Aging population offers pension opportunity

By most measures, Canada’s retirement income support system is an outstanding success. The poverty rate for Canadian seniors, with just 4.4 per cent living below half the median income, is among the lowest in the world. The Canada Pension Plan, once careening towards insolvency, is now on a sounder footing. Millions of Canadians contribute to their Registered Retirement Savings Plans every year, with a view to replacing more of their income than the 25 per cent covered by the CPP; TaxFree Savings Accounts are a fast-growing alternative. For most people, then, the pension system works well. There is no evidence of a generalized pension “crisis.”

There is, however, a pension problem. With the proportion of the population in retirement projected to double in coming decades, traditional “pay as you go” and defined-benefit pension models look increasingly unsustainable: More of the burden will have to be borne by pre-funding, that is out of beneficiaries’ own savings. Yet that message has yet to hit home to a sizable minority of Canadians, who continue to put aside less than the amount needed to maintain a standard of living in retirement comparable to that which they enjoyed in their working lives.

What to do? For many pension experts and a number of the provinces, the answer is to expand the CPP, increasing the replacement ratio to 35 per cent or even 50 per cent of income, perhaps financed by an increase in maximum pensionable earnings. At this week’s meeting, federal finance minister Jim Flaherty came under pressure from his provincial counterparts to sign off on CPP expansion; as expected, Flaherty demurred, citing a lack of consensus and the uncertain state of the economy. He’s right to be cautious, and not only because of the economy.

Certainly there can be no question of raising CPP benefits without an offsetting increase in premiums. Spending on Baby Boomers is projected to be enough of a burden on future generations, without enriching benefits still further.

At the same time, the very size of the CPP Investment Fund, now at $170 billion, presents its own difficulties. Not only are there risks associated with putting so many eggs in one basket, as the Quebec Pension Plan’s beneficiaries discovered in the wake of the asset-backed commercial paper debacle, but the CPP Investment Board has been taking an increasingly aggressive, hands-on style to managing its assets. When first liberated from its original mandate of lending to provincial governments (at below market interest rates), the fund was required to pursue a passive investing strategy, i.e., buying the index. It has since shaken off that constraint, to the point that it now has its own representatives sitting on boards.

Is this really in the best interest of pensioners? History teaches that where such large pools of capital are placed within reach of politicians, the temptation often proves overwhelming to tap it for some purpose or other.

Supporters of CPP expansion make two good points. First, to get people to save at the level required, you probably have to force them to do it. RRSPs may ensure that anyone who wants to save is not discouraged by the income tax from doing so, but you still run into a free-rider problem in the long run: Those who spend all their income while they’re younger are simply not going to be denied a pension when they retire.

Second, much of what people invest on their own is wasted.

The willingness of investors to shell out two per cent and three per cent of their assets to mutual fund managers who, year in, year out, underperform the index is one of the great challenges to the concept of rational economic man.

But the CPP is no paragon of efficiency either. As its ambitions have grown, so have its expenses: At some $440 million a year, they are roughly triple what they were only four years ago. Throwing everyone together into one big fund, moreover, means everyone is effectively exposed to the same portfolio risk, regardless of age or risk tolerance. And so far as CPP premiums are viewed as taxes, there are legitimate concerns about the employment effects of premium increases.

Yet the pressure to “do something” about pensions will remain. If Flaherty is to hold out against CPP expansion in the long run, he’ll need an alternative. Here’s one: Suppose an additional levy were tacked onto CPP premiums. Only instead of going into the regular CPP pot, the funds would accumulate in the contributor’s own personal fund — like an RRSP, only compulsory. To avoid wasting money on management fees, funds would be invested strictly passively (i.e., buying the indexes), with the particular asset mix varying as the investor aged: more stocks when younger, more bonds when older.

Any increase in benefits would thus have to be fully funded; at the same time, since legal title to the funds would rest with the contributor, there would be no way politicians could raid the kitty.

On its own, this would be vastly preferable to CPP expansion. If we liked the results, we might even think of going further. Over time, one could imagine migrating more and more of the regular CPP over to these mandatory personal accounts, allowing the CPP fund to be slowly wound down. Rather than simply expanding the CPP, the challenge of population aging presents an opportunity to reform it.