necessarily be paid for by others. Those others are young people. I wonder how much we can tax these young people to pay for lavish retirement benefits before they revolt.


  1. @Dale: Hopes can't be wrong :-)

    But, I agree that boomers are likely to get more than they put into CPP. I just want those who propose expanded benefits to see them for what they are: an inter-generational transfer. I find it laughable that so many boomers seem to think that being forced to enter retirement without enough income to support a big house, two cars, and frequent travel is some sort of disaster. For those who save enough money to have these things in retirement, well done. Those who haven't saved enough should be supported to cover basic life needs, but not a middle-class lifestyle.

    1. The comment above is a reply to Dale Rathgeber's comment:

      Sadly, I suspect that you are wrong in your hope that this will not be a wealth transfer to the politically important boomers from their children.

  2. @CC: I agree that "phased in" implies that extra benefits will only be available to those who make extra contributions. However, if CPP changes are made and then boomers figure out that the changes won't help them, I expect some howling. You're right that the 2/3 hurdle is a tough one.

    1. The comment above is a reply to Canadian Capitalist's comment:

      The CPP proposals are very sketchy but I would be extremely surprised if "phased in" doesn't mean that only those who pay the extra premiums would earn the extra benefits. A retiree who is now collecting CPP won't see any increase in their benefits.

      Even then, even "modest" proposals face an uphill battle in adoption. CPP changes must be approved by 2/3rds of provinces representing 2/3rds of the population. How easy is it to get the provinces to agree on anything? Not very.

  3. There is a lot of discussions about Grandfathering IN to Pensions but also now Grandfathering OUT of systems too, where the original members will be excluded from NEW "better" benefits.

    Will our generation ever get to retire? Why do we think we will only 2 generations have been able to do this, why are we sure we can?

  4. @Doctor Stock: Those concerned with protecting people who choose not to protect themselves prefer that there be no opt-out. I'm on the fence.

    @Big Cajun Man: The way I think of it is that CPP benefits for a given individual should be based on how much he or she paid into the CPP system. So, if you paid into CPP under the old rules for 35 years and under the new rules (with higher CPP contributions) for 5 years, you'd get a blended amount of CPP benefits when you retire. You'd get a little more than you would have under the old rules, but not much.

    1. The first reply above is to Doctor Stock's comment:

      I'm still hoping we'll see a "opt out" option become available... but I doubt it.