Canada's retirement income system

Canada's retirement income system has three main tiers or "pillars". The overall intent of this system is to allow all Canadians to maintain a reasonable standard of living in retirement. In Canada, the responsibility to save for retirement is shared by individuals, their employers and governments. The retirement benefits are typically delivered through a mix of government programs and incentives for private savings.

The three main tiers, including an "unofficial" fourth tier (described later), can be visualized as stacked on top of each other:



This article provides an overview of the Canadian retirement income system and serves as an introduction to more detailed articles on the components of the different tiers. The first part of the article presents each tier, whereas the second part show which tiers contribute at different income levels, and how the different tiers interact.

Tier 1: OAS and the GIS
Tier 1 of the Canadian retirement income system provides universal federal government benefits for seniors from the age of 65. These consist of Old Age Security (OAS) and the Guaranteed Income Supplement (GIS). These benefits are funded from general government revenue, i.e. on a pay-as-you-go basis. OAS eligibility depends on status and residency history, not on employment history. You must have resided in Canada for 40 years or more after turning age 18 to be eligible for the full OAS pension.

The original intent of these programs was to provide basic protection from poverty in old age, although with the current life expectancies, 65 is not really that "old" anymore. According to the OECD, seniors are less likely to be poor in Canada, relative to the general population.

The Office of the Chief Actuary reports that:
 * 98% of Canadian population 65 and over receive basic OAS
 * 33% of OAS beneficiaries also receive some GIS
 * basic OAS is 13% of average earnings, and average GIS paid is 12% of average earnings
 * OAS costs between 2% and 3% of the GDP

Actuary Fred Vettese notes that Tier 1 will "gradually decrease in importance because the OAS and GIS amounts are indexed only to price inflation, not to wage inflation". Wages grow faster than prices over the long term, because of productivity gains. More specifically, in 1966, the OAS pension replaced 18% of the yearly maximum pensionable earnings (YMPE), it replaces 12.5% of the YMPE in 2016, and it is projected to replace only 8% in 2055.

Tier 2: CPP or QPP
Tier 2 of the Canadian retirement income system is the Canada Pension Plan (CPP), or the Québec Pension Plan (QPP), depending on the province of residence when the application for a pension is made. These are mandatory, partly funded, public pension plans to which workers aged 18 and more contribute. The intent is to replace 25% of wage-indexed career average earnings, up to a maximum. The maximum is linked to the Canadian average wage. In CPP/QPP parlance, this is known as the YMPE (or sometimes just MPE). The normal retirement age for CPP and QPP is 65, but the pensions can be claimed as early as age 60 (with a reduced monthly payment) or as late as age 70 (with an increased payment). CPP and QPP were introduced in 1966.

Tier 3: other retirement savings
Tier 3 of the Canadian retirement income system consists of other retirement-dedicated assets including workplace pensions, Registered Retirement Savings Plans (RRSPs), locked-in accounts, and perhaps Tax-Free Savings Accounts (TFSAs). In workplace pension plans, retirement with reduced benefits can be available as early as age 55. Tier 3 savings range from mandatory to voluntary, for example RRSP and TFSA savings are voluntary. Generally, Tier 3 savings and pensions are supposed to be fully funded. Contributions to workplace pension plans and RRSPs reduce taxable income for the year, and investment income earned within these plans is exempt from tax as long as the funds remain in there. Of course, RRSP withdrawals and pension plan payouts are taxable.

Tier 4: other assets
Some authors also consider a "fourth pillar" to the Canadian retirement income system. Tier 4 consists of assets such as home equity, non-registered investments, insurance payouts, collectibles, equity in a business, inheritances, etc. TFSAs are also sometimes counted as "fourth pillar" assets, because they are not intended exclusively for retirement.

Inflation
The benefits and pensions of tiers 1 and 2 are fully indexed to the cost of living, i.e. they are protected against the effects of price inflation. Tier 3 retirement income is variably protected against price inflation, and so are Tier 4 assets.

Comparison with other countries
Canada scored B overall in the Melbourne Mercer Global Pension Index report for 2016 (only 3 countries scored B+ or A). Canada scored higher than average for the three sub-indices:
 * B for adequacy (benefits, savings, tax support, …);
 * C for sustainability (coverage, total assets, contributions, demography, …);
 * B for integrity (regulation, governance, costs, …).

Putting it together
We now look at how the tiers are combined, and interact, for single Canadians retiring at age 65. Five cases are examined:
 * 1) The poorest Canadians who may only have access to Tier 1 benefits
 * 2) Low-income workers with pre-retirement earnings of 0.5*YMPE
 * 3) Average income workers with pre-retirement earnings equal to the YMPE
 * 4) High income workers with pre-retirement earnings of 1.92*YMPE (the significance of the 1.92 factor will be explained later)
 * 5) Very high income individuals

In summary:
 * For the poorest Canadians, Tier 1 provides protection against poverty in old age, and may represent their main or even only source of income.
 * For low income Canadians, a combination of Tier 1 and Tier 2 may sufficiently replace their employment income during retirement, if they contributed to Tier 2 schemes for a long period; otherwise they will have to add some Tier 3 savings.
 * Canadians with average to high pre-retirement incomes will combine all three tiers to fund their retirements, and perhaps Tier 4.
 * Finally, the richest Canadians will fund their retirements using tiers 2, 3 and 4.

The analysis changes for early retirement, couples living together, and so on, but we assume a single person retiring at 65 throughout for simplicity.

Living on OAS and the GIS
The following graph shows what a single senior earning no other income (except withdrawals from TFSAs, the first $3500 of employment income, and other exceptions ) and eligible for full OAS pension, can receive from Tier 1 programs in late 2016:



This may be the situation of the poorest Canadians during retirement.

Combining Tier 1 with other income
For most retirees though, there are other sources of retirement income, from the other tiers. The following graph shows the effect of adding other income to Tier 1 benefits during retirement years. This is again for a single person eligible for maximum OAS in late 2016 and "other income" includes some exceptions as noted above.



The OAS amount is constant up to a threshold, at which a 15% recovery tax, commonly known as the clawback, begins. For each dollar of extra income (except TFSA withdrawals) beyond the threshold, OAS is reduced by 15 cents. The threshold is expressed as total income including OAS and is $73,756 in late 2016. Subtracting the $6,942 OAS value we get the inflection point of $66,814 of other income on the graph.

Replacement rates for tiers 1 and 2 combined
The traditional goal in policy discussions about the Canadian retirement income system is to replace 70% of final pre-retirement income (e.g., ). There have been arguments about the suitability of this target (it may be too high or too low depending on cases ) but for the sake of illustration we will use it here.

The following figure shows how tiers 1 and 2 interact, in the absence of other income during retirement.



For a single person retiring at age 65 in late 2016, who has contributed to CPP for 39 years of more, or to QPP for 40 years or more, with employment earnings always exactly equal to half of YMPE during those contribution years, we get a 71% replacement rate, so Tier 3 savings are not needed.

For a single person retiring at 65 with an equally long CPP/QPP contribution history, but with employment earnings exactly equal to the YMPE during all those contribution years, we obtain a 41% replacement rate. Note that GIS is still available for this person because he or she has no retirement income beyond OAS and CPP/QPP, in the graph. Because a 41% replacement rate is very low, in real life this person will probably have planned for some Tier 3 income, and this will decrease or eliminate GIS. For a 70% replacement rate, Tier 3 income is important and no GIS will be received.

For pre-retirement earnings of 1.92 times YMPE, the replacement rate obtained by combining Tier 1 and Tier 2 is only 21%. Substantial retirement income will be needed from Tier 3 pensions and savings.

Replacement rates for tiers 1, 2 and 3 combined
We have already seen that a single low income (0.5*YMPE) worker can retire at age 65 on tiers 1 and 2 alone based on the usual 70% replacement rate. The average income (1*YMPE) worker needed Tier 3 assets to replace 70% of pre-retirement income, and so did the high income (1.92*YMPE) worker. (NOTE: a pre-retirement income of 1.92*YMPE, multiplied by 0.7 to get the target retirement income, equals the lower threshold for the OAS clawback in late 2016. This was chosen for convenience). But what is the required Tier 3 income, and how does Tier 3 interact with the other tiers?

The following figure shows the retirement income sources for three scenarios, expressed as a percentage of pre-retirement income, with the total always equal to 70% (or 71% for the 0.5*YMPE case):



As previously, we see that our low income individual does not need any Tier 3 assets, as 71% of his income is already replaced by tiers 1 and 2. A note of caution is that this scenario assumes a very long contribution history to CPP/QPP, and retirement at 65. For earlier retirement, shorter contribution histories, or higher replacement rates, Tier 3 assets are needed.

Our average earner who replaces 70% of his pre-retirement earnings during retirement does not qualify for any GIS because he is adding too much Tier 3 income to his maximum CPP/QPP pension. Therefore, tiers 1 and 2 replace 37% of pre-retirement income, not 41% as on the previous graph. This means that Tier 3 income must replace 33% of pre-retirement income.

Finally, our high income person gets the same (maximum) amount in CPP/QPP as the average earner, no GIS, and still the full OAS because we placed the person just at the clawback threshold. All considered, this person must replace 51% of pre-retirement earnings with Tier 3 income.

Canadians with very high incomes will not get any Tier 1 benefits.

The Tier 3 savings, of course, will only provide the percentages required to reach the 70% replacement rate if the individual has saved enough in workplace pension plans, RRSPs, and the like. The effect of inflation must also be considered. See savings rate and Sustainable withdrawal for further discussion.

For another way to look at the same results, the following figure shows the income sources for the three scenarios, expressed as a percentage of retirement income, with the total always equal to 100%: