To Relieve Pension Headaches

by David K. Foot

Reprinted from the Globe & Mail, December 8, 1997.

Canada Pension Plan: The bill to change the CPP may short-change most baby boomers. A slight adjustment to the retirement age would help.

Finance Minister Paul Martin introduced a bill this fall to reform the contributory Canada Pension Plan. Under that bill, which was passed by the House of Commons last Thursday [December 4, 1997] and now proceeds to the Senate, premiums will rise by a substantial 73 per cent over the next six years and future benefits will be cut by about 1.6 per cent. A grandfather clause protects the pensions of those who have turned 65 by year end.

Mr. Martin says the overhaul, the largest since the plan was introduced in 1966, is necessary to "prepare for the numbers of retiring baby boomers early in the next century."

While it is encouraging to see demographic analysis forming the foundation of public policy, it is important to use it responsibly and completely. The first boomers, born in Canada in 1947, will not reach the traditional retirement age of 65 until 2012. The peak of the boom, born in 1960, will turn 65 in 2025; so the problem emerges in the second and third decades of the 21st century.

It is always responsible to be well-prepared, which is why Mr. Martin is acting now. But is the bill fair, and is it wise?

Those now receiving the unreduced pension have contributed for at most 31 years, and many for a considerably shorter time. Granting unreduced pensions to this group regardless of length of contributions has been an important instrument of social policy, resulting in a noticeable reduction in poverty among seniors over the past three decades.

However, a new youth entrant to the labour force today at age 20 can expect to contribute for 45 years to get a slightly reduced pension. Even most of the boomers, the oldest being 19 in 1966 when the CPP and the Quebec Pension Plan were established, will have contributed for 45 years by the time they retire. This contribution period is 50 per cent longer than that of those now turning 65, and twice as long as the contribution period of today's 74-year-olds. While discussions of their relative contributions to the economy and country are beyond resolution, there is no debate about the disparity in pension amounts contributed and received. The benefit-cost ratio is much greater for today's seniors than today's youth, so it is not surprising that the seniors defend the pensions while the youth debate them.

Was there an alternative? Canada chose a retirement age of 70 in the 1920s, when average life expectancy was 61 (60 for men and 62 for women). In other words, we chose our first retirement age when, on average, we didn't expect anyone to make it!

In 1951, a means-tested pension was made available at age 65, when average life expectancy was 68 1/2, giving an average of 3 1/2 years of pensions for those who were eligible. In 1966, when the Canada Pension Plan was introduced, the expectation was for seven years of pension income, based on a life expectancy of 72. Today, life expectancy is 78 (75 for men and 81 for women), so the average retiree can expect to enjoy 13 years of pension income. So perhaps "the pension problem" has been the result of not raising the retirement age commensurate with increasing life expectancy.

The United States has recognized this problem. Its legislation, passed in 1983, raises eligibility for pensions by an average of one month in every year, beginning in 2003. For example, the retiree in 2015 will have to be 66 before being eligible for pension benefits. This law was passed with enough lead time to enable future retirees to plan their finances accordingly, but was also timed to coincide with the retirement of their baby boom (which starts in 2011, a year before Canada's). The law covers 24 years, thereby raising the retirement age for pension benefits to 67 by 2025, which more than covers the length of their boom generation.

Why didn't we implement a similar policy in Canada? Actuarial calculations have shown that even with modest productivity growth, an increase of two to three years in the retirement age would cover the contingencies anticipated by Mr. Martin's announcement. At the very least, some small gradual increase in the age of pension eligibility could have been used - and could be included in the proposed bill - to moderate the announced increase in premiums. This is particularly important because the premium increase is effectively a further tax on employment, since both employees and employers pay the contributions. Any government concerned with unemployment should be reducing such taxes, not increasing them.

But perhaps the most worrying feature of the proposed overhaul of the pension plan lies in the use of the revenues from premiums to create a pool of investment capital. This new fund, to be invested in a diversified portfolio by an arm's-length agency called the CPP Investment Board, will quickly grow into one of the country's largest pension funds. It is reported that the board will have up to $76-billion under management within 10 years. That is equivalent to almost 30 per cent of all monies currently held in Canada's rapidly growing mutual funds.

Since the board will have a mandate to maximize returns, much of this money will inevitably end up in the Canadian stock market, especially if the current prohibition on investing more than 20 per cent of pension funds in foreign markets is maintained. This will compete with the rapidly growing pot of mutual and pension funds for the limited quantity of offerings, thereby assuring a bull market for many years. This capital appreciation means that the 12-member board should have no difficulty achieving excellent rates of return, at least for the next 15 years.

Not only will this plan result in a brokerage-fee windfall for Bay Street, but the fund will likely end up holding a significant portion of some companies' stocks, much as some mutual funds do today. This means that selling those assets to pay pension obligations will have a negative impact on the price of the stock, even if gradual selling enables the board to "walk down" the stock's price.

These selling pressures will begin when the first boomers reach 65 and start to draw on the fund. For the following 20 years, as wave after wave of boomers look to their mutual and retirement funds to maintain their standard of living in retirement, funds will be gradually withdrawn from the market. Of course, the maximum withdrawals will probably not occur until the third decade of the next century, just when those who have contributed the most to the plan will be expecting their benefits.

So, just when the majority of the boomers turn to the new CPP Investment Board to fund their retirement, the investment fund is likely to be experiencing capital depreciation of its assets. Is this any different from, or any more secure than, relying on a government that at least can use taxing powers to meet its pension obligations?

There are other solutions to the pension problem. Gradually raising the retirement age is one alternative. Implementing flexible workplace policies that encourage older workers to work less than full time while still making pension contributions is another; this could maintain revenues and could also create employment for today's young workers, who will then be contributing the most to the plan. Moreover, these two alternatives could be easily combined into an innovative solution to the pension problem and an attack on youth unemployment - another of the government's priorities.

Demographic change does present challenges that require innovative solutions. Carefully examining the impact of demographic change on pensions while at the same time apparently ignoring its impact on employment and the stock market is neither innovative nor complete. Now is the time to overhaul the analysis and the proposed legislation, not just the pension plan.