The next chapter in pension reform
Individually the pension initiatives are advances for Canada’s retirement income system, but as a whole the reform has left a lot of unfinished business.
Bob Baldwin, Richard Shillington
One can see why the governments would want to turn the page. But, while each of these initiatives on its own constitutes a step forward for Canada’s retirement income system (RIS), taken as a whole, the reform has left a lot of unfinished business. In our IRPP study, published today, we find that the potential benefits of enhanced CPP benefits are greatly diminished when the interactions with other components of the retirement income system (RIS) and personal income taxes (PIT) are taken into account. Moreover, the reform fails to respond to ongoing social and economic changes, which are having a profound impact on the functioning of the RIS.
Changes to OAS, GIS and CPP
The impact of changes to OAS and GIS are relatively straightforward, but the changes to the CPP are quite complex.
The enhanced CPP increases the earnings replacement rate from 25 to 33 percent and increases the level of earnings at which benefits kick in by 14 percent. The new benefits are fully funded and will be phased in over 40 years. They will be calculated somewhat differently from the way benefits are currently calculated.
Impact of changes to CPP
The CPP increase is actually relatively modest compared with reforms proposed earlier by the Prince Edward Island and Ontario governments. The limited effect of the CPP reforms is even more striking when the interaction between CPP, the RIS and the PIT is taken into account.
The impact of enhanced CPP benefits on total incomes net of taxes is affected by several dynamics.
Each additional dollar of CPP benefits reduces GIS benefits by 50 cents (by 75 cents for those receiving the GIS top up)
We estimate that the majority of low-income seniors will lose more than half of the CPP benefit increase as a result of these interactions, and the lower the income level, the greater the loss.
We share the views of Michael Wolfson and the Quebec government that enhanced CPP benefits will produce little or no advantage for low earners, although their preretirement CPP contributions will increase as a result of the changes.
The federal/provincial agreement on CPP enhancement is a significant achievement. But as the RIS environment evolves, will the agreement endure? We expect that after a brief hiatus, there will be renewed calls for additional increases in CPP benefits, particularly as the incidence of nonstandard employment rises and access to workplace pensions wanes.
There are other important issues that still need attention.
The current system assumes that workers follow a pattern of entering the labour force around age 18 and retiring around age 65. Yet the average age at which people enter and exit the workforce is changing rapidly, as are trends at both ends of the working life. More research is needed on the question of whether early entrants are also early leavers and late entrants are late leavers. If this is so, the assumptions behind public pensions need to be revisited.
The indexing of pensions is also likely to become an important issue. Over the period from 1980 to 2005, consumer prices and wages moved at almost exactly the same pace. Therefore, OAS and GIS benefits, indexed quarterly to the consumer price index, maintained not only their purchasing power, but also their ability to replace average wages and salaries. The slowdown in population and labour force growth is likely to result in real wage increases, which have been observed since 2005. Recently the Office of the Chief Actuary has estimated that average real wage growth will be more than 1 percent per year. In 20 years, the CPP benefits will be half-way phased in, and those benefits will increase the “income replacement rate” (the amount of income needed for people to maintain their standard of living when they retire) by four percentage points. But if wages and salaries do increase by 1 percent or more per year, the decline in OAS benefits — compared with low earners’ wages and salaries — will be more than the four percentage point gain in CPP benefits.
The government’s decision to maintain the age of eligibility for OAS/GIS at 65 involved a significant fiscal commitment. Ensuring that OAS/GIS benefits keep pace with wage growth will require an even greater commitment. Our sense is that because of fiscal pressures and international trends, the age of eligibility for OAS/GIS will be a recurring issue. Ultimately, given fiscal constraints, setting the age at which wage-indexed benefits kick in at over 65 years of age may make more sense than providing price-indexed benefits starting at age 65.
That said, increasing the eligibility age for OAS/GIS would cause hardship for many people. To relieve hardship, Ottawa could consider providing an enriched GIS at age 65 and the basic benefits at a later age.
In 1973, the maximum GIS for a single person was equivalent to 70 percent of the maximum OAS benefit; it is now 1.5 times larger. This is the result of various governments choosing over the years to increase the OAS/GIS income guarantee through “one off” increases in GIS.
The fiscal advantage of increasing GIS rather than OAS is clear: raising the GIS involves a smaller increase in government spending than would an increase in OAS. But the disincentives created by GIS are also clear. For elderly individuals with very low incomes, the 50 percent GIS clawback, the other benefit clawbacks and the PIT overlap. These clawbacks and taxes are disincentives for people to save for their retirement and to continue working longer. We can’t emphasize too strongly the need for a concerted effort within the federal government and between the federal and provincial governments to minimize overlapping tax and tax-back rates.
The retirement income system requires regular review and adjustment to ensure it responds to ever-changing demographic, labour market and financial environments. The recently adopted changes to the CPP mark the third major reform in its 50-year history, and there have been smaller changes along the way. There is much to commend in the management of the CPP and the RIS more generally. But it could be substantially improved in several areas. In particular, the triennial review of CPP finances should be more open and transparent, and there should be a regular assessment of the income prospects of the current and future elderly. This will require addressing gaps in the data and modelling capacity of governments.
The individual reforms to the retirement income system introduced by the current government are a step forward. But, taken together, they amount to less than might have been hoped for. They are not coordinated, they ignore other components of the retirement income system and personal income taxes, and they fail to respond to evolving socio-economic conditions. What is needed is a holistic, forward-looking approach to pension reform. This is an area where governments will have to show leadership in assessing the retirement income prospects of Canadians and framing options for reform. Such leadership was much more evident in previous rounds of the pension debate.