Chapter 7 Separation, linkage and blurring in the public and private pillars of canada's retirement income system1

Introduction
Objectives and value conflict
Separation
Linkage
Blurring
Concluding comment
Bibliography

Introduction

This paper extends the analytical framework advanced by Rein and Thacher (Chapter 6) to the case of Canada. In their paper, Rein and Thacher argue that the social security retirement system in mature industrial economies is typically committed to at least three basic values: the economic well-being of retirees (or redistribution), the productivity of firms, and individual self-reliance. These values come into conflict with each other.

According to Rein and Thacher, these value conflicts are managed through the art of separation: the public pillar of retirement income system is redistributive and designed to meet the needs of retirees; the firm pillar designs occupational pensions in such a way that best advances the productivity of business enterprises; and the personal savings pillar serves the needs of risk adverse individuals, who want to supplement their public and private occupational pensions, and hence promotes self-reliance. Rein and Thacher explain that these separate institutional pillars are linked to each other on the principle of either substitution or supplementation. The linkage mechanism creates blurring and becomes the force for clarification of the interaction between the pillars. The stronger the linkages are among the pillars, the greater the blurring becomes and the risk of loss of the identity of each pillar increases. Blurring plays a significant role in producing value change. The concepts of separation, linkage and blurring thus provide a framework to examine the institutional, political and normative engine of change that helps us ground our understanding of institutional change in the pension system.

By focusing on the institutional dynamics of change, Rein and Thacher arrive at new questions that deserve attention: what degree of separation (or conversely, of blurring) best promotes the core values of retirement policy? What kind of linkage reduces separation and promotes more coherence and unity in the overall pension system? If we can differentiate the degree of separation, blurring, and the kind of linkage, can we gain a better understanding of the nature or kind of pension system that exists in a particular country at a point in time and how it changes over time?

This paper analyzes the Canadian retirement system in the framework outlined by Rein and Thacher. It first reviews the fundamental values and goals of the Canadian system. It then examines the three pillars in terms of their separation, linkage and blurring and draws comparisons with the United States. The paper focuses on the blurring between the public and private pillars and explores the implications of such blurring in terms of fairness and adequacy. In particular, the paper discusses the increasing public mandate of private pensions and the challenges in delivering a growing portion of retirement income security through the market mechanism. The paper concludes with a note what the future evolution of the system might entail and how we should re-think about the fundamental issues of fairness and adequacy in the Canadian pension system.

Objectives and value conflict

Objectives

The Canadian pension system is a massive social security program, affecting every retired and working-aged Canadian. It was designed to achieve two objectives:

The first objective is to alleviate poverty among the elderly. The second objective is to help and/or require people to allocate appropriately their lifetime income - and hence consumption - between their preretirement and post-retirement years (Task Force on Retirement Income Policy, 1979).

In other words, the first objective protects the elderly from destitution and the second objective prevents a brutal drop in the standard of living at the time of retirement. These objectives are met jointly by the following three pillars, each of which is described in more detail in the next section:

1. The income tested minimal income security system consisting of the Old Age Security, Guaranteed Income Supplement and the Allowance and Allowance for Survivor programs (hereinafter referred to as "OAS/GIS system");
2. Mandatory public pension plans, namely, the Canada Pension Plan (CPP) and the Quebec Pension Plan (QPP); and
3. Tax-assisted private pensions, including employer-sponsored Registered Pension Plans (RPPs) and individually-based Registered Retirement Savings Plans (RRSPs).²

The first two are publicly administered programs and thus are the so-called "public pillars". The third is privately administered and is thus the private pillar. While all three pillars contribute to the two main policy objectives, the first and second pillars are designed primarilyto meet the objective of old-age income support, and the second and third pillars are designed primarily to replace earnings. The three pillars also reflect the three values described in the chapter by Rein and Thacher.

Values

The value of promoting the economic well-being of all Canadian seniors finds its expression mostly in the public pillars. The OAS/GIS pillar is clearly redistributive. It provides an income-tested, basic pension to everyone over 65. Because it is financed by general tax revenues, not earnings-based contributions, there is no link between contributions and benefit payments (Battle 1997, Schembari 2003b). Benefits are determined by age, residence test, and financial need. There is, thus, a redistribution of income from other taxpayers to the OAS/GIS recipients. Its progressivity is determined by the progressivity of the tax system.

The CPP/QPP pillar involves an intergenerational redistribution because of the nature of the pay-as-you-go system (that is, current pension benefits to retirees are financed by current contributions by employers, employees and the self-employed). Intra-generational redistribution is not significant because the rates of contribution and benefit are proportional and the maximum annual pensionable earnings are tied to the average Canadian wage. However, there is a small element of progressivity because of the exempt earnings in computing contributions. As such, even though the contribution rates are flat, the effective rate might be slightly progressive, depending on an individual's total earnings.

The value of self-reliance underlies the design of all three pillars and is the driving force behind the third pillar. The first pillar suggests the value of self-reliance by imposing an income test and by providing a minimum amount of guaranteed income. The message is that people should save for themselves if they want more than the bare minimum when they retire.

The second pillar clearly reinforces this value by (a) compelling individuals to save for their retirement under the CPP/QPP, and (b) providing only a very limited replacement of pre-retirement earnings. People who want to achieve a higher level of replacement are required to do so through the private pillar. The public pillars are designed to replace 40% of the average preretirement earnings. Individuals must save through private arrangements if they wish to maintain their preretirement standard of living. However, the government encourages such savings through hefty tax incentives.³

The value of firm productivity underlies the design of the private pension system, which has the key features of being voluntary, flexible, and funded. Savings through private pension plans are voluntary, deferring the judgment to firms and individuals. Employers are not required by law to sponsor any registered pension plan for the benefit of their employees. Firms set up pension plans in order to obtain an optimal workforce, which included removing elderly and infirm workers from the workforce, attracting and retaining skilled workers, and discouraging unionization (Deaton 1989, Hacker 2002). Trade unions have played a crucial role in the growth of employer-sponsored benefit plans when they treated pension benefits as a key element of employment compensation package (Georgetti n.d.). Good labour relations contribute to the productivity of the firm.

Private pension schemes also allow a great degree of flexibility in terms of their design and investment choices. RPPs can be defined benefit plans, defined contribution plans, or a combination of both as a hybrid plan. RRSPs can be established by a taxpayer for himself/herself as well as for his/her spouse. They can be self-directed or administered by a financial service provider. RRSPs can also be withdrawn without tax penalty to purchase a home or finance post-secondary education. Such flexibility presumably encourages firms and individuals to participate in RPPs and RRSPs.

Rein and Thacher correctly point out that the values of redistribution, self-reliance and firm productivity are in conflict. This point has been evidenced by the history of the Canadian retirement income system (Bryden 1974, Burbidge 1987, Guest 2003). Both the OAS/GIS regime and the CPP/QPP regime were created as a result of balancing these values and reaching a political compromise between the "left" and the right".⁴ In the mid-1960s, when the framework of the current system was put in place, the government made it clear that it wanted to leave considerable room for private pensions. In the 1990s the CPP was criticized and there were calls for its the replacement by individual accounts (Lam and Walker 1997, Pesando 1997, Robinson 1996). The CPP was preserved with some changes. In the meantime, the government has encouraged private pensions by increasing the amount of tax assistance and the level of flexibility and accessibility of private pension plans.

Separation

The value conflicts in the Canadian retirement income system are managed through the art of separation. Each pillar was designed to embody a distinct value, and all three pillars constitute a coherent whole that delivers retirement income security to Canadians. The nature of separation in Canada has already been indicated in large part in the preceding discussion on values. Accordingly, in this section the text is focused on points about separation that add to the information already presented above.

Public pillars

As stated above, the two public pillars are the OAS/GIS and the CPP/QPP. Although both are administered by the government, these two programs differ in terms of coverage and the financing mechanism. The OAS/GIS system is financed by general revenue, and the CPP/QPP is financed mostly by contributions.

The OAS program was introduced in 1951 to replace a means-tested Old Age Pensions Act, which was enacted in 1927 (Bryden 1974). The OAS system is now supplemented by the GIS and Allowance for the Survivor programs. The OAS program itself currently provides a uniform flat rate benefit to all eligible Canadians aged 65 or older who meet the residency requirements. The GIS provides an income-tested benefit on a tax-free basis The GIS and OAS jointly provide a minimum income security for older Canadians. The Allowance and Allowance for the Survivor program pays benefits to persons aged 60 to 64 on an income-tested basis. It is designed to help surviving persons and couples living on one pension.

The CPP/QPP pillar is compulsory, earnings related, and pays benefit to those who have made contributions during their working years.⁵ Both CPP and QPP operate on a pay-as-you-go basis: benefits are financed primarily by contributions from employers and employees, and the self-employed. The CPP contribution rate is linked to the average Canadian wage. Earnings below a prescribed threshold are exempted from contribution. There is the maximum amount of benefit. The CPP is designed to replace only 25% of the average Canadian wage. At earnings above the average wage, the CPP replaces declining portions of earnings.

Private pillar

When the CPP was established in 1966, it was designed to leave considerable room for privately administered retirement savings schemes (Government of Canada 1982). Employment-based pension plans (e.g.,RPPs) and individual savings plans (e.g., RRSPs) are two main types of private pension and retirement savings plans. RPPs are pension plans sponsored primarily by employers in the private or public sector that have been accepted and registered by the Minister of National Revenue for purposes of the Income Tax Act (s.147.1). They are the most important type of private pension plans in terms of assets accumulation and coverage. As of January 1, 2003, there were more than 5.5 million workers covered by 14,376 RPPs (Statistics Canada 2004). Nearly 40% of all paid workers were members of RPPs.⁶

In Canada, defined benefit plans have the largest number of members. Eighty-two percent of all persons covered by RPPS are covered by defined benefit plans. The majority of defined benefit plans members are employed in the public sector. In contrast, most of the members in defined contribution plans work in the private sector (Department of Finance 2005a).

An RRSP is a retirement savings plan set up by individuals that qualify for the deductions under section 146 of the Income Tax Act. By nature, all RRSPs are in individual accounts, managed directly by the taxpayer or a financial service provider. In recent years, less than 30% of tax filers contributed to their RRSPs. There are also some employer sponsored "group RRSPs" which are funded by monthly payroll deductions and qualify as deductibleRRSPcontributions to the employees.

RPPs and RRSPs are tax-assisted plans. The tax assistance is provided in the form of a current deduction for contributions, and a tax exemption of investment income earned by the pension plan. Funds in an RPP or RRSP are not taxed to the beneficiary until they are withdrawn from the plan. At present, there is a universal limit for the maximum amount of tax-deductible contributions to all types of tax-assisted pension plans.

Logic of separation

The three pillars of the Canadian retirement income are separated institutionally. Human Resources and Skills Development Canada (HRSDC) administers the payments of benefits under the public pillars. The Canada Revenue Agency (CRA) administers the collection of CPP contributions and federal taxes. Private pensions are administered privately, but the CRA is involved in the registration of plans and monitoring the eligibility for preferential tax treatment. Also, as noted earlier, the source of funding is different for each pillar.

In terms of coverage, the OAS/GIS covers 98% of older Canadians, the CPP/QPP covers over 80% of the labour force, and the private pension pillar covers about one third of the labour force (Maser 2003: Table 1-1). In general, individuals with stable employment (especially in government, education and health sectors) and in middle- or high-income groups tend to participate in private pensions, while every worker and the self-employed must participate in the public pensions (Statistics Canada 2001).

As a source of retirement income, private pensions constituted about half of the income of those with incomes of $40,000 to $79,999. Those with incomes under $20,000 were less likely to have been members of RPPs, or to have saved through RRSPs - less than 10% of their income came from private pensions. The public pension system is the main source (77%) of income to persons 65 and older who had an income of less than $20,000. Reliance on the public system diminishes as income increases (Maser 2003).

Linkage

Rein and Thacher define "linkage" as the "ways in which distributive decisions made in one institution influence distributive decisions made in another institution" (2006). One way is substitutive and the other is supplementary. The system is substitutive if when one pillar contributes more, then the other pillars need to contribute less. In contrast, the supplementary system adds the public pension to the private pensions with no limit on the total amount, as occurs in the U.S. system. Rein and Thacher also note that in the U.S. there is no national administratively agreed upon adjustment technique to tie the pillars together, as exists in Holland where the "franchise" specifies how the public and private spheres should be uniformly linked.

The pillars in the Canadian retirement income system are perhaps more closely linked than those of the American system. As explained earlier, the design of the public pillars leaves room for private pensions. The public pillars were intended to replace about 40% of the average wage.

One aspect of linkage in Canada involves the limitation on tax deductible contributions to the aggregate of pensions and RRSPs. This limit is 18% of earned income up to a specified dollar amount, $16,500 for 2005. This is based on the assumption that income in retirement would, on average, replace 60 to 70% of preretirement income.

Overall, linkage in the Canadian system involves deliberate limitation of earnings replacement by the public pillars, in order to leave room for private pensions, with the policy goal that the income received in retirement would replace a high percentage of preretirement earnings. Despite references to 60% or 70% in the literature, there is no legislation or administrative arrangement to force the third pillar to contribute any specific amount of pre-retirement earnings. Instead, tax incentives are used to stimulate private arrangements to top up what the public pillars provide.

Is linkage in Canada substitutive or supplementary? Above certain income levels OAS and GIS are not available, and contributions to RPPs and RRSPs tied to each other. This is substitution. However, there seems to be no legislated limit to the total pension income, since the contribution of the third pillar is totally voluntary. Linkage in Canada seems to be a blend of being substitutive and supplementary.

Blurring

Rein and Thacher use the concept of blurring to explain the interplay between the principles of separation and linkage, as well as changes arising from demographic and economic fluctuations, and the maturing of the retirement system over time. For example, in discussing blurring in the United States pension system, they make reference to the fact that personal accounts are replacing defined benefit plans and that this shifting seem to occur in the absence of any major legislative pension reform.

Private pensions with public mandate

In the Canadian pension system, there is blurring between the public pension pillar and the private pillar. This blurring can be observed in at least two respects: funding, and state-imposed standards on coverage, investment, and management of pension plans.

With respect to funding, private pensions are not completely "private" because of the tax subsidies. For example, in 2000, the net tax expenditure on RPPs was $8,655,000,000,⁷ and net tax expenditure on RRSPs was $9,120,000,000. ⁸

The important social role of private pensions requires that governments pay special attention to the private pension system and ensure that private firms - to which certain duties can be said to have been delegated - are properly fulfilling their obligations (OECD 1998). The government imposes standards and obligations on private pension plans through pension regulations and income tax law.

To begin with, an RPP plan must be established for the primary purpose of providing periodic payments to individuals after retirement. This requirement is found in the prescribed conditions for registration. Once a plan is established, the employer is subject to regulatory control. With respect to coverage, for example, the federal Pension Benefits Standards Act, 1985 (PBSA) and provincial legislation generally require that every full-time employee who belongs to the class of employees for whom the plan was established must be allowed to join the plan after two years of employment. Part-time employees who are in the same class as eligible full-time employees and who have earned the specified amount of earnings must be allowed to join the pension plan.

Additionally, in order to minimize the financial risk, the government regulates private pensions in order help safeguard the rights of members and the financial security of plans. For example, the pension standards legislation and the Income Tax Act set forth standards for contributions. The federal PBSA requires that defined benefit pension plans be funded based on both "solvency valuations" and "going-concern valuations" of plan assets and liabilities. Solvency valuations use assumptions consistent with the plan being terminated, while going-concern valuations are based on the plan continuing. Solvency funding requirements are intended to reduce the risk of a loss of benefits in the event that a plan is terminated, including as a result of the failure of the plan sponsor.

Shift towards private pensions and individual accounts

Between the public pension pillar and the private pension pillar, blurring occurs in terms of the increasing role of private pensions in the Canadian retirement system and the shift towards individual accounts.

Private pensions (RPPs) and retirement savings plans (RRSPs) are becoming more important as a mechanism for capital accumulation and a source of retirement income to retirees. If we compare the value of assets held in the public pensions and private pensions in 1990 and 2000, we can detect the increasing importance of the private pillar to Canadians. In 1990, the accumulated assets in public pension plans accounted for over 11% of the total assets in the pension system (i.e., CPP/QPP, RPPs and RRSPs). As of 2000, they accounted for less than 5% of total assets in these programs. Private pension income grew from 18% in 1990 to 29% in 1999 as a source of retirement income (Maser 2003:18).

Within the private pension sector, there has been a shift towards individual accounts in the form of defined contribution plans and RRSPs. From 1993 to 2003, members of defined contribution plans increased by 1.8 times in spite of the decline in the number of such plans (from 8,713 to 7,347) (Maser 2003:12). The number of contributors to RRSPs increased from 31.5% of the labour force in 1990 to 39.7% of the labour force in 1999 (Maser 2003:14). By 1995 RRSPs had replaced RPPs as the program through which Canadians were saving the most. The growth of group RRSPs⁹ (Frenken 2003) also explains the shift. Under a group RRSP, a single trust or contract is established for participating employees. Although an individual contract is registered for each participant, the contributions are pooled and invested accordingly. Group RRSPs are apparently the fastest-growing type of plan now offered by employers.

When compared with the shift in the United States, two differences are notable. First, the shift towards defined contribution plans has been less significant in Canada. As of January 1, 2003, four out of five RPP members still belong to a defined benefit plan, whereas in the United States defined contribution plans have recently become the main form type of occupational pension plans. Second, in the United States the pillars "seem to be shifting without there being any major legislative pension reform inspiring the change in practice." (Rein and Thacher) In contrast, the shift in Canada was likely promoted by the tax reforms in the 1990s that increased the accessibility of RRSPs to taxpayers as well as the amount of tax subsidy to RRSPs (Fougere 2002).

In addition to the increased tax subsidy to RRSPs, other factors may also create the impulse for the increase in defined contribution plans. One factor is demographic. The shock of the baby boom generation in Canada was found to be largely responsible for the rapid growth in RRSP savings: the greater the proportion of middle-aged and older workers, the greater the savings will be in the form of RRSPs (Fougere 2002, Statistics Canada 2001). Another factor is the changing structure of the Canadian economy and the labour structure. The decline of traditional industries and downsizing of government that feature strong unions led to decline in RPP membership. Eighty percent of union members belong to RPPs compared to less than 30% of non-union members (Georgetti n.d.). The increasing participation of women in the work force also contributed to the change as it is "more difficult for women to maintain pension coverage through time than it is for men" (Georgetti n.d.:4). Non-RPP members generally rely on RRSPs for retirement savings.

"Privatized" management of CPP funds

Blurring also occurs in respect to the investment of CPP funds. Historically, CPP funds have been loaned to federal and provincial governments as non-marketable 20-year bonds at preferred interest rates. ¹⁰ During the 1996 reform, the CPP became partially funded, and the reform introduced some significant changes to the CPP investment practices. For the first time in its history, surpluses generated by higher contributions would be invested in a broader range of securities, including equities, with these investments managed by an independent board - the CPP Investment Board. Earnings on the investment fund will not be needed to supplement contribution revenue and pay benefits until 2021.

Concluding Comment

The shift towards private pensions and retirement savings plans has occurred within the three-pillar system. In its 2005 budget, the Government of Canada reinforced its commitment to the three pillars by (a) strengthening income assistance through an increase in the GIS benefits, (b) providing additional investment flexibility to the CPP Investment Board, and (c) enhancing private savings by increasing the RRSP and RPP contribution limits (Department of Finance 2005a). Therefore, in order to manage the various risks associated with pensions (such as demographic risks, financial risks, political risks, etc.), changes through blurring might be the only plausible option.

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Notes

1. The author thanks Bob Baldwin, John Myles, Martin Rein, Monica Townson, Leroy Stone and Gilles Paquet for their valuable comments on the earlier drafts of this paper. She also thanks Aihua (Charlotte) Wu, Joanne Gort, and Xue Yan for their research assistance, Sylvie Michaud and her staff in Income Statistics Division at Statistics Canada for their assistance with data. This paper also benefited from a research memorandum prepared by Karen Garabedian for Leroy Stone in August 2004. Research for this project is generously funded by a grant from SSHRC.
2. This paper discusses the pension system at the federal level. Canadian provinces also play an important role in the retirement income system by providing "top-ups" in the case of public pension programs and by subsidizing private pensions through tax incentives. Because the contributions to private pensions are deductible in computing income and provinces generally use the same tax base for computing their individual tax rates, the tax deductions at the federal leval also reduces the tax base at provincial level. As such, provincial income tax is reduced accordingly.
3. Encouraging Canadians to save for their retirement promote a sense of economic freedom and dignity after retirement. This point is made abundantly clear in the 1957 budget speech on the proposed RRSP program:
   "It is difficult to estimate what effect this poroposal will have on the future yield of our income tax. ... Whatever the subsequent loss in revenue may be it can, however, be regarded as an indication of the volume of provision being made by Canadians towards freedom from financial worry at a time when their earning power has lessened. To me, this policy makes good sense."
4. For a vivid description of the history of creating the CPP, see J. LaMarsh (1969). The "left" is represented by trade unions and other similar organziations that wish to see more social redistribution of income. The "right" is represented by businesses and institutions that wish to see the market play a bigger role in allocating resources and distributing income.
5. In addition to retirement benefits, teh CPP and QPP also provide survivor and disability benefits, a death benefit, and benefits to the children of disabled and deceased contributors. The retirement benefit is the core benefit, accounting for more than two-thirds of CPP expenditures.
6. Because RPP participation is restricted to paid workers having an employer-employee relationship, so the self-employed with unincorporated businesses, unpaid family workers and the unemployed are not eligible. If estimates of these groups were included in the labour force, the coverage rate is about one third of the labour force.
7. This is computed by subtracting the taxes on RPP pensions ($6,695,000,000) from teh $4,895,000,000 tax foregone on deductions for RPP contributions and the $10,455,000,000 non-taxation of investment income earned by pension funds. The net tax expenditure on RRSPs is $9,120,000,000 (Department of Finance 2004).
8. This is computed by subtracting the tax on RRSP withdrawals ($3,515,000,000) from the tax foregone for RRSP contributions ($7,155,000,000) and the non-taxation of investment income by RRSP plans ($5,480,000,000) (Department of Finance 2004).
9. No data exists on the number of group RRSPs. There is some evidence that a growing number of employers are setting up group RRSPs for their workers in lieu of sponsoring an RPP.
10. Until 1997, the provinces borrowed money at a preferred interest rate. Since 1997, each province has had the option to roll over matured bonds for a further 20-year term at their current market rate. The proceeds from bonds not rolled over are transferred to the CPP Investment Board for reinvestment unless needed by the Canada Pension Plan to pay current pensions. By 2033, all bonds in the CPP portfolio will have matured.