Published in the Financial Post on June 11, 2011
By William B.P. Robson
The recent economic crisis highlighted the weak foundations of defined-benefit (DB) pension and social-security schemes around the world. The Canada Pension Plan appears to have weathered that storm well, and some are advocating an expanded CPP to alleviate risks of low incomes in retirement. Proposals for a bigger CPP that talk of guaranteed or “fully funded” benefits may mislead distressed savers, however, since the CPP offers target benefits, not guarantees, and proposed increases would not be fully funded as most people understand the term.
Treat the CPP as a DB plan making firm promises, and it would need investment returns materially higher than those currently available on assets that match those obligations. Projections using the yield actually available on the federal government’s real return bond show that, enlarged or not, the CPP cannot pay scheduled benefits at its current 9.9% contribution rate, and would instead need a contribution rate well above 11% to avoid benefit cuts. Expanding the CPP would raise the stakes on a bet that is different from, and riskier than, most Canadians understand.
In the wake of the 2008 crisis and slump, sagging financial assets and threatened or actual bankruptcy of some private-sector pension-plan sponsors made the seemingly greater stability of government-backed pensions attractive to many Canadians. Not surprisingly, proposals to fill gaps in voluntary and contractual retirement saving with an expanded CPP got a hearing. With asset prices and the private economy in recovery, and the severe post-crisis corrosion of government balance sheets more evident, this idea needs a sober rethink.
CPP-style social-security plans have many pros and cons as pillars of a national retirement-income system. A critical misunderstanding about the CPP, however, arises from use of the term “fully funded” to describe its current status and potential expansions.
To most people, “fully funded” implies an ability to pay obligations with assets on hand. The CPP is not, and is not designed to be, fully funded in this sense. In discussions of the CPP, “fully funded” refers to the ability to pay existing promises or the enhanced benefits envisioned by big CPP advocates from a contribution rate (currently 9.9%) that will stay the same for more than seven decades. Critically, those projections depend on an assumption of a 4% net real return on the CPP’s investments — a number well above the yields currently available on sovereign-quality Canadian debt.
What advocates of an expanded CPP do not sufficiently advertise is that the CPP does not guarantee its benefits.
For the CPP to effectively guarantee its benefits by fully funding the plan in the normal sense of the term, it would need to back them with an asset of sovereign-risk quality that is indexed to inflation. The asset that comes closest to meeting that description is the federal government’s real return bond.
A cogent objection to using the RRB yield to evaluate the CPP would be that the CPP is not, in fact, a defined-benefit plan. The CPP is a target-benefit plan that, in principle, might justifiably not match its assets and its liabilities. While some experts know of these provisions, however, most Canadians do not.
Too few realize that, like DB plans that failed or are struggling — or indeed any individual seeking a secure retirement at modest cost — the CPP is currently relying on future returns significantly higher than those available on low-risk assets. To fund its benefits securely at today’s RRB yield, the CPP would need to charge much more than 11%.
It is misleading to tell Canadians that the CPP is fully funded and could reliably deliver richer benefits on the same basis. The CPP is not fully funded in the sense most Canadians would understand the term, and its benefits are not guaranteed. The CPP is a gamble, not a guarantee. Doubling down means running the same risks on a larger scale.
William B.P. Robson is president and chief executive of the C.D. Howe Institute.
