Such a Deal!
In the early 1990s, it was apparent that existing Canada Pension Plan (CPP) contribution levels could not sustain future benefits. In early 1998, the CPP was amended to phase in a dramatic increase in the required contribution rates. The new regulations took contribution rates from 5.85% of pensionable earnings in 1998 to 9.9% in 2003. (The rate was only 3.6% in 1966 when the CPP system began.) Pensionable earnings are basically annual employment or self-employment income falling between $3500 and an upper amount that is inflation-adjusted. In 2015, this upper limit was $53,600. Therefore, if your employment income in 2015 was more than $53,600, you and your employer each paid half of the maximum CPP contribution for 2015 of:
0.099 × ($53,600 − $3500) = $4,959.90
The primary benefit that contributors expect to receive from the CPP is the retirement pension. This pension is indexed to the CPI. To be eligible for the maximum CPP pension, you must be age 65 and have made the maximum annual CPP contribution for 83% of the years since 1965 or age 18, whichever is the shorter period. In 2015, the maximum annual CPP retirement pension was $12,780.
In this Point of Interest, we will estimate the rate of return that CPP contributions must earn to deliver the expected pension. The assumptions are:
• Shona begins to make maximum CPP contributions ($4,959.90) at age 25 in 2015.
• Thereafter, the rate of inflation (and, consequently, the annual increase in the CPP contribution and the retirement pension) will be 2%.
• Shona will retire and begin drawing the maximum retirement pension at age 65.
• Shona will live to age 86 (current life expectancy for a woman aged 65).
• CPP contributions and pension payments will be made at the end of each year.
If the pension is funded by Shona’s contributions,
(Future value, at age 65, of CPP contributions ) = (Present value, at age 65, of pension payments )
Since both the contributions and the pension payments grow at the constant rate of inflation, Formulas (13-2) and (13-3) must be used for these calculations.
QUESTIONS
1. What is the future value, at age 65, of Shona’s CPP contributions if the rate of return they earn is:
a. 3% compounded annually? b. 4% compounded annually?
2. What will be the (indexed) CPP retirement pension in Shona’s first year of retirement? (The maximum annual CPP retirement pension in 2015 was $12,780.)
3. What is the present value, at age 65, of Shona’s pension payments if the discount rate is:
a. 3% compounded annually? b. 4% compounded annually?
4. Suppose Shona could take the amounts that she and her employer will contribute to the CPP and instead invest these amounts to provide for a do-it-yourself pension. What is your estimate of the minimum rate of return Shona’s investments must earn to provide the same pension payments as we have projected for the CPP retirement pension?
5. Are you underwhelmed? (No explanation is required.)