Canada's Retirement Income System:
Myths and Realities

Thirteen common myths

Myth No. 5: The government can no longer afford the rising costs of public pension programs like OAS and CPP/QPP

Fact: It is true that the aging of the population is driving up expenditures on OAS and the CPP/QPP, and will continue to do so well into the next century as the baby boomers enter old age. But whether Canada can afford rising public pension costs is a separate and quite contentious question.

It is important to remember that the government collects income taxes on OAS and, therefore, recoups part of the program's cost. Ottawa will recover an estimated $2.0 billion of the $16.5 billion it will pay out on OAS in 1995-96, and the provinces will collect an estimated $1.1 billion in provincial income taxes. The clawback on OAS will bring in another $400 million, for a total federal recovery of $2.4 billion or 14% of gross OAS payments.

The federal government already has taken steps to limit future increases in expenditures on seniors benefits. The clawback of OAS will reduce the old age pensions of increasing numbers of middle-income seniors in the years to come because the income threshold for the clawback (which is only partially indexed to inflation) is falling steadily in value. Income-testing has cut the cost of the age credit, and partial indexation of the income tax system is steadily reducing the cost of tax benefits for seniors.

Measured as a percentage of the Gross Domestic Product (GDP), OAS expenditures have risen from 1.3%, when the program began in 1952, to 2.7% in 1995. But even assuming a low 1.5% real rate of economic growth in future, the OAS-to-GDP ratio will rise to only 2.8% by 2030 and then will decline steadily thereafter, falling back to its 1995 level by 2060. If GDP increases more (e.g., in the 3 to 4% range), then the OAS-to-GDP ratio will actually decline in future because economic growth will outpace OAS growth.

While OAS is funded by the general tax revenues collected by the federal government, the CPP/QPP is not. It is funded entirely by employer and employee contributions. The only real cost to government is the income tax credit for CPP/QPP contributions, which cost Ottawa and the provinces an estimated $1.4 billion in 1992. However, this cost is more than offset by the estimated $4.3 billion that the two levels of government collected in 1992 by taxing CPP/QPP payments. Since the CPP is not part of federal spending, questions of 'affordability' relate to whether or not employers and employees will be willing to pay increased contributions to the plan to offset the decline in the number of contributors relative to beneficiaries.

In 1995, employees must contribute 2.7% of earnings, up to a yearly maximum of $862, matched by a 2.7% contribution from their employers; the self-employed must pay the full 5.4%, up to $1,724. However, employees and the self-employed can claim a tax credit to help offset the cost of their contributions to the CPP/QPP. In 1995, the maximum CPP/QPP federal tax credit for employees is $147 and the maximum average provincial income tax savings is $80, for a total maximum tax credit of $227. In 1995, the maximum federal/provincial tax credit for self-employed Canadians' CPP/QPP contributions is $454. These tax benefits reduce the maximum CPP/QPP contribution to $635 for employees and $1,270 for the self-employed.

By the year 2030, it is projected that employee contributions will have risen to 5.8% of covered earnings.⁶ This would amount to an estimated maximum $3,077 for workers with average earnings or more (in constant 1995 dollars), with a matching contribution from employers; the self-employed would have to pay 11.6% of their earnings up to the average wage, up to $6,154. In 2030, the tax credit for CPP/QPP contributions will reduce the maximum contribution to an estimated $2,266 for employees and $4,532 for the self-employed.

From the beginning of the CPP/QPP in 1966, it was understood that contribution rates eventually would have to rise to keep the plans financially viable in light of increased expenditures on Canada's aging population. The federal and provincial governments met late this autumn, according to their schedule of regular five-year reviews, to discuss future contribution rates for the CPP/QPP. In the future, there is no doubt that employees, employers and the self-employed will have to pay considerably more to maintain the CPP/QPP.

Myth No. 6: High payroll taxes required to fund the CPP/QPP puts Canada at a disadvantage compared with other countries

Fact: Canada enjoys an advantage relative to other countries in terms of the costs of pension programs. Pension contributions in other countries are actually substantially higher than those in Canada-both in terms of total revenues and in relation to employee compensation. A 1988 report from the Organization for Economic Co-operation and Development (OECD) estimated that pension contributions amounted to 8% of employee compensation in Canada, compared with 11.1% in the United States, 14.7% in Japan, 24.7% in Belgium, 34.8% in Austria, 36.6% in France and 39.4% in the Netherlands.⁷

Myth No. 7: The CPP/QPP is going bankrupt

Fact: The CPP/QPP is not funded in a way that makes it possible to go bankrupt. Many people do not understand how the CPP/QPP is funded and apparently believe there is a fund which will run out of money well before they get to retirement. However, unlike private employer-sponsored pension plans, the CPP/QPP does not have a fund from which pension benefits are paid. Instead, the CPP/QPP is a 'pay-as-you-go' plan. Contributions made by employees, the self-employed and employers pay for the pensions of those who are retired. As contributions come in from the current work-force, they are paid out in benefits to the current retirees.

Based on experience and actuarial calculations, the federal and provincial governments set contribution rates to provide the promised benefits for those who are retired. Like all social insurance programs, the CPP/QPP is backed by the taxing power of the government. For this reason, it is generally considered unnecessary to create a fund from which to pay the benefits.

A long-term financing plan for the CPP, which takes account of population aging, was established by agreement between the federal government and the provinces in 1985. Under this agreement, a 25-year schedule of contribution rates was set out in the Canada Pension Plan Act to keep the plan financially viable. It was agreed that contribution rates would be reviewed regularly every five years and adjusted, if necessary, to take account of current expenditures. At each five-year review, contribution rates would be extended by a further five years. Contribution rates have been established up to and including the year 2016. The agreement also provides that CPP contribution rates will be set to provide a contingency fund equal to about two years of benefits over time. (As manager of its own plan, Quebec has been able to act unilaterally in making adjustments to the QPP. On the whole, changes made to one plan have been eventually made to the other, so as to maintain substantial parallelism between the CPP and QPP.) Given this regular adjustment of CPP/QPP contribution rates, it is meaningless to describe the CPP/QPP as 'bankrupt.'

Myth No. 8: The CPP/QPP as billions of dollars in unfunded liabilities

Fact: The benefits promised to future retirees ('unfunded' liabilities) are guaranteed by the government's capacity to adjust rates of contribution to the CPP/QPP. Private occupational pension plans are required by law to have a fund from which pensions will be paid, so that there will be money to pay the promised benefits, regardless of what happens to the employer. Actuaries calculate what contributions will be required to fund the benefits, making assumptions about such factors as the demographic composition of the employer's work-force, the potential number of employees who will reach retirement, the length of time for which pensions will have to be paid, the rate of return that will be earned by the pension fund investments and the future rate of inflation. The promised benefits are the 'liabilities' of the pension plan. If liabilities have accrued and the fund is not adequate to pay them--for example, because the actuarial assumptions proved inaccurate or not enough contributions were made to the plan--the pension plan has 'unfunded liabilities'. A plan with 'unfunded liabilities' would not have enough money to pay the benefits if the employer went under.

By definition, a pay-as-you-go plan like the CPP/QPP does not have a fund. Current pensions are funded by current contributions, which in turn are backed by the taxing power of the government. As the Royal Commission on the Status of Pensions in Ontario said in its 1980 report, "Sometimes the unfunded actuarial liability of the CPP, calculated as it would be for a private pension plan, is pointed to as an indication of the precarious position of the CPP... However, to relate this liability to the soundness of the Canada Pension Plan, which is premised on continuance in perpetuity, is meaningless. Like the fear of bankruptcy, it indicates an imperfect understanding of the nature of a social insurance program."⁸