Tag: CPP

The case for CPP at 70

Why and how advisors can help

[A version of this article appeared in Advocis Forum February 2021]

While playing charades over the holidays, my youngest son stumbled with “a bird in the hand is worth two in the bush”. Eventually we guessed it, and I explained to him that it means accepting a sure thing now rather than holding out for something potentially bigger later.

Coincidentally, that adage also featured prominently in an item on my holiday reading list. It’s a research paper[1] about delaying Canada Pension Plan retirement benefits, released in late 2020 by the National Institute on Ageing and the FP Canada Foundation.

My long-held opinion has been to take at 65, unless there are compelling reasons to start earlier. After reading this paper, I’m now leaning toward 70 as the default position.

When we’re starting CPP, and why

The majority of Canadians – 7 out of 10 – take their CPP retirement pension at either 60 or 65. Less than 5% take after age 65, and only 1% wait until 70. The study’s author, Bonnie-Jeanne MacDonald, attributes this pattern of early uptake to a combination of lack of advice, bad advice and ‘bad “good” advice’.

The bad advice includes the emotional pull of the bird-in-the-hand: ‘If you die early (so the argument goes), you’ll leave money on the table, so take CPP as soon as you can’. However, the only guarantee is that your payments start sooner, not that you’ll receive more. And ironically, the early uptake may in fact increase the likelihood that you will receive less, as we’ll see following.

The ‘bad “good” advice’ is the mainstream practice of using a breakeven age. It compares two starting ages, say 60 and 65, focusing attention on whether you will reach the age when the cumulative receipts are the same. This plays to our behavioural tendency to favour the near-term (from first age to second age to breakeven age), thereby undervaluing the lifetime income security that CPP offers. On top of that, academic research shows we tend to underestimate our life expectancy, making it even more likely to choose the earlier start. 

According to Canada’s Chief Actuary, life expectancy at age 60 is 85.9 for men and 88.5 for women. In my own experience, I’ve never seen a suggested breakeven/crossover age much over 80. This has long been my discomfort with this approach, as you are betting on being in the ‘dies-before’ half of the cohort population. You lose (statistically) simply by being average, and it gets worse the longer you live.

Measuring the dollar difference

Early uptake would not be a concern if it in fact leads to a better financial outcome. To test this, MacDonald departs from the breakeven approach, favouring a calculation of the current dollar value of the expected loss, or “Lifetime Loss”.

For someone with average life expectancy entitled to the median CPP income who takes at 60 rather than delaying to 70, the Lifetime Loss in current dollars is over $100,000. 

The model factors-in the drawdown of RRSP/RRIF savings until the CPP begins. Including this component, it finds that most people will still be much better off by bridging this way, than by taking CPP early and stretching their RRSP/RRIF money over the expected retirement years.

Notably among the scenarios canvassed in the paper, someone entitled to the maximum CPP pension who lives close to age 100 (a 25% probability from age 60 according to the dataset used), the current dollar loss can exceed a quarter of a million dollars.

Advisors have a key role

To be clear, Lifetime Loss is not intended to be applied without consideration of individual circumstances. There are many situations where it would make sense to begin early, such as when there is a known life-limiting health condition, or when someone is trying to preserve income-tested benefits or shield against the Old Age Security clawback.

For most people, it’s a challenge just to identify all the contributing factors in making such a decision, let alone evaluate the trade-offs among them. It’s both technically complicated and emotionally charged, which together can be overwhelming. 

In addition to being a dependable information source, financial advisors can guide their clients by applying some of the lessons of behavioural finance:

  • Loss aversion holds that we feel the pain of loss twice as much as the joy of gain, which is what Lifetime Loss illustrates in concrete terms. 
  • It also frames the discussion on the more likely scenario of longevity, as opposed to early death.
  • Lastly, it anchors at the later age of 70, to be lowered as the analysis warrants rather than having to make the uphill battle from age 60.

Ultimately the decision should be informed by individual particulars and reliable evidence. In the latter respect, I recommend this paper as a helpful resource for all financial advisors. 

1 https://www.fpcanadaresearchfoundation.ca/media/5fpda5zw/cpp_qpp-reseach-paper.pdf

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.

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

Published version: Linkedin

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.