Budgeting for 2021 CPP changes — and beyond

Will the pandemic lead to higher future premiums?

[Link to original on advisor.ca]

We’re midway through the first phase of Canada Pension Plan (CPP) enhancements announced in 2016. Over the long term, the enhancement is designed to increase the CPP income replacement level from one-quarter to one-third of eligible earnings.

Phase one, which began in 2019, increases employer and employee contribution rates by 1% over five years. Next year marks the halfway point in both time and amount: the cumulative increase will be 0.50% in 2021, taking the contribution rate to 5.45% from the 4.95% starting point.

The rate is applied to the year’s maximum pensionable earnings (YMPE), recently announced as $61,600 for 2021. At the new rate, the 2021 maximum contribution will be $3,166.45 each for employer and employee. Self-employed individuals pay both parts, totalling $6,332.90.

Table: Annual CPP enhancements

Year Addition Cumulative addition Contribution rate
2018 – – 4.95%
2019 0.15% 0.15% 5.10%
2020 0.15% 0.30% 5.25%
2021 0.20% 0.50% 5.45%
2022 0.25% 0.75% 5.70%
2023 0.25% 1.00% 5.95%
Budgeting for next year

Over the five-year phase-in period, contribution rates will increase by 20%. That will erode an employee’s net paycheque by as much as about $600 once phase one is fully implemented (again, double that for those who are self-employed).

The 20-basis-point addition for next year will probably go unnoticed by most people. Still, it’s a worthwhile discussion to raise in year-end client reviews, as you look toward budgeting adjustments and cash flow planning over the coming few years.

Phase two begins in 2024

Phase two adds a second earnings limit beyond the YMPE, to be called the year’s additional maximum pensionable earnings (YAMPE). The YAMPE will begin as 107% of the YMPE in 2024 and move to 114% in 2025. After that, the two thresholds will be separately indexed using the same standard indexation factor.

Employer and employee contributions up to the YMPE will continue at the 5.95% rate, while the rate between the YMPE and YAMPE will be 4% each. All contributions are deductible for employers.

Employees will continue to claim a tax credit on contributions up to the YMPE, but contributions between the YMPE and YAMPE entitle employees to a deduction. A deduction better aligns to the employee’s cost since it’s set at the marginal tax rate, rather than the lowest bracket rate accorded to the credit.

Will the pandemic prompt more CPP changes?

In its fiscal sustainability report for the third quarter of 2020, the parliamentary budget officer (PBO) raised the spectre that additional funding may be required for the CPP.

The CPP is funded by those employer and employee contributions. Excess cash flow is invested in financial markets to fund anticipated future cash shortfalls as the population ages, which in turn raises the ratio of beneficiaries to contributors.

Analysis from the PBO suggests the CPP is “not sustainable over the long term — albeit to a modest extent.” Though it appears adequate to meet its 25- and 50-year measures, “projected contributions and benefits are not sufficient to ensure that, over the [75-year] long term, the net asset-to-GDP position returns to its pre-pandemic level.” The PBO estimates that increased contributions or reduced benefits amounting to 0.1% of GDP may be required to sustain the plan.

The government is obviously focused on the pandemic for now, but be prepared that we may yet see further CPP adjustments beyond the current enhancement process.

A tax strategy about nothing

What Seinfeld can teach us about the value of staying the course

Like a lot of families, we’ve been doing things differently while social distancing during the pandemic. In addition to dusting off board games and semi-regular family walks, our latest streaming service has allowed us to catch up on classic TV, including Seinfeld.

More than three decades since it hit the air, there’s still something about the sitcom that came to be known as the show about nothing. That worked in the world of comedy, and may give us something to think about in the more serious world of portfolios.

I’m certainly not suggesting that investors set up portfolios once and ignore them thereafter. On the contrary, it’s imperative to be aware of economic developments — such as the market movements since the onset of Covid-19 — as well as any changes to the businesses behind individual securities.

Financial advisors are the source for this kind of information, reviewing with clients what’s relevant (including the effect on the investor’s appetite for risk) and deciding if adjustments are warranted. Those may include portfolio changes, behavioural changes, or both — or nothing at all.

The critical point is to resist the urge to make changes for the sake of change alone. The urge to just do something can be particularly harmful to a non-registered portfolio.

Unlike registered accounts, changes to non-registered holdings can result in taxable dispositions. Tax deferral that an investor enjoyed while holding rising securities over the course of years will be realized when those securities are sold.

If those portfolio changes are based on a focused review, then the tax implications should not stand in the way of action. However, if the original portfolio continues to suit the investor’s planning needs, then a premature change not only drifts away from the plan but also compounds that diversion by triggering taxes unnecessarily.

A tale of two investors: Gerry & Jorgé

Consider sister and brother investors Gerry and Jorgé, 40 year-old fraternal twins saving for an elaborate trip together for their 50th birthdays. Both have high incomes, so we’ll use a 50% marginal tax rate. Ten years ago, each used $10,000 to buy 1,000 units of VanDelayed mutual fund for $10 per unit. The price rose as high as $18, but has since come back to $14. It pays no dividends.

Despite the recent price decline, Gerry leaves her investment alone. Jorgé, on the other hand, is convinced that VanDelayed will continue to fall, so he sells.

With a fair market value of $14,000 and a $10,000 adjusted cost base, Jorgé realizes a $4,000 capital gain. As half the capital gain is taxable, he has a $2,000 taxable capital gain that costs $1,000 in tax, leaving him with $13,000.

A few months later Jorgé reconsiders and decides that Gerry was right. As it turns out, the price is again $14 when he reinvests his $13,000.

Ten years later when it’s time to book the trip, VanDelayed is at $28.

Gerry’s $28,000 holding realizes a $18,000 capital gain, resulting in $4,500 in tax, netting to $23,500.

With the price doubling from $14 to $28 from the time Jorgé reinvested, his $13,000 rose to $26,000. Taking away $3,250 tax due to the $13,000 capital gain, Jorgé is left with $22,750.

Even though Jorgé got back in at the same price as when he exited, the early tax payment hampered his growth, putting him $750 behind Gerry. The amount lost would vary depending on the growth rates, but, as long as there was indeed growth, the difference would never come out to nothing — which is something to think about.

How medical symptom checkers can shine a light on robo-advice

The limits of expert systems

While running in the great outdoors this weekend, I was listening to the Skeptics Guide to the Universe podcast, which explores and de-bunks pseudo-scientific claims. It got me thinking about the delivery of financial advice, and automated advice in particular.

After discussing Covid-19, co-host Steven Novella, a medical doctor, went on to question the accuracy of online symptom checkers (SCs). In a recent blog post, he summarized the findings of an Australian study that evaluated the accuracy of 27 online SCs.

Novella characterized the study’s results as “pretty disappointing.” On average, the correct diagnosis was listed first 36% of the time.

Not bad at first blush to hit it on the head more than one-third of the time, but the correct diagnosis was only listed among the top 10 possible diagnoses 58% of the time. For practical purposes, that means the correct diagnosis was missed 42% of the time, as most patients likely don’t look beyond the top 10.

More interesting to me, though, were the potential reasons why the diagnoses were so poor.

Parallels with automated financial advice

As the panellists shared their thoughts, I couldn’t help but see the parallels with automated tools in the personal finance and investment fields. These include do-it-yourself online brokerages and robo-advisors that offer online investment portfolios, but also advisors’ own tools: from the reference sources that clients never see, to side-by-side processes, to that solo interaction between the client and the evaluation tool.

Wherever the technology lies on that spectrum, it can’t be a proxy for the advisor.

As with the doctor-patient relationship, a financial advisor has to understand the client in order to deliver personalized advice. The less the advisor interacts with the client, the more difficult it is to deliver.

And even with the benefit of direct contact, it remains the advisor’s responsibility to apply and explain the tools and their output so the client’s interests are adequately served.

Points to ponder

Here are some of the podcast panellists’ thoughts on symptom checkers, and how I see them applying to financial advice:

Quality of input

Patients are often not very good at describing symptoms. People may say numbness when they mean weakness, or they may treat the two as the same, Novella said.

A client may use similarly imprecise language to describe their personal goals or their feelings about risk.

Alternatively, a client may adopt words offered by the document they’re filling out or the platform they’re using without appreciating nuances. Absent the advisor probing further, the premises for a client’s action (or inaction) may not properly reflect their intentions.

People come to you with a narrative

Both medical patients and financial clients can be biased, frequently responding with their relative feelings anchored on recent experiences. One has to ask questions in multiple ways to deconstruct the objective facts from the narrative, and then reconstruct those facts in the medical or financial arena where they are to be applied.

It’s a dynamic investigative process that takes a lot of insight into how people think and communicate. A focused professional can then use this knowledge to move the relationship forward.

Body language

An experienced physician reads all the signs, including the patient’s body language. Advisors can observe a client’s posture and tone of voice, and how a couple interacts — things you don’t experience through checks in boxes or even the most eloquent text summaries.

Triage function

This is the “Do I go to the hospital?” moment. The SCs reviewed in the Australian study scored 49% on this measure, though they erred more on the side of sending people when it wasn’t necessary.

While there’s no life or death counterpart in financial advice, the accumulated harm of unverified guidance could make it difficult for someone to recover should problems materialize in later years.

The “why” of the output

It’s not enough to produce an output and expect that it will speak for itself. Newer SCs that use artificial intelligence give reasons for why they predict certain things, as well as how sure they are about the output provided.

That’s a large part of the financial advisor’s value to the client: explaining where things come from and where they are headed. It’s a check against the quality and thoroughness of the inputs that led to the output, and an opportunity to reinforce the client’s confidence and commitment to the plan you are creating together.

As a final point, it should be noted that SCs have no common regulation, if any at all. Comparatively, there is plenty of regulation in the financial field, and compliance departments help advisors stay vigilant and within boundaries.

Still, financial tools can be very complex. It’s incumbent on advisors to fully understand what is at their disposal so that digital platforms are used as tools of the advisor, and not in place of the advisor