Pension tension

More than 95 per cent of Canadians 65 or older collect government pensions, according to income tax data. And Statistics Canada estimates those benefits provide about one-third of the average retiree’s income. Government pension programs are clearly important. Yet 75 per cent of all Canadians polled this summer by Léger Marketing expressed concern about their future financing.

Never intended to fund retirement
Do you feel you can no longer rely on these programs to fund your retirement? The reality is that you never could — unless you were poor. Public pensions were designed to replace only up to 40 per cent of pre-retirement income for those at the average national wage — $39,100 in 2002. With total maximum benefits of less than $15,000, they are meant to serve only as an anchor, providing a basic income that is fully indexed for inflation and guaranteed for as long as you live. 

Inflation protection is a key safeguard since few private sector employer pension plans — and no RRSPs or RRIFs — are automatically indexed. Consider that even with seemingly low inflation of two per cent, a dollar will lose almost half its purchasing poweover 30 years. The longevity guarantee is a cushion for the growing number of people who rely mainly on RRSPs and defined contribution pension plans, both of which can be exhausted if not prudently managed.

There are two main public pension programs. The first is Old Age Security (OAS). It covers virtually everyone and includes a Guaranteed Income Supplement (GIS), spousal allowance and survivor’s allowance for low-income recipients. The second program is the Canada Pension Plan (CPP) and the very similar Quebec Pension Plan (QPP). Together, CPP and QPP cover almost everyone in the paid workforce.


Next page: Old age security

Old Age Security
The OAS pension starts at age 65. Apply six months before your 65th birthday to allow time for processing. Don’t delay; retroactive claims are limited to 11 months’ benefits. Paid monthly, last year’s (2002) maximum annual benefits totalled a little more than $5,300.

The actual amount is adjusted for inflation four times a year. Those with 40 years of adult Canadian residence qualify for the maximum. Immigrants get a full or partial pension, depending on when they arrived and whether Ottawa has a social security agreement with their home country.

Worried about clawbacks?
Many middle-class people assume they’ll get little or no OAS because of the clawback, which phases out benefits for upper-income seniors. But most need not worry.

The Mulroney government imposed the clawback in 1989 on OAS recipients with more than $50,000 of net income — gross income minus tax deductions. This group comprised just four per cent of recipients at the time, but the threshold was only partially indexed for inflation so more middle-income retirees got hit every year. Fortunately, the Chrétien government fully indexed the income tax system in 2000, and the clawback threshold — $56,968 for 2002 — now rises in line with inflation:

  • five per cent of recipients are now subject to the clawback, but most still get something because it’s phased in. 
  • clawback claims 15 per cent of the amount by which your net income — including OAS — exceeds the threshold.
  • Last year (2002), you needed $92,435 in net income to lose the full benefit. Even then, your spouse could still receive full OAS since the clawback applies to individual, not combined, income.

Some seniors can inadvertently get hit by the clawback if they realize a substantial windfall, often by selling a long-held business, cottage or investment property. But there are ways to structure such deals to ease or avoid the hit; consult a tax adviser.

The clawback is estimated based on your previous tax returns and deducted at source. An adjustment is made after you file your tax return for the current year. If the automatic deduction creates hardship, you can ask the Canada Customs and Revenue Agency to reduce it.

Will OAS continue to be funded?
OAS is a federal program funded entirely from general revenues. It’s also one of Ottawa’s fastest growing expenditures. The clawback was one of three attempts to control costs. The other two were defeated by strong pressure from retiree groups: the Mulroney government’s 1985 bid to remove full inflation indexing and the Chrétien government’s 1996 proposal to replace OAS with a new Senior’s Benefit.

When he killed the Senior’s Benefit idea in 1998, Finance Minister Paul Martin said OAS could continue in its current form only if Ottawa keeps its debt load in check. So we could see more assaults if the government reverts to deficit financing. One likely move would be to base the clawback on combined income for couples, a key provision in the aborted Senior’s Benefit.

Next page: CPP/QPP

Canada and Quebec Pension Plans
CPP and QPP are twins. QPP covers those working in Quebec except for RCMP and military personnel. The rules are integrated so you don’t lose credits when moving to or from Quebec.

As with OAS, you must apply for C/QPP — ideally six months before your intended start date. Those with both CPP and QPP credits apply only once, where they live.

The maximum C/QPP retirement benefit was $9,465 last year (2002). The pension for new claimants is adjusted each January to reflect growth in the average national wage. Benefits for recipients are adjusted each January for inflation.

What you get will depend on your earnings and contributions during your “contributory period.” That’s the period that began on your 18th birthday or Jan. 1, 1966, whichever came later. It also depends on the impact of as many as three “drop-outs” and on when you start collecting C/QPP.

To calculate your pension, C/QPP first adjusts your record so $1 earned in, say, 1966 carries the same weight as $1 earned this year. Then, your lowest income months are excluded under drop-out provisions.

Two drop-outs apply automatically:

  • general drop-out excludes 15 per cent of your contributory period when earnings were lowest. So you’re not penalized for low income. Many people, for example, earned very little while in college or university. This can also help those retiring early.
  • disability drop-out exists as well; in addition to the general 15 per cent exclusion, C/QPP automatically drop any month for which you received C/QPP disability benefits.

The third drop-out is not automatic; you must request it. The child-rearing drop-out is for a parent whose earnings fell while caring for a child under the age of seven years. That’s if the child was born after 1958 and you were a Canadian tax resident during the child-rearing period. Either spouse can claim this, but you can’t double up for the same period.

Remaining earnings are averaged
After excluding your low-income periods, the C/QPP computers average the remaining earnings. Your retirement pension then equals 25 per cent of that if you start it at 65.

You can, however, start as early as 60. C/QPP then reduces your pension by 0.5 per cent for each month between your start date and the month following your 65th birthday. So, you lose six per cent a year — or 30 per cent if you start at 60. Even so, most analyses show you’re better off starting early.

Technically, you are supposed to be “substantially retired” if you start C/QPP early. That means you earned less than the maximum retirement benefit in the month before and expect to earn less in the month you start receiving CPP benefits. The two-month limit for 2002 was $1,578. But this limit is based on an expectation with no penalty provision. And once your pension starts, you can earn as much as you want.

Beward employer pension plan pitfall
Those starting C/QPP early should be aware of a cash flow pitfall if they are in an employer’s defined benefit pension plan — the traditional type that promises a set level of retirement income based usually on earnings and years of service. This does not affect those in defined contribution pension plans and group RRSPs.

Defined benefit plans aim to replace a set percentage of income, perhaps 70 per cent for those with 35 years of service. But employers include C/QPP benefits in that calculation — after all, they pay half of the C/QPP contributions. The pension plan is thus “integrated” with C/QPP.

There are various forms of integration. One method kicks in at 65, reducing the employer pension by the C/QPP benefit. Here’s a simplified example. Suppose you retire at 60, your company pension is $2,000 a month and you’re due $800 from CPP payable at 65. You accept 30 per cent less CPP and start it immediately at $560. So you receive $2,560 a month from 60 to 65. Then, integration kicks in and reduces your company pension by the full $800 CPP benefit that was payable at that age, not the $560 you actually get. So, your income falls to $1,760 — $240 less than you expected. Some employer pension plans let early retirees smooth this by taking less initially and more later. That way, the difference in your monthly benefits when integration of these two plans takes effect is less jarring.

Next page: The bottom line

Will CPP go bankrupt?
Many people fear Canada’s aging population will bankrupt CPP. Not so, says the chief federal actuary, Jean-Claude Ménard. Even with more retirees and fewer workers, he projected last June that CPP will hold nearly $1.6 trillion in assets by 2050 — almost six times its projected annual expenditures. This growing fund results from a huge reform that took effect in 1998. Note that while OAS is a federal program, CPP is run jointly by Ottawa, the provinces and territories. And while OAS is funded by the public treasury, CPP and QPP are financed by employer-employee contributions. In effect, incoming contributions go right back out as benefits for retirees, the disabled and families of deceased workers. Meanwhile, a reserve fund provides a cash flow cushion.

CPP was overhauled amid warnings that, without change, the combined employer-employee contribution rate would have to be 14.2 per cent of covered earnings by 2030, when the last baby boomer turns 65. Policymakers considered that too high a burden and resolved to keep the rate below 10 per cent. 

In one key change, planned increases in contributions were accelerated so the combined employer-employee rate tops out at 9.9 per cent in 2003.

Investment Board empowered
Higher contributions were expected to create a burgeoning surplus, and a new arm’s-length board was created to manage this money. The Canada Pension Plan Investment Board was empowered to act as a private pension fund, with diversified investments in stocks, bonds, real estate and venture capital holdings. Its target annual return is four per cent plus inflation, a common goal for pension funds.

At June 30, the CPP fund held $56 billion — 69 per cent in bonds and 21 per cent in equities. Thanks to its large bond component, a pre-reform legacy, the fund has so far beat most large mutual funds and pension funds. In any event, no withdrawals are expected for another 20 years when the fund will start topping up workforce contributions to maintain both benefits and the 9.9 per cent contribution rate.

The reform also tightened the CPP disability program whose cost was soaring. And it tinkered with many other aspects, including freezing the $3,500 bottom-level income not subject to contributions and the $2,500 lump-sum death benefit. Significantly, the reformers rejected proposals for raising the retirement age and reducing inflation-indexing for current recipients.

QPP, which had already invested its reserve in diversified holdings, adopted most of the other CPP changes to keep in step.

The bottom line
The bottom line: public pension programs will be around to provide a base for your retirement funding. But it’s up to you and your employer to build on that if you want anything more than a very basic lifestyle.

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Bruce Cohen is co-author of The Pension Puzzle; Your Complete Guide to Government Benefits, RRSPs, and Employer Plans (John Wiley & Sons Canada Limited, 2002).