July 31, 2020

In this analysis, I will review the enhancements to the Canada Pension Plan and the Quebec Pension Plan.   I will also take a critical look at the key assumptions used, as well as the arguments put forward to support this major change to our pension structure.

Effective in 2019, these Plans (CPP and QPP) introduced similar changes which involved increasing the percentage contribution levels for both employees and employers. There will also be gradual increases in the maximum level of earnings subject to such contribution requirements.  These higher contribution levels are designed to ultimately deliver retiree pensions equal to 33% of average earnings instead of the existing 25%.  There are also improvements to other benefits (consult with CPP and QPP for details).  The stated reason for increasing contributions and benefits is that too many Canadian families have not been saving enough for their retirement.  The goal of these changes is to help address that problem.  These pension increases are particularly valuable, as they provide life-time guaranteed security and are inflation adjusted each year.


 Why has this problem arisen in the first place?  Statistics Canada data from the last twenty-five years shows that the personal savings rate has declined from the 10% level to around 2-3%.  Over the same period, interest rates have also declined in a similar fashion.  So, Canadians appear to have responded in a very rational manner.  Since we were being paid less to save, we cut back on our savings.  Interest rates are now so low that there is no real return on savings. By transferring more of our savings to the CPP and QPP, all future pensioners will benefit.  These large Pension Plans are forecast by the actuaries to earn much higher returns than are available to most individuals.  These higher returns are reflected in the higher pensions that are forecast for the future.  Employees will also benefit from their employer’s contributions, unless they are self- employed.


These increased benefits will be “fully funded”.  This means that only the money that is paid in for these higher benefits (and the earnings on this money) will be available to pay those higher pension amounts.  The risk is that the world-wide low interest rate environment (as exists today) may prevent some of those forecast returns from being realized.  If that happens, then in the future either the required contribution levels will go up or the benefit levels will be adjusted down.

 Employers and employees bear almost all of the costs and risks associated with these enhancements.  Of course, the employees get all of the benefits while the employers are burdened by this extra cost.   Employers may respond in ways not beneficial to employees.  Possible actions might include more substitution of automated equipment and artificial intelligence for labour, delaying or reducing wage increases, or more “contracting out”.  The only direct cost to the government will be for improvements to the “Working Income Tax Benefit Program”.   This Program will provide relief to lower income individuals to offset the cost of higher pension payments.  Like RRSP contributions, employee contributions will be tax deductible.  Employers will also receive a tax deduction for their contributions.


The CPP Investment Board is investing the funds from this Enhancement Plan differently than the Basic Plan.  The stated purpose is to reduce the volatility (change from year to year) of the returns.  Therefore, 30-50% of the monies are being invested in a long-term debt fund, with the remainder invested in the same manner as the Basic Plan.  Effectively, about 50% of the funds received would be invested in debt securities.   In developing this Plan, the assumption was made that long-term interest rates would gradually rise to provide a real return (actual return minus the rate of inflation) of 2.3% per year. 

Unfortunately, since October 2018, the Bank of Canada reports that actual long-term interest rates have steadily fallen.  As a result, the real return on thirty year government of Canada bonds is now a significant negative number. Around the world, there are many trillions of dollars of debt securities trading at actual negative interest rates.  This means that bond buyers have to pay interest instead of receiving interest.  Economists with the Bank for International Settlements concluded in June, 2019 that “Our empirical estimates suggest that the world real rate of interest is likely to remain low or negative for an extended period of time”.  The Governor of the Bank of Canada recently said that “he expects global interest rates to remain low for years to come due to the effects of structural forces such as sluggish productivity and population growth”.   This easing of interest rates is reinforced by the expansive monetary policies being generally pursued in response to the pandemic.

As a result, it will be difficult to achieve the targeted real return of 2.3% on long-term debt securities.  Of course, the actuaries for the Canada Pension Plan did not have the knowledge of more recent market information when their estimates were made.  The CPP Investment Board is addressing this problem by investing more money into private debt.  The lack of liquidity with such securities is offset by the higher yields that are available.  Growth in this area is expected to focus upon China, India and Brazil. 


 Proponents of these Enhancements suggest that the economy will benefit in the long-term from the higher spending of pensioners.  However, in the short term, spending capacity will be reduced as implementation takes place and contribution rates increase.  Canada presently faces serious trade issues with our major trading partners, as well as problems (low prices and environmental concerns) with future resource development.  Many of our traditional sources of job growth may not be there in the future.   The challenge is to attract investment capital to technology and other growth businesses.  In doing so, we have to compete with both the United States and China which have the biggest technology companies in the world.

Reflecting these problems, the Conference Board of Canada stated recently that “Beyond 2020, economic growth will be constrained by declining labour force growth and weak business investment.”   They go on to conclude that “From 2020 to 2040 GDP growth is projected to average just 1.7%.”  This compares to a GDP growth rate of 3.1% from 1962 to 2019.   Slower economic growth could eventually cause an increase in required contribution levels or a reduction in benefits.


It is suggested by advocates of these changes that overall savings levels will increase, thereby causing individuals to be better prepared for retirement.  This assumes that other types of savings will continue as before.  Individuals have certain spending needs and desires.  If they are forced to save more through CPP and QPP, they may reduce other types of savings. This is obviously more likely to occur when interest rates are very low.  Only time will tell if overall savings rates will go up.

Supporters of these changes have also said that the additional money available to these Plans will result in higher investment activity with associated job creation.  At present, the Canada Pension Plan invests 90% of its money outside of Canada.  So, other countries will be the main beneficiary of additional funds inflows.  On the website for the Canada Pension Plan Investment Board, the question is asked whether investment proposals can be submitted.  The answer given is that they do not generally respond to unsolicited proposals.  Also, there is no articulated plan to increase investment in Canada.


Despite my critical comments, I moderately support these enhancements.   My concern is with arguments made that there are no downside risks to these changes.  If we fail to recognize the problems that may arise, then we won’t be motivated to deal with these issues.  When the Enhancement Plan was developed, there were assumptions made with respect to economic growth and the level of real long-term interest rates.   Particularly in the light of recent information, it appears that these assumptions were too optimistic.   As a result, the overall cost of the Enhancement Plan will likely be greater than forecast.  This means that employees and employers will pay more than was forecast if benefits are maintained.  My comments do not take account of the long-term impact of the COVID-19 pandemic, as this will require analysis at a later point in time.

Elliot M Rodin
Bachelor of Commerce -University of Manitoba
MBA                                  -Harvard Business School