Canada’s Pension Plan? Make the Kids Pay

The Canada Pension Plan (CPP), conceived in 1965 by the Liberals under Lester Pearson, is growing into an ever-heavier anchor dragging down the country’s economy. This year the Liberal government of Justin Trudeau hiked the CPP payroll tax – which it refers to as “contributions” – from a combined 9.9 percent to 10.2 percent of pensionable earnings (to a maximum of $57,400, less a basic $3,500 exemption). Someone earning or exceeding the maximum and their employer will pay a combined $5,498 in CPP taxes, in addition to whatever federal and provincial income tax they must pay. For lower-middle-income workers, this is a large share of overall pay. But the tax rate will continue to rise – or be “enhanced” to again use the government’s language – to 11.9 percent by 2023.

The purported reasons for enhancing Canadians’ contributions are to create “a stronger economy and more middle class jobs” and “reduce the risk of not saving enough for retirement.” But the real risk lies in forging ahead with an expanded pension scheme that shrinks paycheques and is increasingly prone to political abuse. In its current state, it is difficult to see the CPP as anything other than a job-killing, economy-sapping tax that cripples Canadians’ ability to finance retirement on their own.

The problem-plagued CPP

Suppose a concerned politician, upon learning from Health Canada of the country’s rising proportion of adults who are overweight or obese, concluded that Canadians were spending an insufficient fraction of their income on fruits and vegetables, and proposed a new program to tax workers’ incomes up to a certain maximum and in exchange send packages of healthy foods to the workers’ homes. Such a politician might cite a “risk of workers not eating enough fruits and vegetables.” By keeping workers healthier, the program would create “a stronger economy and more middle class jobs.” But such a paternalistic program, treating millions of Canadian adults as if they were children, would largely be derided as absurd.

Substituting “retirement savings” for “fruits and vegetables” doesn’t make the program any more defensible. The interventionist conceit of an ever-expanding CPP is that politicians in Ottawa are more concerned with, and know better how to manage, the personal savings of millions of Canadian workers than those workers themselves. Of course, there are people who do not save adequately for retirement, just as there are people who do not eat enough fruits and vegetables. But this alone does not justify the CPP – not least because there are also people who won’t work to begin with and who therefore make no CPP contributions, ultimately living off the other government supports for low-income seniors. In other words, if the truly incapable or irresponsible are already being taken care of for free, why should all others who are merely suspected of being insufficient savers be forced to pay more throughout their entire careers?

The CPP is ill-conceived in many other ways. In the first place, workers are not actually saving for their retirements when they pay into the CPP. Rather, they are paying for someone else’s retirement. The government simply transfers CPP taxes from current workers’ incomes to today’s retirees, with the promise that when today’s workers retire, their retirements will be paid for by the next generation of workers. So the CPP is unlike a genuine investment fund. The future financial wellbeing of today’s workers depends on the competence and good faith of future politicians, and on the solvency of Canada’s public finances decades from now.

Cracks in the CPP foundations

Just as importantly, if the case for expanding the CPP is that Canadians are too short-sighted and reckless to be trusted with managing their own retirement finances, then it is difficult to imagine that the solution is to hand over more financial control to the federal government, since it rarely demonstrates prudent and careful management with the dollars it already takes from Canadians.

Source: Fraser Institute

There’s considerable evidence that Canadians are getting a bad deal with the CPP. A Fraser Institute project in 2016, entitled “5 Myths of the Canada Pension Plan”, demonstrated that Canadians are in fact saving enough for retirement outside the CPP. Moreover it showed that additional payments into an expanded CPP would very likely be offset by decreases in private saving, erasing any increase in total retirement savings. This suggests that, for the most part, workers are not mismanaging their own finances and the CPP does not help those who want to save more for retirement. If anything, the CPP’s growth mainly decreases financial self-reliance and personal control by displacing voluntary private savings with mandatory contributions.

The Fraser Institute research also debunked the myths that the CPP is a low-cost pension plan and that it provides a good return on the mandatory investment by workers. Canadians born after 1956, the Fraser Institute showed, would receive an annual rate of return of 3 percent or less. And the Canada Pension Plan Investment Board (CPPIB), the organization that administers and invests today’s surplus contributions to minimize future increases in CPP rates (with currently $356 billion under management), has become much more expensive since its founding in 2000. It has grown from a lean staff of five spending a total of $3.7 million per year to a 1,500-employee leviathan costing $3.2 billion per year. This winter, the CPPIB launched a prime-time TV ad campaign, spending $300,000 of pensioners’ money to tell them the CPP is financially secure and well-managed – even though the CCPIB’s investment returns, despite the massive cost increases, have been mediocre.

Since it was created in 2000 the CPPIB has grown from a staff of five spending a total of $3.7 million per year to a 1,500-employee leviathan costing $3.2 billion per year.

The bad deal workers are getting from the CPP may well worsen if the CPPIB’s investment agenda deviates from maximizing returns and begins instead to serve political interests. There are already ominous signs of political meddling. Last year, federal environment and climate change minister Catherine McKenna tweeted that the CPP’s investment of more than $3 billion in renewable energy “is something that Canadians can be proud of.”

However, as Andrew Coyne wrote in response, the best returns on investment aren’t necessarily obtained from “investment in things ministers think appropriate.” McKenna declared support for the green investments, Coyne wrote, “not because they were likely to make pots of money for pensioners, but because they fit with the Trudeau government’s image of itself as forward-thinking environmentalists.” If CPP investments are going to be directed towards green energy to please politicians, then taxpayers, who already subsidize many expensive green energy ventures, get a doubly raw deal. First, they pay higher taxes to subsidize innately inefficient forms of energy production, and second, some of their enforced retirement taxation is invested in uncompetitive ventures.

A scene from Canada Pension Plan’s $300,000 television advertising campaign.

With the risks of pension investment politicization growing, Canadian workers’ already bad pension deal is likely to get worse. The question is whether and how the program can be fixed. The pension reform experience of a relatively small and once-poor country lying on the other side of the equator offers intriguing lessons.

An unlikely alternative: the Chilean experiment

By the 1970s, Chile’s government-run pension system, introduced in 1924, was experiencing the same problems that eventually plague every pension system that operates as an income transfer from workers to retirees. The longer lifespans and declining fertility rates (a very rapid decline in Chile’s case) typically associated with modernization meant that far fewer workers were supporting far more retirees than originally envisioned. In 1955, there were 12.2 Chilean workers for every retiree. But by the 1970s, profound demographic changes were combining with shorter-term economic woes. Chile’s steep mandatory pension contribution rates worsened the problem by discouraging hiring and encouraging “informal” employment to evade the tax. By 1980, the ratio of workers to retirees in Chile’s pension system had plummeted to 2.5 to 1.

Ruled by an at-times brutal military dictatorship, Chile was an unlikely setting for upending tradition and gambling on an all-new approach based on free choice and individual judgment. But instead of spinning further down the spiral of worsening demographics, higher pension taxes, more rebellious workers, and increasing financial fragility, a small group of mainly U.S.-educated government officials was allowed to tackle the problem before it became a crisis. José Piñera, Chile’s Minister of Labour and Social Security at the time, recognized that the fundamental problem with government-run pension systems is that everybody’s retirement is paid for by a tax on somebody else. There was “a lack of a link,” wrote Piñera, a Harvard-trained economist, “between what people put into their pension program and what they take out. In a government system, contributions and benefits are unrelated because they are defined politically, by the power of pressure groups. So we decided to go in the other direction, to link benefits to contributions.”

In 1981, Chile introduced sweeping reforms to its pension system. Instead of paying for somebody else’s retirement, workers paying into the system began saving for their own retirement. Instead of a government-run system, each worker could choose from a selection of approved private companies called AFPs (administradoras de fondos de pensiones or pension fund administrators). Chile had privatized its pension system. The reforms not only created powerful incentives to save but gave each worker broad control over how their money would be invested and how much risk they would take on.

Because workers who entered the labour force before 1983 were not forced to leave the government-run system, Chile’s reforms created something of a living laboratory into the popularity and performance of a privatized system. In just the first month of the private system’s operation, one-quarter of Chile’s labour force left the government-run system. “They moved faster,” said Piñera, “than Germans going from East to West after the fall of the Berlin Wall.” Despite union leaders urging workers to stay in the government system, 90 percent of Chilean’ workers were enrolled in the private system by 1995.

Privatization provided far more than abstract benefits like freedom and choice. It also had positive effects on wages and the economy as a whole. According to the OECD, workers who switched to the private system enjoyed an average 11 percent effective increase in net wages, thanks to reduced pension contributions. Helped along by other pro-market economic reforms, Chile generated economic growth averaging 6 percent per year from 1987 to 2007, more than twice the rate across Latin America as a whole. Over the same period, the poverty rate was cut from 45 percent to 14 percent. These stunning achievements lifted Chile from Third World status to in 2010 becoming South America’s first and so far only member of the 36-nation OECD.

José Piñera led Chile’s pension privatization in the 1980s.

Chile’s privatized pension system had its flaws. Critics charged that despite competition between AFPs, choices were too limited, administrative costs too high and investment styles too similar from fund to fund. Yet the private system offered more choice and lower administrative costs than the government-run system, and continues to do so. Another controversy, however, spurred massive protests around Chile in 2016, and that was the contention that the system was failing to deliver a decent pension to retirees. Hundreds of thousands of Chileans demanded the system’s renationalization. These calls were rejected, but the Chilean government did intervene, most notably by mandating employer payments into pension accounts.

Ian Vásquez, director of the Center for Global Liberty and Prosperity at the Cato Institute in Washington, D.C., has argued that the intervention was unwarranted. “Critics in Chile assert that the average pension provided by the private pension fund companies is around $340 per month, which is not better than the public pension system,” according to Vásquez. “But as the Chile-based Liberty and Development institute (LyD) has shown, that is like comparing apples to oranges.” Critics of the private system calculated its pension benefits by including everybody with an account (even if they only contributed once) while calculating average government-run pension benefits by including only those workers who had paid into it for 10 or more years. After controlling for the frequency and size of contributions into each pension system, Vásquez reported, the “value of the pensions the AFPs provide is three times higher than that of the public system.”

Lessons for Canada

Three lessons from Chile stand out. The first is that a government-mandated retirement savings program, if it must exist, should be one in which workers actually save for their own retirement. The current CPP is no such program, and is instead an income transfer from workers to retirees that today carries an unfunded liability – the actuarial estimate of total future pension payment obligations less future investment income and worker contributions at planned rates – in the neighbourhood of $900 billion. The likely results of this liability are even higher CPP payroll taxes or slashing future retirement payouts.

Second, the system should be privatized to give workers choices over how their money is invested. Many Canadians might object to the CPPIB’s active investment management philosophy, which incurs annual costs of approximately 1 percent of assets under management – about ten times the rate of passively managed funds. And many Canadians would want some say, as Chilean workers have, in whether their pension contributions are invested in riskier (and potentially higher-earning) or less risky portfolios. Canada’s current monopoly system imposes a one-size-fits-all formula on all plan members, plus exposes their pensions to the risk of political abuse. Lastly, to give Canadians more flexibility over how much to save and how, the mandatory contributions – or tax – ought to be cut. The blueprints that the federal government draws up for the management of personal savings of millions of workers should not override the preferences and judgement of the workers themselves.

All of this is a tall order politically, to be sure. Many might regard it as impossible. But equally dramatic changes were accomplished by a country that most Canadians would not regard as more visionary or functional than their own. As the CPP becomes more expensive, less effective and more politicized, it is high time we begin the conversation.

Matthew Lau is a writer in Toronto.

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