Bigger CPP, Bigger Risks?

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Gary Marr of the National Post reports, New report suggests a ‘fully-funded’ expanded Canada Pension Plan might not be such a sure thing:

A new report that looks at the federal government’s blueprint for an expanded Canada Pension Plan warns the larger payouts are predicated on returns that may not materialize over the next 40-75 years.

The C.D. Howe Institute in a paper out Tuesday is calling on Ottawa to be more forthcoming about the potential investment risk for the plan, suggesting that over the next 40 years the expanded plan will achieve 90 per cent of targeted benefits only 54 per cent of the time based on the current return expectations.

“There are risks and we don’t know whether there (are) going to be enough assets and contributions in the fund to ‘fully fund’, as we normally understand it, (the CPP),” said Alexandre Laurin, one of two authors along with William Robson of a report titled Bigger CPP, Bigger Risks: What “Fully Funded” Expansion Means and Doesn’t Mean.

Currently, the C.D. Howe report says, participants pay 9.9 per cent per year on earnings covered by CPP and the benefit, after 40 years, equals 25 per cent of that covered amount.

Under the new plan, announced in June, the level of earnings being covered will increase: Participants are expected to pay an extra two per cent on currently covered earnings and eight per cent on the newly covered earnings. After contributing for 40 years, participants will receive benefits equal to 33.33 per cent of the higher earnings level.

While the government and other advocates of the expanded plan have used the term ‘fully funded’ to describe it, the C.D. Howe paper says there is a catch: they are not using that term to mean the plan has assets to cover the present value of benefits accrued to date.

The group maintains the rate of return assumed in projections for the base CPP and the expanded plan are “well above the current yields available on the kind of sovereign-quality Canadian debt that people might think appropriate” for the plan.

The authors go on to say the expanded CPP will “expose participants to more risk than they know” and say it is tough to assess the risk that returns will be too low to cover promised benefits.

The report says the chief actuary for the government has plotted a course for a return of 3.55 per cent in real (inflation adjusted) terms over 75 years. It noted the federal government’s real return bond currently yields 0.7 per cent.

“The return is very important because the new CPP is different than the old. CPP has to be funded through contributions and investment on the contributions so the investment income is important,” said Laurin, adding his group looked at reasonable risks that the fund could not meet its goals.

Over the next 75 years, the paper says the expanded CPP will see 65 per cent of targeted benefits covered 90 per cent of the time. That was based on the 3.55 per cent real rate of return which the chief actuary said would be established with an asset mix that included 37.5 per cent equities, 37.5 per cent fixed income securities and 25 per cent real asset.

“The base CPP, only a small portion is contingent on returns. Our annual contributions mostly cover the current benefits and it will be the same in the future,” said Laurin.

He says the bill that created the expanded CPP has issues that still need to be resolved, such as regulations as to what happens if there is a shortfall.

“There are really only two options (if the expanded CPP comes up short). Lower benefits if there is not enough investment return or higher contributions and the future generations will pay more than what they get which is already the case with the base CPP,” said Laurin, adding at the very least the government should make it clear an expanded CPP is contingent on financial returns.

Alexandra Macqueen of the Globe and Mail also reports, CPP changes could leave younger workers footing the bill, report says:

Policymakers may be misleading Canadians into thinking the expanded CPP is on firmer financial footing than it actually is, and if the plan’s investment returns stumble, younger workers may be at risk of footing the bill for older Canadians, says a report released Tuesday by the C.D. Howe Institute.

In June, 2016, the federal and provincial finance ministers announced they’d reached a deal to expand the Canada Pension Plan to replace more of the income Canadians earn during their working years.

Under the revamped CPP, working Canadians would contribute 1 per cent more than current rates for the “base” CPP benefit and an additional 4 per cent on newly-covered earnings above that amount. Employers would be required to match these increased contributions.

While the current CPP is designed to cover up to 25 per cent of the average industrial wage, the expanded CPP – or “CPP2” – would cover up to 33.33 per cent of the higher covered earnings amount.

The importance of investment returns to plan success

The problem, say the authors of the C.D. Howe Institute’s report, William Robson and Alexandre Laurin, is that federal and provincial policymakers have described the CPP enhancements as “fully funded,” but what this means in the context of CPP is not what most Canadians might think.

In the context of a defined benefit pension plan, a “fully funded” plan has assets sufficient to cover the present value of benefits earned by plan participants to date. In the context of the CPP, however, “fully funded” means the plan’s investment returns are expected to offset the need for contribution increases as the number of contributors (working Canadians) falls in the coming decades, relative to the number of retired Canadians receiving CPP income.

Canada’s Chief Actuary has calculated that CPP2 will be able to pay the projected increased benefits from the higher increased contribution rates so long as the Canada Pension Plan Investment Board (CPPIB) is able to earn a 75-year average rate of return of 3.41 per cent, after investment management expenses.

If this assumed rate turns out to be too low, retirees could expect higher benefits or lower premiums (or both). Alternately, if this rate of return is not attained in reality, the C.D Howe report, entitled “Bigger CPP, Bigger Risks: What ‘Fully Funded’ Expansion Means and Doesn’t Mean,” says Canadians may end up with lower-than-expected benefits or higher-than-expected costs.

Who foots the bill for shortfalls?

Achieving the projected long-term rate of return requires “a fair amount of investment risk and uncertainty,” said Mr. Robson and Mr. Laurin. In addition, they believe that low-risk, relatively secure assets – such as long-term government bonds – are not producing a rate of return that is close to the 3.41 per cent CPP minimum.

For example, they pointed to the rate of return for a federal long-term, real-return bond, which is currently yielding 0.7 per cent. “If the CPPIB were to invest in such an asset [to produce the required investment returns], and its yield stayed at that level,” the authors said, the contribution rates on CPP2 would need to more than double, or promised benefits would need to fall by more than half.

The CPP legislation provides that contributions can be increased in the future, if the provinces consent. Rate increases, however, are limited to not more than two-tenths of a per cent per year, which might not be sufficient to cover shortfalls, and if the provinces and the federal government cannot agree on contribution rate hikes, the rules about changes to benefit levels and contribution rates (which themselves will also be subject to provincial consent) have not yet been written.

A call for increased transparency

For the report’s authors, the problems stemming from the increased investment risk embodied in the enhanced CPP are twofold: first, the plan might not hit its return targets and secondly, if the targets are not met, the actions policymakers can take to rectify any shortfalls are not yet set, which means younger working Canadians could be on the hook.

The bottom line? For the authors, CPP needs more transparency regarding its risk exposure – which its participants will bear the brunt of – and how the plan will respond if things don’t work out as expected.

“In fairness, if the investments do better than expected, the current generation might end up paying for benefits enjoyed by future generations,” said Joe Nunes, an independent actuary and president of Oakville, Ont.-based Actuarial Solutions Inc. “Then again, if the investments do well, I am sure there will be political pressure to improve benefits as soon as possible, again pushing the risk of insufficient assets to a future generation.”

The C.D. Howe report recommends that the provinces and Ottawa consider developing safeguards to protect against CPP2 increasing contributions from (younger) working Canadians to cover shortfalls for older (retired) Canadians if the realized investment returns from the CPPIB don’t meet the minimum required threshold rates.

One option would be to adopt a “target benefit” model, in which benefits above a target amount (for example, 80 per cent of the base benefit) are protected, but benefits above this basic amount are allowed to adjust downwards in the event of a plan shortfall.

“The starting place for this discussion,” said Mr. Robson and Mr. Laurin, “needs to be understanding among the officials and interested Canadians that, in an uncertain world, even the Canada Pension Plan makes no guarantees,” as neither the base CPP nor CPP2 are, or will be, “fully funded.”

You can read a summary and the full C.D. Howe report, Bigger CPP, Bigger Risks: What “Fully Funded” Expansion Means and Doesn’t Mean, by clicking here.

Now, before I share my opinions, let me be upfront and tell you I actually like the C.D. Howe Institute and don’t find it as ideologically warped as the Fraser Institute.

I also like Bill Robson, its President and CEO, who I have met at pension conferences in Montreal and Toronto. Bill is a smart and sensible guy and he and his co-author Alexandre Laurin have written a decent report highlighting some important issues on the expanded CPP.

Still, I wish these “think tanks” would be more upfront on who exactly funds them and why they perceive expanded CPP to be such a threat (ie. Canada’s large financial services companies who know they cannot compete with Canada’s large, well-governed defined-benefit plans).

From a policy perspective, there’s no doubt Bill Robson understands the intricacies of expanding the CPP extremely well. But from an investment and actuarial perspective, neither he nor Alexandre Laurin are authorities on how Canada’s large pensions take calculated risks across public and private markets all over the world to achieve their long-term actuarial target real rate of return.

Now, it’s true that the Canada Pension Plan (CPP) is not a “fully funded” plan like Ontario Teachers’, HOOPP, OPTrust or OMERS. Instead, the CPP is a partially funded plan:

Beginning in the 1980s, the CPP’s financial sustainability became a key issue due to a convergence of factors, including increases in the life expectancy of the Canadian population, and a large, aging baby boom demographic that would soon be retiring (meaning more people would be drawing on the retirement system and fewer would be contributing). Accordingly, the concern was for the long-term viability of the CPP and its ability to provide meaningful benefits in the future.

While this issue was recognized in the 1980s, little action was taken due to a lack of political will. It wasn’t until 1998 that the federal government and the provinces agreed to make substantial reforms to the program to address the issue of its sustainability. Under the reforms, CPP contributions by employers and employees were significantly increased to provide a stronger revenue base. Additionally, the Canada Pension Plan Investment Board was established to invest those funds that were collected but not immediately required (for payout of benefits).

As a result of these reforms, the CPP moved away from a “pay-as-you-go” basis, where contributions were set at a level that would accommodate pension payouts and provide a contingency fund of two years’ worth of benefits for all eligible Canadians. (Under the previous system, any surplus was automatically loaned to the provinces.) Under the new reforms, the CPP moved to a “partially funded” model, accumulating a larger fund of approximately five years’ worth of benefits. In turn, these monies are subsequently invested more broadly by the Canada Pension Plan Board to achieve a better rate of return ― meaning that the funds are not simply sitting “parked” somewhere, but are accruing value.

These reforms significantly improved the financial sustainability of the CPP, such that in 2007, the federal Office of the Chief Actuary released a report on the CPP, which concluded the CPP will be financially sound over a 75-year period. It also found that between 2007 and 2019, CPP contributions will be more than sufficient to cover benefits. After 2019, a portion of the CPP’s investment income will be needed to make up the difference between contributions and expenditures. That said, the economic recession of 2008-09 did impact the CPP. In February 2009, the CPP Investment Board reported a decline in the fund, of $13.8 billion for the nine-month period ending December 31, 2008 (CPPIB, February 2009). By September 2009, however, the board had reported a sharp increase in the fund’s value, which regained the value it lost during the recession (CPPIB, November 2009).

Being partially funded effectively means that CPPIB can take more risks than these other large pension plans because it’s not managing assets and liabilities very closely.

Still, CPPIB is very risk conscious and it has plenty of assets to meet its actuarial obligations:

In the most recent triennial review released in September 2016, the Chief Actuary of Canada reaffirmed that, as at December 31, 2015, the CPP remains sustainable at the current contribution rate of 9.9% throughout the forward-looking 75-year period covered by his report. The Chief Actuary’s projections are based on the assumption that the Fund’s prospective real rate of return, which takes into account the impact of inflation, will average 3.9% over 75 years. CPPIB’s 10-year annualized net nominal rate of return of 7.3%, or 5.6% on a net real rate of return basis, was comfortably above the Chief Actuary’s assumption over this same period. These figures are reported net of all CPPIB costs to be consistent with the Chief Actuary’s approach.

The Chief Actuary’s report also indicates that CPP contributions are expected to exceed annual benefit payments until 2021, after which a small portion of the investment income from CPPIB will be needed to help pay pensions.

“Over the period of his latest report, the Chief Actuary confirmed that the Fund’s performance is well ahead of projections as investment income was 248% higher than anticipated. The Fund’s investment returns have made a favourable impact and contributed to the lowering of the minimum contribution rate required to help keep the CPP sustainable over the long term,” added Mr. Machin.

So, after reading this, you have to wonder, why all the fuss about expanding the CPP? I happen to think it’s a great thing for Canadians and the Canadian economy over the long run as it ensures more people will escape pension poverty and live off a solid retirement well into their golden years.

I’m also at a loss as to this passage from the National Post article:

“The C.D. Howe Institute in a paper out Tuesday is calling on Ottawa to be more forthcoming about the potential investment risk for the plan, suggesting that over the next 40 years the expanded plan will achieve 90 per cent of targeted benefits only 54 per cent of the time based on the current return expectations.”

I don’t know where they pulled these figures from and as for Ottawa being more forthcoming about the potential investment risk for the plan, maybe Canada’s banks and mutual fund companies should be more forthcoming on the fees they charge on their mediocre funds (it’s coming with CRM2) and be brutally honest on how DC plans expose millions to pension poverty.

Over the weekend, John Mauldin posted a great comment, Angst in America, Part 3: Retiring Broke, which is a must read for all of you. In the UK, one in five Brits have no pension savings and face retirement poverty. The situation in Canada isn’t any better where nearly half of working-age Canadians are not saving for retirement, which is why enhancing the CPP is so critically important.

Sure, we can discuss whether a 3.55% actuarial real rate of return target is realistic over the next 75 years, or whether we need to introduce more risk-sharing in a “fully funded” Canada Pension Plan so if there is a persistent shortfall, benefits need to be cut or contributions raised, but it’s too early to worry about these issues and they certainly shouldn’t be used as an excuse to question the expansion of the CPP, which is good pension and economic policy, period.

We have the best defined-benefit pension plans in world in Canada. Instead of acknowledging this and building on their success, some think tanks are criticizing them and question their long-term sustainability without highlighting their success or the abject failure of the private sector’s solutions to our ongoing retirement crisis.

Anyways, don’t get me started, I like Bill Robson and have nothing against the C.D. Howe Institute, and while this report raises a few valid concerns, it also perpetuates myths that CPPIB will not be able to deliver over the long run, exposing the CPP to serious funding risks.

I simply don’t buy this and neither does Bernard Dussault, Canada’s former Chief Actuary, who will share his thoughts later today in an update to this post (you can click on the pig at the top of this blog to reload the page and get the latest updates).

Update: Bernard Dussault, Canada’s former Chief Actuary, shared these insights with me on this new C.D. Howe report (added emphasis is mine):

I am not inclined to agree whatsoever with the main conclusions of the C.D. Howe report. Here is why.

The C.D. Howe report claims, without really substantiating it, that “… the rate of return assumed in projections for the base CPP and the expanded plan are “well above the current yields available on the kind of sovereign-quality Canadian debt that people might think appropriate” for the plan.”

Despite the investment losses incurred by the CPP fund in 2008, at the time of the largest economic downturn since the 1929 crash, the CPP has since rapidly recovered from those losses in such a way that the average real rate of return on the CPP fund over the last 10 years exceeds the one (4%) assumed in CPP actuarial reports since the 1998 CPP reform.

In other words, CPP statutory actuarial projections have so far always proven to be reliable. I have yet not seen any evidence that the pension investment landscape has been subject pursuant to the 2008 economic downturn to any structural change that should cause a material decrease in the expected average long term economic growth.

Therefore I tend to give to the Chief Actuary’s following conclusion (last paragraph on page 9 of 28th CPP actuarial report) more credit than to the conclusions in the C.D. Howe report.

This report confirms that if the Canada Pension Plan is amended as per Part 1of Bill C-26, a legislated first additional contribution rate of 2.0% for the year 2023 and thereafter, and a legislated second additional contribution rate of 8.0% for the year 2024 and thereafter, result in projected contributions and investment income that are sufficient to fully pay the projected expenditures of the additional Plan over the long term.

I thank Bernard for sharing his wise insights with my readers and I agree with his and the current Chief Actuary’s conclusion.

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