Understanding The Benefits Of CPP Expansion: One More Try

“ Given the importance of the changes being made to the CPP and the wider implications for Canada’s retirement income system, it’s unfortunate that an expert of Ambachtsheer’s stature has fuelled misunderstanding over the benefits of CPP expansion”.

The Fraser Institute

The last thing in the world I want to do is to fuel misunderstanding over the benefits of CPP expansion. The Fraser Institute (FI) believes I did this in demonstrating that all five of its criticisms of CPP expansion were off the mark in my recent KPA Policy Paper "Is The New Canada Pension Plan Expansion Based on Myths or Facts? A Readers Guide". 

They said so last Friday in a piece in Canadian Investment Review titled  “Rebuttal—5 Myths About The CPP”, which is the source of the quote above. I rebut their rebuttal in this short (and I promise final!) piece in this exchange.

Understanding the Looming Retirement Savings Challenge

I reminded FI that the CPP enhancements were not about today’s retirees, but about giving today’s young people “a reasonable shot at retirement security 20, 30, 40 years down the road”. The underlying premise was that today’s young people face a radically different set of economic circumstances than their ‘boomer’ parents did when they were young (e.g., later workforce entry, later family formation, higher house prices, fewer workplace pension plans, lower investment returns). FI responded that I “provided no evidence to support his assertion”. There are, in fact, a number of recent studies that have reached that same conclusion.

One example is the C.D. Howe study by Moore, Robson, and Laurin titled “Canada’s Looming Retirement Challenge: Will Future Retirees be Able to Maintain Their Living Standards upon Retirement?” The authors conclude “while only about 16% of recent retirees are in circumstances that imply a substantial reduction in consumption post-retirement, the persistence of recent trends would raise this number over time to 44% of current 25 to 30-year-olds…..”.  FI is of course right to say that this is only a projection which may, or may not be on the mark. The frustrating thing about the future is that it is uncertain.     

Understanding the Role of Investment Returns

FI claims I am mistaken “that future retirees will benefit from strong investment performance of the CPP Investment Board (CPPIB). This simply isn’t true”. This assertion unveils FI’s fundamental misunderstanding of the difference between ‘pay-as-you-go’ and ‘pre-funded’ pension arrangements. As there are no investment reserves in ‘pay-go’ arrangements, investment performance is an irrelevant concept. However, as ‘pre-funded’ pension arrangements do have significant investment reserves, simple logic suggests investment performance matters a lot in the ultimate cost of the pension arrangement. Specifically, the stronger the investment performance, the lower the contribution rate required to pay the promised benefits.  

The original 1960s version of the CPP was a largely pay-go arrangement, meaning that only sufficient contributions were collected over time to pay the calculated benefits (plus a small reserve). This original version of CPP (call it ‘Old CPP’) was modified in the 1990s to build up a larger reserve fund to stabilize the CPP contribution rate at 9.9% of pay (it is still that today). So today’s CPP is about 20% funded and 80% pay-go. FI is correct to point out that as a result, CPPIB’s investment return will only have a minor impact on the ‘value-for-money’ return CPP participants get on their contributions in the form of ‘Old CPP’ benefits.

What FI seems to not have caught up with is that the economics of CPP enhancements (‘New CPP”) are quite different, because the CPP Act requires these enhancements must be fully pre-funded. This means that the investment return CPPIB earns on ‘New CPP’ contributions will matter a great deal. The most recent CPP Actuarial Report is very clear about this. Table 13 on page 33 projects that the sources of ‘Old CPP’ revenues will be 70% contributions and 30% investment returns, and 30% contributions and 70% investment returns for ‘New CPP’ revenues (i.e., for the fully-funded piece).

Understanding the Elephant in the Canadian Pension Room

The FI rebuttal sings the praises of people saving for their own retirement, ignoring the empirical reality that most of those savings run the gauntlet of Canada’s investment ‘advisor’/high mutual fund fee network. My critique of FI’s ‘’Five Myths about the CPP’ article cited a study which found that a sample of 500,000 Canadian mutual fund investors underperformed the market by an average 3%/yr. over the last 15 years. This kind of investment outcome has disastrous consequences for these unsuspecting  investors. For example, $100 invested by a young worker today grows to $326 over a 40-year working life if it earns a real return of 3%/yr. If that 3%/yr. goes to other people, the starting $100 is still only $100 40 years later. This amounts to 70% pension ‘haircut’ for our young worker, and constitutes compelling evidence of a ‘market failure’. It is the elephant in the Canadian pension room. 

How can the market for pension investment services fail its participants so badly? George Akerlof was awarded the 2001 Nobel Prize in economics for the explanation. He demonstrated that fair market outcomes require fully-informed market participants. If a market suffers from ‘asymmetric’ information, that market will fail and produce unfair outcomes. Akerlof teamed up with another Nobel Prize-winning economist Robert Shiller to demonstrate the implications for retail investors. They show that the kind of investment outcomes cited above are predictable events. I urge FI to read their 2015 book “Phishing for Phools: The Economics of Manipulation and Deception”.  

Speaking of books, I am sure my FI friends have read “Cost and Choice” by the most conservative, libertarian economist ever to be awarded the Nobel Prize: James Buchanan in 1986. He argued that just because a government is democratically elected doesn’t mean they cannot mess up economic policy decisions….and indeed, often do. However, in the end, even Buchanan recognized the possibility of market failures and the legitimate right and obligation of democratically-elected governments to address them. While Buchanan might have questioned the decision of Canada’s federal and provincial governments to enhance the CPP, my guess is that he would also have seen it as a legitimate response to a clear case of ‘market failure’. 

That’s it. I’m done.

-Keith Ambachtsheer