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(January 2008) There’s no denying that saving for retirement is key, but it’s also important, maybe even more so, to talk about retirement income planning with your clients.
A primary element of retirement income planning is the sources of retirement income, a major one of which is government benefits such as Canada or Quebec Pension Plan benefits.
Depending on your clients’ other financial resources, the importance of CPP retirement benefits will range from significant to trivial. In either case, I feel that the role of CPP is not as fully appreciated as it should be when it comes to the retirement income planning process. To get a handle on why this is important to retirement planning, I’ve answered five central questions about CPP.
What role do CPP benefits play in retirement income?
CPP retirement benefits are viewed by government policymakers as one part of a three-legged pension system, the other two being Old Age Security (and Guaranteed Income Supplement for those who qualify) and private retirement assets, either accumulated through membership in a company pension plan or through individual saving and investing. When taken at age 65, CPP benefits are intended to replace 25% of the contributor’s average lifetime earnings up to a maximum of Canada’s average industrial wage, which is currently $44,900.
For a single person with average annual pre-retirement income of $50,000, CPP and OAS combined will replace approximately one-third of his or her pre-retirement income. For couples with the same level of pre-retirement income, these public benefits will replace approximately 65% of pre-retirement income. At the other end of the income scale, singles with annual pre-retirement income of $200,000 can expect combined CPP/OAS benefits to replace only 5% of pre-retirement income while couples in the same situation can expect a 14% replacement rate.
Can my clients depend on future CPP retirement benefits?
Future CPP retirement benefits are about as sure a bet as you can get. As the Canada Pension Plan Investment Board website notes, “In his most recent report, the Chief Actuary of Canada reaffirms the findings of the previous actuarial report and states the CPP is sustainable throughout the 75-year projection period.” The most recent actuarial report on the QPP stated the plan is well positioned through 2050, though monitoring of future contribution rates is needed to ensure the QPP’s sustainability in the years beyond.
The increase in premiums and changes to benefits that were part of the plans’ reform packages a decade ago restored financial viability to both the CPP and QPP. A particularly important part of the CPP reform package was the formation of the Canada Pension Plan Investment Board and the change in the investment of surplus funds away from low-return lending to governments to a diversified portfolio of equities, fixed-income and alternative investments such as infrastructure. As a result, the rate of return improved significantly. Neither plan is fully funded, but the effect of the change in investment policy and the creation of the CPPIB have increased the financial resources of the CPP significantly. With its independence from government, its leading-edge governance model and its excellent investment returns, the CPPIB is viewed as among the best in the world. Like the CPPIB, the Caisse de dépôt et placement du Québec (CDP) manages the QPP’s funds and was established at the plan’s inception in 1965 for this purpose. Today, the CDP manages well in excess of $100 billion in deposits for a variety of institutions in that province.
How do CPP benefits deal with the five key risks to retirement income planning?
In 2005, Fidelity introduced the five key risks to lifetime income that investors need to consider when planning their retirement. The risks include outliving their money, losing their purchasing power due to inflation, investing too conservatively or too aggressively, withdrawing too much money too soon, and not having enough saved to get the health care they need and want. CPP/QPP benefits help to reduce longevity risk by providing guaranteed benefits for life. They substantially reduce inflation risk by indexing payments to the increase in the Consumer Price Index over the previous year. They mitigate withdrawal rate risk by being drawn from funds that are completely separate from the recipient’s own retirement portfolio. They manage asset allocation risk by making use of the highly sophisticated investment management capability of the CPPIB and the CDP. And they help manage health care risk by providing the recipient with a source of guaranteed, indexed income that can be used to cover medical expenses in retirement.
When should one begin using his or her CPP benefits?
CPP retirement benefits can be taken any time between ages 60 and 70. Age 65 is used as the “benchmark,” or normal retirement age, with monthly benefits being reduced by 0.5% for each month before 65 and increased by 0.5% per month after 65. This means that retirement benefits at age 60 will be 30% less than those at age 65, while waiting until age 70 will raise benefits by 30%, other things being equal.
The decision as to when to take benefits is very much client-centric. If a client needs the money, the decision is a no-brainer. For the remainder of client situations, there is more to consider. One aspect is the relation of when a client begins taking benefits to the total lifetime benefit amount a client receives. When comparing start dates of 65 and 70, the “break-even” point is approximately age 85. But your client needs to live well beyond 90 to get a substantially larger lifetime benefit. If your client starts taking benefits at 60, he or she may have done better delaying taking the pension in the event of living past age 75. However, in actual application, there are often other issues involved. For example, some advisors recommend taking benefits early and investing the proceeds. Another point is that the certainty and stability of CPP retirement benefits can be a useful offset against investment income whose certainty and stability is less. Another issue is taxation. Many advisors say that if a client doesn’t need the money, he or she is better off delaying benefits from a tax standpoint, but other advisors are of the view that taking the CPP/QPP benefit early can help reduce the client’s tax load down the road.
Can CPP retirement benefits be split between spouses?
Up to 50% of CPP benefits can be shared between spouses, subject to the limitations that both are at least 60 and shared benefits are limited to those accrued while the couple was married or in a common-law relationship. There are a couple of potentially confusing issues here. The Service Canada website indicates your clients must provide either a marriage certificate or proof of a common-law relationship. It isn’t specific about what type of documents are needed for the latter.
The other point of potential confusion is that the federal government considers pension-splitting of CPP benefits to be a different issue than splitting other types of pension income. The section of the Department of Finance website that deals with pension income-splitting and indicates that CPP benefits are not eligible may be confusing to clients, but one of the advisor’s roles is to clear up such confusion.
The bottom line
Like so much else in retirement income planning, one size doesn’t fit all when it comes to the role of government benefits in your clients’ retirement income plans. Nevertheless, the near-universal applicability, certainty and flexibility of CPP/QPP benefits suggest they are an important retirement income component.
Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years’ experience as an economist, he leads Fidelity’s research efforts in retirement in Canada today. He can be reached at peter.drake@fmr.com.
(01/16/08)