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.
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.
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.
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!”
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.