Friday, August 14, 2009

Will CPP/OAS Be There When You Retire?

I often hear this question when talking to people. For some reason, the younger the person, the more it is assumed that there will be no Canada Pension Plan or Old Age Security. However, it is also interesting to see how many older people assume that it is their inherent right to receive OAS benefits. As you are about to see, they may both be very wrong.

While the information I am about to show you is old, rest assured it will explain the problem/crisis we face in the future. These numbers are from the 2003-2004 fiscal tax year. During that year, the federal government brought in $186B in revenue. The largest single expense that year? Interest payments on Canada’s federal debt (money borrowed by previous federal governments, which has not been repaid). These payments – to institutions and individuals who hold federal bonds, Treasury bills and other forms of the debt – cost $35.8 billion. This represents 19% of all tax revenue.

Transfer Payments are cash payments that go directly to individuals, to provincial and territorial governments, and to other organizations. Overall, these three categories of transfers combined make up just over half of all federal spending, or almost 51 cents of each tax dollar. Of this group, the biggest transfer category was Major Transfers to Persons. Altogether, these payments cost almost 23 cents of every tax dollar. These transfers included payments to eligible elderly Canadians through Old Age Security payments, the Guaranteed Income Supplement and the Spouses Allowance.

Here is a simple point - for every dollar the government brings in, 42 cents goes to pay the debt and provide OAS and related benefits. Now here is the crisis part - what happens when the first wave of baby boomers turn 65. This will lead to lower tax revenues and higher transfer payments. Over the past several years, the federal government has been paying down the deficit at the rate of about $10B per year. The past 12 months changed everything and it is expected to put us back where we began. The federal debt level was still substantial at $467 billion in 2006-07. expect to see a number in the $550 billion range next by 2010.

If you think we have it bad, the US is in much deeper trouble. I found this best illustrated their problems going forward.

Let's turn to the state of the Canada Pension Plan. Canadians currently receiving their CPP benefits have no cause for concern. The plans has a total (March 2009) of $105.5 billion in it's portfolio. In fact, it will be another 11 years before a small portion of the CPP Fund’s investment income will be needed to help pay pensions. Beyond that time, the CPP Fund will continue to grow for decades to come. The $105.5 billion CPP Fund is broadly diversified and structured to help secure Canadians’ CPP pensions over the long-term and the funding structure of the CPP means that it is able to weather an extended market downturn.

CPP contribution levels have increased dramatically over the past 15 years to their current levels of 9.9%. The reason for this was to preserve future benefits. According to the Office of the Chief Actuary of Canada, the CPP fund needs a real rate of return – that’s return after inflation – of 4.2 per cent, over the 75-year projection period in his report, to sustain the plan at the current contribution rate. Over this long time frame we expect that there will be periods where returns are above or below this threshold. In the ten years since the CPP Investment Board began investing, returns for the CPP Fund in all four-year periods prior to fiscal 2009 exceeded the 4.2 per cent real rate of return.

Public equities make up 44.0 per cent of the CPP Fund. The current asset mix is as follows:
Public equities: 44.0%
Fixed Income: 27.9%
Private equities: 13.4%
Inflation-sensitive assets: 14.7%

Interestingly, only 45% of the portfolio is actually invested within Canada. Don't think that makes sense? Here is a response from the CPP Investment Board to that question.

Our mandate is to contribute to the financial strength of the CPP by investing in the best interests of 17 million CPP contributors and beneficiaries and by maximizing returns without undue risk of loss.With approximately 45.5% of our portfolio (or $48.0 billion) invested in Canada, we will always have a large part of the fund invested here but we do not want to be overly dependent on the strength of the Canadian economy and so are systematically looking for opportunities to diversify internationally. But portfolio diversification by asset class and by geography is a fundamental part of the CPP Investment Board’s long-term investment strategy to manage the growing complexity of the fund. On its own, Canada does not provide sufficient diversification opportunities. Canada’s stock market is small, representing less than 2% of the world market capitalization, and it is heavily concentrated in a few sectors. The flow of contributions to the CPP varies directly with the health of the Canadian economy. By reducing the fund’s reliance on the Canadian economy, global diversification offers a source of returns for periods of weak performance by the Canadian economy.

Since the Canada Pension Plan is funded by contributions from it's "members", there are fewer issues of affordability. Nonetheless, as explained in a previous blog, there are changes pending to the plan and the amount of benefits people can/will receive. Expect lower benefits in the future, as well as possible increases in costs. If I were a gambling man, I would bet on CPP being around for 50-100 years. As to the Old Age Security (OAS) program? I think that the future definitely holds some snake eyes.

Stay Well and Pay It Forward.

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