- For those with an interest in public policy, demographics are making pension policy increasingly important. With Defined Benefit pension schemes disappearing, the quality of pension provision is dropping, and this will become an increasingly important political issue.
- For fixed income analysts, there appear to be only two ways that interest rates will rise appreciably above zero. The first possibility is that New Keynesians are replaced at central banks. The second possibility is that there is a structural change in fiscal policy that eliminates persistent demand weakness. Given the demographic trends, a loosening of pension policies could provide that structural change.
A Quick Introduction To The Canadian Pension FrameworkAlthough most of my readers are not Canadian, I am going to use the Canadian pension framework to illustrate my points. My feeling is that the Canadian situation is not too markedly different from other developed countries, although there are quantitative and qualitative differences. I need to reference data to illustrate the problems facing a potential expansion of universal pensions, and I am familiar with the Canadian scheme as a result of my knowledge of Canadian financial planning. I would note that I am not an expert on pension policy, and I am simplifying some concepts.
I will also apologise that the dollar amounts that I am quoting are based on measurements taken in different years. There has not been any significant changes in the income structure over recent years, so these date mismatches should not be significant.
We can divide the income sources for Canadian retirees as follows.
- Old Age Security (OAS). This can be thought of as an income guarantee for Canadian seniors at age 65 and above. However, seniors with higher incomes will have the benefits "clawed back". In 2013, the income paid was $6,700 per year, and the clawback started at an income of around $70,000. There are additional supplements for households with low incomes, so one could view the minimum guaranteed income to be somewhat higher. ( I am quoting the 2013 numbers as those are the ones I had handy.)
- Canada Pension Plan (CPP). This is a universal defined benefit pension that is generally paid for by source deductions (those of us who are self-employed pay it along side our income taxes). The exact formula of how much is paid is similar to that of a defined benefit pension. The pension paid depends on the size of contributions, which are a percentage of workers' income, up to a certain maximum amount. The maximum benefit in 2013 was around $12,000.
- Tax-Advantaged Investment Vehicles. The default tax-advantaged way of saving for retirement is to use a Registered Retirement Savings Plan (RRSP). This is an investment account that is registered with the tax authorities; income that is placed into the account is only taxed upon withdrawal (presumably at retirement, but it can be earlier). The contribution limit is 18% of "earned income" (not investment income), up to a maximum around $24,000 (in 2014). (There is also the new TFSA, but it is less significant as it has only been around for a short period.) If the worker has a pension plan at work (Defined Benefit or Defined Contributions) , the pension contributions are also tax-free (until withdrawal), but these contributions take away the available RRSP contribution room.
- Housing. Housing is quite often the most important "saving vehicle" for Canadians. In 2011, 69% of households owned their dwelling (link to source). Residential real estate was a fairly successful investment vehicle, at least when compared to some of the more dubious financial products available historically (such as mutual funds with management expenses of greater than 2% per year). However, the obvious fear going forward is that this will work out just as well for Canadians as it did for Americans after the Financial Crisis. This large position in real estate is one offset against the evidence (such as wealth surveys) that most Canadian households have low financial asset holdings.
|Average after-tax income ($)|
What The Universal Pension System AccomplishesThe OAS and the Canada Pension Plan appear to achieve their original objective: keeping seniors out of absolute poverty. (That is my impression; I am not an expert on poverty statistics.) Returning to 2011 Census data, the median benefit from the OAS (and supplements) was $6,200, and the median CPP benefit was $6,800 (link to source). For individuals earning $30,000 or less, these retirement programmes largely replicates their working income.
However, these programmes are not going to do much about relative poverty or inequality. If we take a couple where both persons received the median benefit, the total benefit received would be $26,000. This is less than half of the Canadian average household; instead it fits between the second and third decile. (Since my income distribution data includes all households, and senior household income is less than working age household income, such a household would be lower ranked when compared to just working-age families.)
Will The Universal Pension Be There?A common fear that I run across is that the various universal pensions will not be there when the currently young retire. I disagree with that sentiment, but we need to be careful about what we mean.
If you accept the role of these programmes as being a safety net that allows seniors to have a standard of living which is comparable to the working poor, it seems very unlikely that they will be discontinued. The burden of transfers are small relative to most households' income. Furthermore, the last period of severe economic stress in Canada was in during the Great Depression, which led to the creation of the welfare state. With universal voting entrenched, that experience would easily be replicated. My reading of poll results is that it has been political suicide to embrace a platform of leaving seniors freezing and starving on the streets for decades, and there is little sign of that changing given the ageing of the voting population.
But if you want to think about the programmes in terms of an absolute standard of living, the outlook is cloudy. For example, one might ask what will the value of the transfers be in "2016 dollars" 40 years in the future?
If you use the measured Consumer Price Index to calculate those "2016 dollars," it is probable that the programme will look good. However, the Consumer Price Index is a polite economic fiction in an environment where the basket of goods and services available to consumers changes radically. The goods that are no longer available are largely quaint: whale bone corsets, buggy whips. However, depending on your views regarding resource depletion and climate change, the outlook over the next decades offers the potential for more wrenching changes. People will adapt, and the measured CPI will reflect those adaptations. Nevertheless, a common sense view of the "standard of living" could easily be less cheery than is suggested by CPI-adjusted dollar amounts -- many goods will essentially be unavailable.
Concluding RemarksIn summary, if we view public universal pensions as being a safety net that gives recipients a benefit flow that is comparable to lower income deciles, the policies are achieving that objective, and should be able to do so going forward. Unfortunately, what future benefit flows will be able to purchase is essentially unknown. If you believe the economic bears, our best and brightest New Keynesian forecasters at the Fed were unable to forecast an industrial slowdown that was under way months earlier; the quality of 40-year forecasts is going to be even lower.
However, there are strong arguments that this is not enough. Although the private sector theoretically has the tools to provide replacement income flows for seniors, we have seen that there are large gaps in practice. These gaps are large enough to catch the attention of politicians. However, even though the current focus is on the "1%" or even the "0.1%", there are large dollar income gaps amongst "the 90%". For example, the after-tax household income of the sixth decile is almost double that of the third decile (although I suspect that is magnified by the mismatch between single earners and two-income families). Those income disparities, even amongst the middle of the income distribution, makes the design of a universal supplementary income scheme much more awkward politically.
I will turn to those issues in follow-up article(s).
- Leo Kolivakis has an article about the Ontario provincial government expanding public pensions. One may note the political difficulty faced by this plan, which is not surprising based on the arguments that I will discuss in the following articles.
(c) Brian Romanchuk 2015