Archived - Backgrounder: Canada Pension Plan (CPP) Enhancement

Middle class Canadians are working harder than ever. But many are worried that they won’t have put away enough money for their retirement, and fewer and fewer Canadians have workplace pensions to fall back on.

To help Canadians achieve their goal of a safe, secure and dignified retirement in the face of these challenges, the Government of Canada committed to working with the provinces to strengthen the Canada Pension Plan (CPP). Cooperative efforts as joint stewards of the program led to Canada’s Ministers of Finance reaching an historic agreement in principle on June 20, 2016 to enhance the CPP.

This document provides further background on the analysis conducted by federal, provincial and territorial officials in advance of the June 20th Finance Ministers Meeting, and which provided the basis for discussions towards the agreement in principle reached at that meeting.

What the Agreement in Principle Means for Canadians

• Once fully in place, the CPP enhancement will increase the maximum CPP retirement benefit by about 50 per cent. The current maximum benefit is $13,110. In today’s dollar terms, the enhanced CPP represents an increase of nearly $7,000, to a maximum benefit of nearly $20,000.¹
• Enhanced benefits will accumulate gradually as individuals pay into the enhanced CPP. Young Canadians just entering the workforce will see the largest increase in benefits.
• To fund these enhanced benefits, annual CPP contributions will increase modestly over 7 years, starting in 2019. For example, an individual with earnings of $54,900 will contribute about an additional $6 a month in 2019. By the end of the 7-year phase-in period, contributions for that individual would be about an additional $43 per month.²
• To ensure that eligible low-income workers are not financially burdened as a result of the extra contributions, the Government of Canada will enhance the Working Income Tax Benefit, an existing benefit that is designed to help keep people in the workforce and encourage others to join it.
• Enhancing the CPP will significantly reduce the share of families at risk of not saving enough for retirement and the degree of under-saving.
• The CPP will always be there for Canadians: It helps to fill the gap for those who do not have a workplace pension plan, and it is portable across jobs and provinces.

Canada’s retirement income system provides a balanced mix of public pensions and voluntary savings opportunities to enable Canadians to save for their retirement. The retirement income system is based on three pillars:

1. The Old Age Security program (OAS) provides a basic level of retirement income, along with additional support for low-income seniors through the Guaranteed Income Supplement (GIS). It is funded from government revenues;
2. The CPP and the Quebec Pension Plan provide a basic level of earnings replacement for workers. They are financed by contributions from workers, employers and self-employed individuals.
3. Voluntary tax-assisted private saving opportunities, such as Registered Pension Plans (RPPs), Pooled Registered Pension Plans, Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts. Individuals and their employers may contribute to these savings vehicles.

In addition to saving through the retirement income system, Canadians may also choose to draw upon other financial and non-financial assets for retirement income. These include, for example, financial assets held outside tax-assisted registered plans, housing equity and small business equity.

Middle class Canadians are working harder than ever, and many are worried that they won’t have set enough money aside for their retirement. Young Canadians in particular are facing the challenge of securing adequate retirement savings at a time when fewer can expect to work in jobs that will include a workplace pension plan. However, the question remains as to just how much Canadians are “under-saving”, and what will be needed to address this gap.

The Department of Finance Canada has examined whether families nearing retirement are adequately prepared for retirement, based on household income and wealth data from the 2012 Survey of Financial Security (Statistics Canada).³ Families are considered to be at risk of under-saving for retirement if their projected after-tax income at retirement does not replace 60 per cent of their pre-retirement after-tax family income.⁴

Although Canada’s retirement income system has served many Canadians well, the Department has estimated that 24 per cent of families nearing retirement age are at risk of not having adequate income in retirement to maintain their standard of living (Chart 1). This suggests that roughly 1.1 million families approaching retirement age won’t have enough money to maintain their standard of living when they retire.

Middle class families without workplace pension plans are at a greater risk of under saving for retirement. It is estimated that 33 per cent of families nearing retirement age who have no workplace pension plan assets may be at risk of under-saving for retirement, compared to 17 per cent of families who have workplace pension plan assets.

Overall, families in the lowest income group were found to have the lowest risk of under-saving, as OAS and CPP benefits provide relatively high income replacement at this income range. However, some lower-income families are likely to require a higher level of income replacement than other income groups to maintain their pre-retirement living standard. For example, lower-income families are less likely to have children, own a house or contribute to private savings, so their expenses should fall to a smaller extent upon retirement.⁵

Canadians are living longer and healthier lives. Longer life expectancies increase the level of savings required at retirement to maintain comparable living standards, which increases the risk that Canadians may outlive their savings (Chart 3).

Overall participation in private sector RPPs has declined since the 1970s and there has been an ongoing shift from defined benefit to defined contribution plans (Chart 4). These trends of declining workplace pension plans and the shift from defined benefit to defined contribution plans suggest that younger Canadians will need to increasingly rely on individual forms of private savings to ensure that they have an adequate standard of living in retirement.

Economic conditions since the global recession of 2008–09 pose a particular risk that younger Canadians could need to save more than past generations to achieve the same living standards in retirement. This is because a prolonged period of low interest rates could mean that future generations may face lower returns on their retirement savings. In addition, younger generations are more exposed to market risks (such as interest and asset price movements), as they have both higher debts and assets than previous generations and rely more on individual savings for retirement.

Further, given the shift from defined benefit to defined contribution plans, a larger share of younger workers will face increased uncertainty. Defined contribution plans expose individuals to investment risk, which could result in a shortfall in their pension savings just prior to their planned retirement, forcing them to work longer than desired. The CPP enhancement will help to mitigate this risk by providing higher, predictable retirement benefits.

Improving the retirement income security of Canadians through the CPP offers a number of advantages:

• The CPP provides a secure, predictable benefit, which means that Canadians can worry less about outliving their savings, having their savings impacted by large negative market shocks, or the security of their savings through their workplace pension plan.
• CPP benefits are fully indexed to prices, which reduces the risk that inflation will gradually erode the purchasing power of retirement savings.
• The CPP is a good fit for Canada’s changing job market. It helps to fill the gap left by declining workplace pension coverage, and it is portable across jobs and provinces, which promotes labour mobility.
• The CPP is an efficient way to save. It is a large program with millions of contributors, which allows the CPP Investment Board to take advantage of economies of scale in order to deliver strong net returns.
• With the automatic collection of contributions for all workers, the CPP is a simple way to save.

In particular, an enhanced CPP is the right tool to improve the retirement income security of younger workers. As it would take roughly 40 years of contributions for a worker to fully accumulate an enhanced benefit, younger Canadians who are just entering the workforce would be the greatest beneficiaries of a CPP enhancement.

On June 20, 2016, Canada’s Ministers of Finance reached an historic agreement in principle to enhance the CPP. The deal will increase the pension that working Canadians will get from the CPP—from one-quarter of their eligible earnings, to one-third. Simply put, there will be more money waiting for Canadians when they retire. In addition, under the agreement, the changes will be phased in slowly over 7 years—from 2019 to 2025—so that the impact of higher contributions is small and gradual.

The enhancement will have the following design features:

• The income replacement level will be increased to one-third of eligible earnings.
• The upper earnings limit will be increased by 14 per cent, which is projected to be equal to roughly $82,700 upon full implementation in 2025.
• There will be a gradual 7-year phase-in beginning on January 1, 2019 consisting of:
  • A 5-year contribution rate phase-in below the Yearly Maximum Pensionable Earnings, followed by
  • A 2-year phase-in of the upper earnings limit.
• An increase to the Working Income Tax Benefit to help low-income workers.
• Tax deductibility for the enhanced portion of employee CPP contributions.

Chart 5 illustrates the two-step phase-in of the CPP enhancement.

While the agreement in principle set out the broad parameters of the CPP enhancement, consideration must be given to secondary design issues regarding other elements of the CPP that would be impacted by an enhancement.

While all working Canadians covered by the core CPP will benefit from its enhancement, the CPP enhancement is designed to target middle-income Canadians. The CPP enhancement will increase income replacement from one-quarter to one-third of pensionable earnings, from the first dollar earned up to a higher earnings threshold—the maximum amount of earnings covered by the CPP will be increased by 14 per cent, which is projected to be equal to roughly $82,700 in 2025. This design generates the greatest improvement in retirement outcomes for modest- and middle-income families, as enhanced CPP benefits will accrue over their full range of earnings. Under this design:

• Roughly 7 out of 10 workers will have the entirety of their earnings covered by the enhanced CPP in any given year.
• Approximately one-third of workers will see more of their earnings covered by the enhanced CPP in any given year as a result of the extension of the earnings range, and, over their careers, approximately two-thirds of workers will see more of their earnings covered by the enhanced CPP.
• Although all contributors will see higher benefits as a result of the enhancement, younger workers will see the greatest increase in benefits.

Chart 6 presents illustrative examples of enhanced CPP benefits for individuals with varying incomes and years of contributions to the enhanced CPP.

To ensure that Canadians and the businesses they work for can adjust to these changes, the CPP enhancement will be introduced through a 7-year gradual phase-in starting on January 1, 2019.

• The higher contribution rate on earnings below the Yearly Maximum Pensionable Earnings (YMPE—$54,900 in 2016) will be phased in over the first 5 years. In 2023, the CPP contribution rate is estimated by the Department of Finance Canada to be 1 percentage point higher for both employers and employees on earnings up to the YMPE.
• Beginning in 2024, a separate contribution rate (expected to be 4 per cent each for employers and employees) will be implemented for earnings above the then prevailing YMPE. The upper earnings limit will be extended over a 2-year period and is expected to reach $82,700 in 2025.

Table 1 outlines the phase-in schedule for enhanced CPP contributions. Table 2 outlines the increase in annual contributions for both employers and employees based on various levels of employee earnings. Table 3 outlines the increase in contributions for employees on a bi-weekly basis on a pre- and after-tax basis. Table 4 presents the year-over-year incremental increases in annual contributions for employers and employees. To note, the contribution rate informing these estimates is subject to secondary design decisions and will be confirmed through an independent actuarial assessment, which will be performed by the Office of the Chief Actuary.

The CPP enhancement would benefit all workers, including those with low incomes. However, the Government recognizes that, despite wanting to save more for retirement, many low-income workers may have difficulty making room in their budgets for higher CPP contributions.

The federal Working Income Tax Benefit (WITB) is a refundable tax credit that supplements the earnings of low-income workers. For an eligible couple or family with children in 2015, it provides a refundable tax credit of 25 per cent of each dollar of working income in excess of $3,000, reaching a maximum benefit of $1,844 at $10,375 of working income in 2015. Once net income exceeds $15,915, the benefit is reduced at a rate of 15 per cent of each additional dollar, until the benefit is fully phased out at an income of $28,209. For eligible unattached individuals in 2015, the WITB reaches a maximum benefit of $1,015 at $7,060 of working income, beginning to phase out at a net income of $11,525, and phasing out completely at an income of $18,292. More information on the WITB is available on the Canada Revenue Agency’s website.

The Government of Canada will increase benefits under the WITB to help offset the incremental CPP contributions of eligible low-income workers. The proposed enhancement to the WITB will be designed to provide additional benefits that roughly offset incremental CPP contributions for eligible low-income workers. It is expected that additional annual spending of $250 million will achieve this objective (based on the full implementation of the higher contribution rate on earnings below the YMPE).

In recognition of the important role played by provinces and territories in providing basic income support, the Government of Canada has allowed them to make province-specific changes to the design of the Benefit to better harmonize with their own programs. As such, the Government of Canada will be consulting with provinces and territories before the final design of the enhanced WITB takes effect, coinciding with the introduction of the enhanced CPP.

Employee contributions to the enhanced portion of the CPP will be deductible. A tax credit will continue to apply to existing employee CPP contributions. Providing a tax deduction for new employee CPP contributions will avoid increasing the after-tax cost of saving for Canadians. For example, it will mean that Canadians in pension plans that reduce employee pension contributions—which are deductible—in response to the increase in employee CPP contributions would not experience an increase in tax as a result of replacing a dollar of RPP contributions with a dollar of CPP contributions. Similarly, individuals who correspondingly reduce their RRSP contributions in response to increased CPP contributions would not experience an increase in tax.

Employer contributions to the enhanced portion of the CPP will be deductible from income for tax purposes, as are existing employer CPP contributions.

Self-employed persons, who pay both the employee and employer share of CPP contributions, will be able to deduct both the employee and employer share of contributions to the enhanced portion of the CPP.

The Department of Finance Canada has estimated that the CPP enhancement would reduce the share of families at risk of not having adequate retirement savings by about one-quarter (from 24 per cent to 18 per cent) when considering income from the three pillars of the retirement income system and savings from other financial and non-financial assets.

While some families would still be at risk of not saving enough for retirement after a CPP enhancement, the degree of under-saving would be materially reduced. Among families at risk, the median after-tax retirement income gap—the difference between current retirement income and that required to replace 60 per cent of pre-retirement income—is estimated to be reduced by more than half (from $8,300 to $3,700).

Some individuals with low income in their working years will also have low income in their retirement years, making them eligible for the GIS benefit. The GIS benefit is income-tested, meaning that the benefit is generally reduced by 50 cents for every dollar of family income outside of the OAS program (e.g., CPP benefits, workplace pension plan benefits). Although total retirement income will increase for low-income workers under an enhanced CPP, higher CPP benefits may result in lower GIS benefits for low-income seniors in the future. That said, by enhancing the WITB to roughly offset incremental CPP contributions, the Government is ensuring that low-income workers who are eligible for the WITB will see an increase in their total retirement income at little to no cost during their working years.

Moreover, the Government made significant new investments to support Canadians in their retirement years. In particular, the Government:

• Increased the GIS top-up benefit for single seniors by up to $947 annually to help lift low-income single seniors out of poverty. This measure represents an investment of over $670 million per year and will improve the financial security of about 900,000 single seniors across Canada.
• Restored the eligibility age for OAS and GIS benefits to 65, which will put thousands of dollars back in the pockets of Canadians as they become seniors.

Over the long term, greater CPP benefits will increase aggregate demand, providing a boost to economic output. This will be aided by higher aggregate savings through the CPP, which will increase the amount of financing available for investment.

In the long term, real gross domestic product (GDP) is estimated to be between 0.05 to 0.09 per cent higher than under the status quo as a result of the CPP enhancement. Employment levels are projected to be permanently higher by between 0.03 and 0.06 per cent relative to the baseline.

Similar to those of any pension plan, CPP contributions paid by employers can be considered part of overall compensation to employees, and CPP contributions paid by employees can be considered as part of their retirement savings. As a result of the enhancement, businesses would initially face an increase in compensation costs, the impact of which is expected to be very modest and be mitigated by the phase-in of contributions.

In the short term, employment will continue to grow. There will be a temporary impact that will result in employment being 0.04 to 0.07 per cent lower relative to its projected level in the absence of the CPP enhancement.⁶ The reduction is very modest because the proposed increase in contributions constitutes such a small proportion of overall employee compensation and the phase-in period will give firms time to adjust to the new contribution rate regime.

As with employment, GDP would continue to grow over the short term and it would be largely unaffected as a result of CPP enhancement. Compared to the status quo growth track of GDP, at its maximum impact the level of output is projected to be only between 0.03 per cent and 0.05 per cent lower. By way of comparison, the measures contained in Budget 2016 are projected to increase the level of GDP by 0.5 per cent in 2016–17 and 1.0 per cent in 2017–18.

Changes to the Canada Pension Plan Act to operationalize the CPP enhancement will include consequential amendments to the Canada Pension Plan Investment Board Act identifying that the enhanced CPP assets will be managed by the Canada Pension Plan Investment Board.

¹ Benefits are presented in wage-adjusted 2016 dollars in order to provide a comparison to 2016 CPP levels. Maximum benefits require roughly 40 years of maximum contributions and benefit take-up at age 65. Under the CPP enhancement, the upper earnings limit will be increased by 14 per cent, which contributes to the higher maximum benefit.

² The contribution rate for the CPP enhancement is subject to secondary design decisions and will be confirmed through an independent actuarial assessment, which will be performed by the Office of the Chief Actuary. Contributions have been estimated by the Department of Finance Canada.

³ To assess whether Canadians will be able to maintain their standard of living at retirement, we compare their pre-retirement income with income that could be generated at retirement. To maintain living standards at retirement, savings need not equal pre-retirement income because retirees generally do not have to spend as much on certain items, such as consumer durables, work-related expenses, pension savings, child-related expenses and mortgages.

⁴ Projected income at retirement includes expected income from the three pillars of the retirement income system as noted earlier, in addition to projected income that could be derived from other financial and non-financial assets (e.g. mutual funds, stocks, bonds, business equity and home equity). Families nearing retirement age include those families in which the person with the highest pre-tax income is between 45 and 59 years old.

⁵ For these families, a more appropriate standard may be 70 per cent income replacement, which is generally consistent with the average change in standard of living experienced by lower-income families as they transition from work to retirement. Increasing the income replacement target from 60 per cent to 70 per cent has a more pronounced impact among lower-income families nearing retirement, more than doubling their share of families at risk of under-saving for retirement (from 10 per cent to 24 per cent of lower-income families, considering income from the three pillars of the retirement income system and savings from other financial and non-financial assets; Chart 2).

⁶ The economic impacts of CPP enhancement are estimated using a general equilibrium model similar to those used by central banks, major governments, and international organizations such as the International Monetary Fund and the Organisation for Economic Co-operation and Development. The behavioural reactions of firms and households to the CPP enhancement are based on a range of plausible behavioural assumptions taken from econometric evidence.