Is The Canada Pension Plan A Good Investment For The Self-Employed?

The Canada Pension Plan (CPP) is paid into by all Canadians earning personal income through work. For incorporated professionals, there is the option to avoid paying into CPP by only paying dividends instead of salary from their Canadian Controlled Private Corporation (CCPC). The CPP is usually more like a pension than a tax for the self-employed. However, accountants still sometimes advise to use dividends and avoid the CPP in favor of keeping more money invested in the CCPC instead. Is the CPP really that bad of an investment for incorporated professionals?

What is the return on investment like for CPP?

The CPP Investment Board reports its returns every year. From 1999-2019, the CPP has had a 7.77% compounded annual return. For comparison, the S&P 500 had a compounded annual return of 5.92% over that time frame (with dividends re-invested). So, the CPP has had excellent returns. It also achieved that with about half of the volatility of the S&P 500. So, the risk-adjusted return has been fantastic. However, that does not mean that you see those returns personally.

The CPP is a defined benefit plan. That means that you get the same pay-out regardless of performance. Happily, the excellent performance does mean that the CPP is well-funded to deliver on its obligations. It is currently projected as sustainable for a 75 year period. The fear-mongering that CPP will get folded seems like baloney to me.

cpp assets

What impacts the return on CPP investment for you?

To determine whether CPP is a good investment, you need to compare what you contribute to what you are likely to get out of the plan in benefits.

CPP is less of a deal today than it was in the past.

The return on investment for CPP has actually changed dramatically over time. Current contributions help to cover the existing obligation. When it first started, the contributions were only about 3% of income and you only needed to contribute for 10 years to get the full benefit. With that structure, the CPP was in danger of not meeting its obligations. It was dependent on a perpetually growing workforce and government largess. The hang-over from this probably accounts for the doubts about whether it will be there in the future. However, there have been major changes away from this government-dependent programme towards an independent pension.

Now, the contribution is about 12% and for 39 years to get the full benefit. For self-employed pensioners retiring in 1969, the real return (return plus accounting for inflation) on investment was 23%/yr. For the self-employed retiring in 2015, the real return was more like 2%/yr. It will also change moving forward as enhanced CPP is phased in.

The addition of enhanced CPP.

Enhanced CPP has been getting phased in for the last few years and will be fully phased in by 2025. On the input side, you contribute 11.5% of income up to the maximum pensionable income. The percentage has been rising as the planned benefit is also being increased to replace 33% of income instead of 25% of income when it is collected. That increased contribution/benefit is the so-called “Enhanced CPP”. The maximum pensionable income is $64900 for 2022 which gives a maximum contribution of $7K. The contribution limit and expected income replacement both rise indexed to inflation each year.

Collecting 33%/yr income-replacement while contributing ~12%/yr sounds pretty good. However, whether that is a good return or not depends on a number of factors. Basically, if you contribute longer or collect the pension for a shorter period of time, it is less favorable.

The impact of being able to drop low-income years.

The amount you actually collect is affected by your average income over the contribution period minus the lowest income years. The contribution period is age 18 to when you start collecting CPP, but you can drop up to 17% of the lowest income years over that period. For example, if you were in training from age 18-26 and worked from age 26 to 65, you could drop 17%*(65-18) = 8 years. That means those 8 years of no income would not drag down your pension. In fact, if you worked and earned a high income for the full 47 years, then those eight extra years of contributions become a tax because the maximum pension is based on the 39 highest years of contributions.

If you are able to drop low-income years, then CPP becomes a better deal than if you contributed the maximum every year since turning 18. For most professionals, we would likely be dropping the first 8 years since we were in school and/or earning much lower incomes. There is also a provision for child-rearing that allows you to use your average 5 year prior income instead of lower income during the years where you were the primary care provider for kids aged 6 or under.

The impact of taking CPP early or late.

When you start collecting CPP impacts both the contribution period and how many years you collect for. So, the benefit is adjusted up if you delay taking it until after age 65 and reduced if you start collecting before age 65. This adjustment is based off of the estimates of when the average person would die. Whether to take CPP early or late is a decision with several considerations that will need to be explored in another post.

Using the above factors to model CPP returns.

We need to control for these factors when trying to estimate the personal return on investment for CPP contributions. We can then estimate the CPP return over a given lifespan.

The return on investment for standard CPP for recent contributions.

For the standard CPP, those born after 1970 and working from age 26-65 (dropping the first 8 years), the real rate of return on investment would be 2.1%/yr. That is 2.1%/yr above the rate of inflation. So, if inflation were 2% in a year, that would represent a 4% return. If one made the maximum income from age 18-65 (with no drop out years), then the real rate of return drops to 1.7%/yr due to the “tax-like” contributions beyond the maximum pension benefit. This is assuming average life expectancy (78-80 for that timeframe).

What should the return on investment for enhanced CPP look like?

For us to make decisions around salary (and CPP contributions) versus dividends to move money out of our professional corporations, it is the rate of return moving forward that matters. I replicated the above model using enhanced CPP in its fully-implemented form. That includes higher contributions rates and a second level of a higher pensionable income.

With dropping the first 8 years (starting a high income at age 26) and retiring at age 65, it takes until age 79 to break even. Each year you live beyond that, increases the rate of return as you continue to collect more benefits. In the less likely scenario of working 47 years making full contributions, the break even point is age 82. The life expectancy for those born recently is around 82. Not a big shocker – the professional actuaries know how to do their jobs.

The return would be slightly better if we account for the other features of CPP like the death benefits, disability benefit, or have child-rearing provision years.

Can you beat the CPP by investing on your own?

Most people will look at those returns and think it is pretty easy to beat them. That likely leads to the recommendation to avoid CPP and invest via your CCPC instead. However, that is a flawed comparison. A diversified equity portfolio would easily beat that return in the long run. It should – because it also has way more expected risk.

In contrast, the CPP is a safe inflation-adjusted defined benefit. So, more fair comparisons would be to an annuity or perhaps government bonds.

Compared to saving in a high-interest account, then buying a life-time annuity, the CPP is a good deal.

An annuity is an insurance-like product where you pay a lump sum and it then pays you a monthly amount for a defined period of time. You can buy a life-long annuity which will pay-out for your lifetime. Just like CPP.

Using my enhanced CPP model, from age 26-65, the accumulated contributions would be $338K in today’s dollars. That would yield a lifetime pension income of $2K/month plus a survivor benefit. How much life-time income would we get if we were 65 and paid $338K to buy an annuity? It would vary based on your health, but there are some estimate calculators on the internet. I used a few of them for a 65 year old male and compared that to my estimate of enhanced CPP in the table below. There is a range depending on whether you account for some kind of survivor benefit, and a range of “features” to the annuity product. An important note for comparing annuities, is that costs for females are more expensive because they live longer. The CPP does not cost more for females – so is an even better deal for women.

Male taking at age 65. $338K Premium.

Generally, enhanced CPP cumulative premiums would yield about more income compared to using that amount to buy a life-time annuity. How much more depends on the features of the annuity, but it could be a lot more.

Compared to government bonds, the CPP is a good deal.

At the time of writing this, a Government of Canada bond yields in the 1.5-2%/yr range. When adjusted for inflation and convert that to a real return, it is actually about zero. The real return has been in the 0.5%/yr range since the Global Financial Crisis a little over a decade ago. We have had crazy low interest rates in recent years. Interest rates have risen recently due to inflationary concerns. However, remember that the CPP benefits also rise because they are indexed to inflation.

Peering further back into history, data from 1900-2020 also shows the inflation-adjusted return of government bonds in the developed world ran about 2%/yr. Of course, the CPP also had higher return on investment historically than it will moving forward.

Compared to investing in government bonds, then buying an annuity, CPP is a fair deal.

A high-interest savings account would be lucky to pace inflation, which is what I assumed in the first comparison to annuities. That is ultra-safe. However, what if we invested the amount that we would have contributed into CPP into government bonds during our working years and then bought an annuity at retirement?

For this modelling, I used 4%/yr interest, 2%/yr inflation for a real return of 2%/yr. Contributions and returns were factored in annually. In a corporation, getting 4% interest and flowing that out efficiently using dividends to release the RDTOH and fund lifestyle works out to about a net 0.5%/yr tax drag. So, I used a 1.5%/yr real return. Using the same model contributing from age 26-65, that results in $458,563 to buy an annuity with. I ran this through the same annuity calculators for a comparison.

This approach does mean taking some risk during the accumulation years (bonds) compared to no risk (savings). However, that risk would be reasonably low and probably in the realm of what people would reasonably do. Using this comparison, the CPP is a fair deal.

Summary

The CPP is a defined benefit inflation-adjusted pension. While it could vary based on the CPP/enhanced CPP mix, contribution years, and lifespan – the return on investment for contributions is about 2%/yr above inflation. That would be easy to beat with a higher risk investment. However, the CPP’s return is good return when compared to other low-risk investments. The CPP also has a death benefit, disability benefit, and survivor benefit to sweeten the deal.

So, I would not let the contributions to CPP deter me from paying salary out of my CCPC.

Paying salary has the benefits of generating RRSP room (and Independent Pension Plan room if you plan on switching to one later). Salary is also more efficient in terms of tax integration compared to dividends and it counts as an expense to lower corporate income to keep it below the small business deduction limits. The CPP has a reasonable expected return for the risk, plus other benefits.

There are a few situations, where paying salary and CPP contributions may not make sense:

If CPP is more like a tax, then it may not be as beneficial. That can happen in situations where there are multiple employers or if you have already made 39 years of maximum contributions.

Another situation where CPP may be less beneficial is if your risk tolerance and risk capacity is so high that some sort of fixed income is of no benefit. While I am sure some investing cowboys/girls are going, “Yee-haw that’s me!”

Enhanced CPP ROI

However, the reality is that we are probably less risk tolerant than we think. Plus, to have that level of risk capacity implies a really large portfolio. That would make the CPP component negligible and the benefit of diversifying investment account types beyond a CCPC (using an RRSP) even more important. Having some level of guaranteed income can also help to mitigate sequence of return risk during the early drawdown phase.

13 comments

    1. Hey Phil,

      Just for others, the survivor benefits are outlined a this CRA link. The benefits are based on contributions (so would go up with contibutions) if over 65 and a rate plus that if younger. It is basically 60% as long as the survivor benefit plus the widow/widower’s pension isn’t more than the max for an individual. It is all basically indexed to inflation. Contributions increase with inflation as do benefits.
      -LD

  1. I don’t really look on CPP as an investment. It’s risk management tool. It mitigates market risk, longevity risk, dementia risk and inflation risk. And unlike most risk management tools, you earn a positive return with CPP.

    1. Hi Mick,

      When comparing CPP to investing via a corporation, I accounted for the tax treatment of the investment income and assumed that enough ineligible dividends were paid out to meet lifestyle needs to keep the nRDTOH refund flowing efficiently. That is a best case scenario for corp efficiency. If I needed to pay extra dividends just to release RDTOH collected on the investment income, then the corp becomes much less tax efficient and CPP would be an even better deal. If my corp hit the SBD passive income clawback threshold – even worse for the corp. I put the bar as high as possible against CPP and gave corps the benefit of the doubt where possible. If keeping all money in a corp to invest rather than using salary, RRSP, TFSA – it would be quite common for someone in a physician range income and moderate spending level to hit problems with RDTOH and passive income inefficiencies in the later half of their career. So, definitely not a moot point. Great question – I hope that answers what you were asking.
      -LD

  2. I am 50 years old, I immigrated to Canada when I was 28. I have had part time low paying jobs for the last 22 years. Didn’t contributed much in CPP. Last time I checked on ServiceCanada website, it says I would be getting $100/month at the time of retirement. I recently started working and has salary of $150, 000 , I will be incorporating, and was wondering if it’s worth it for me to give salary to my self, contribute towards CPP or just take dividends instead? is it worth in my case to put in for CPP? Your valuable advice would be appreciated. Thanks

    1. Hey Sid,

      First off, congrats on your new job. I can only imagine all of the work and perseverance required to achieve what you have done. What I would start with is what your investing risk tolerance is and if it requires some stable assets (most 50 year-olds do). If so, then CPP is a reasonable investment. It will be a small amount of money, but for the dollars you put into it – reasonable.

      The second question is salary vs dividends from a corp. Something I would discuss with my accountant (I am not an accountant or advisor). However, salary and RRSPs are generally more tax efficient than dividends. The main reason to use dividends are if your corp receives investment income and you need to pay some dividends out for your corp to get a tax refund on the investment income. The second reason is that it is convenient to do dividends and not have a payroll. Some accountants will say dividends are efficient because you don’t have to pay into CPP – however, this and the preceding article debunk that argument. CPP is usually not a tax. Hope that is helpful.
      -LD

      1. Thank you for a prompt reply!
        I intend to keep majority of funds in the Corp and take out $50,000 a year in salary or dividends. I want to invest rest of the $100 K in stocks , not sure if capital growth or dividend stocks are more tax efficient. Is Passive income inside the Corp’s retained earnings has higher tax rate? So, if i were to have a passive income inside the Corp, should I opt for dividends as compensation from my Corp or stick with the Salary? Thank you so much! πŸ™‚

        1. Hi Sid,

          I can’t give specific investing advice. However, what I would say is that having diversified investments that match the asset allocation for your risk tolerance is the most important thing. Tax efficiency would be a secondary consideration. Especially, if all of your investing is in the corp.

          Passive income in a corp gets a tax collected at a high rate upfront (about 50%), buy most gets refunded to the corp when you pay out a dividend to yourself (and pay personal tax). It is called refundable dividend tax on hand (RDTOH) and the objective is to make it inefficient to have a tonne of passive income sitting in a corp without paying it out. It takes very little dividends to be ok. For example, if your yield on the $100K invested is 2.5%, you would need to pay out 2-2.5K in dividends to keep the RDTOH efficient. So, most people end up with mostly salary plus a few dividends to keep it efficient. Also, don’t forget that an RRSP and a TFSA are actually the most efficient tax shelters. A corporation is a bit less tax efficient, but allows for more space.
          -LD

  3. “…Also, don’t forget that an RRSP and a TFSA are actually the most efficient tax shelters. A corporation is a bit less tax efficient, but allows for more space.
    -LD…”

    Generally that is true — long term. Positive divergence of tax shelters from non-registered accounts takes about 15 years to appear. (I believe Ben Felix had a spreadsheet that showed this phenomena.) So in the short term, say > age 57) to a CCPC might not have the benefits they think they are getting.

    1. Thanks ER. There are actually a couple of nuances. Tax efficiency is the drag on growth from taxes. For example, tax paid on interest/dividends each year. On an annual basis, TFSA/RRSP is more tax efficient than investment income flowed through a corp. Some investment income is lost due to RDTOH and tax integration (except for eligible dividends) flowing through the corp compared to personal taxation.

      However, there is also tax deferral which comes into play with the RRSP/TFSA/Corp comparison. Paying less tax now, to pay it later instead. That is where the 10-15year delay to coming out ahead with a TFSA comes from. In Ben’s white paper the after-tax value is actually the same at the beginning, but meaningfully favours a TFSA around year 15. There is a tax hit upfront, then better annual efficiency using a TFSA and tax-free withdrawal. For an RRSP (or CPP), there is not an upfront tax hit because the salary/CPP is a corporate expense and doesn’t add to current personal income. The trick about tax deferral is the difference between current and future tax rates and it acts on both the corp and RRSP. If your future tax rate is higher, you actually have more after-tax money in the end by taking the hit now, removing that tax burden, and then re-investing (if annual tax efficiency is equal). If your future tax rate will be lower, then tax deferral lowers your eventual tax bill. The assumption that your income/tax rate in retirement will be lower is what makes tax deferral with a corp or RRSP great and where they have an advantage over a TFSA. That is what is happening on the screenshot of his tool on page 8. I have also made a similar tool that does the Corp/RRSP/TFSA comparison, accounts for CPP, and adjusts corporate efficiency over time (it becomes less efficient if you aren’t paying out enough dividends to meet personal needs and release RDTOH). More complicated, but also more personalized.

      Great comment. Hope I didn’t make too confusing of a response. I am going to have a post on tax efficiency vs tax deferral in the basic curriculum I am building.
      -LD

      1. Agreed. The big “if” is “…If your future tax rate will be lower, then tax deferral lowers your eventual tax bill….” and tax brackets don’t change in the future (perhaps not inflation adjusted).

        So balancing that against the good (but unfortunate) problem of having a higher valued RRSP/RIF at age 71. You might be surprise to find your paying way more tax from the registered accounts than you expected.

        I guess I am poking at the problem of planning and targets for your CASH vs TFSA vs RRSP vs CCPC – to get lifetime lower tax rate. Its not an easy thing to do. πŸ™

        1. Hi ER,

          I agree the problem is current vs future tax rate for whether tax deferral is good or bad. Fortunately for my TFSA/RRSP/CCPC comparison, both the RRSP and Corp are both tax-deferred and impacted the same way. The comparison is still pretty intact. Comparing those to TFSA could be impacted. I also didn’t include a personal taxable account – which is another option and could be beneficial if your future tax-rate is higher (making tax-deferral in a corp or RRSP bad). For that calculator, I actually used an equal draw from each account for the income projection. That would draw down the RRSP right away rather wait to 71 and smooths the withdrawal compared to waiting to age 71 (if not needed before). I also put the liquidation output which is pretty much at max tax rate for a large portfolio. Hard to optimize – so I just put both as outputs.

          The other good thing is that if tax rates change, they are likely to at least change in similar proportion to each other. For example, not indexing the tax brackets to inflation would impact income and dividends similarly. The big problem would be if they decide to break tax integration and alter dividend tax credits etc. Anything is possible, but that would be a major tax change. So, yes the after-tax values could easily change. However, my goal was comparison of strategies relative to each other.

          The challenge with all planning is predicting the future. However, I think we need to try. It is closer to guess 40% for a tax rate and reality is 30-50% than to assume it is zero.
          -LD

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