For reasons that would not seem sane to anyone who doesn't check this forum every day, I'm trying to model the value of the CPP to see if it's worth contributing to it when given the choice. This includes the employer contributions, which affects you directly if you own your employer or indirectly if you can't negotiate a higher salary because the employer is paying this cost.
If anyone who knows more can find anything wrong with this that would be great to know
Maximum monthly CPP payment, in 2012, when retiring at 65: $987
Annual contributions including employee and employer for maximum eligible earnings in 2012: $4500+
Ages: starting at 25, retiring at 65
Cost of an annuity worth $987/month in 2012, with inflation indexing: $200k-250k (guessed from indirect sources)
Instead of paying into the CPP, invest $4500/year for 40 years at a 3% real after-tax rate of return
End up with $339k, adjusted for inflation
Buy an annuity paying $1673/month with inflation indexing?
The CPP is worth up to 42% less than investing yourself, with conservative estimates? That almost seems to put it in the same range of financial quality as universal life insurance. If you plug in some slightly higher rates of return you can get as much as 5x the income by investing yourself.
Last edited by valueindexer; 2012-02-03 at 04:51 PM.
First, it is possible to get the actuarial present value of a future income stream. That is, you can get an estimate of the total value of a lifetime income stream even when the end date is random (insurance companies do this all the time).
However, the value is extraordinarily sensitive to the assumptions you use - the mortality assumptions and the discount factor you use for inflation indexing. You need to be cautious when projecting values which are sensitive to assumptions over long time horizons.
Secondly, I'm not sure what sources you used for your annuity quote, but you cannot find a lifeco paying $987/month with a CPI adjustment at age 65 for $250K. You are looking at more like $350K for a male, and higher for a female.
Thirdly, keep in mind that your CPP contributions (and those made by your employer) are made with pre-tax dollars, and you'd need to save with post-tax dollars, unless you save exclusively through an RRSP. (Tax is something of a red herring in this discussion, but to fully model your scenarios, you'd need to include it. Then you'd need to model the tax implications for the kind of annuity you purchase at age 65.)
Finally, for what it's worth, CPP provides a form of longevity-insured income. To some extent I think it is useful to think about this as providing a form of risk transfer - you are transferring the risk of outliving your funds to a (very strong) counterparty - versus thinking of the CPP income stream as "an investment."
By way of example, without a doubt I would be "better off" financially by NOT purchasing house insurance, but instead investing the funds I use now to buy insurance.
If I extend that process over a long enough time period, and make generous enough assumptions about the rate of return I will earn, then I will have enough to cover the cost of replacing my house - so long as it does not burn down while I am foregoing the insurance.
The same thing applies (in reverse) with longevity-protected income: you can think of many scenarios in which you would be better off foregoing the insurance rather than purchasing it (in your example, not paying CPP premiums vs. paying them) - but they are all predicated on the basic assumption that you don't need the insurance.
In your example, you suggest buying a private annuity at age 65 (or whenever) to provide longevity-insured income, you have covered that issue off. But if you want longevity-insured income, you will not be able to find it more cheaply or efficiently than through CPP, if you fully model your contributions over time. The private life insurance business is not very efficient.
I think this discussion is very worthwhile. But there's lots to consider.
Great points. I wasn't sure if I estimated the cost of CPI adjustments for an annuity correctly since all the prices I saw didn't mention them. On the other hand if you can get more than a 3% real after tax return the annuity you can buy climbs quickly. Or if you want to keep an investment portfolio, $987/month is a 3.5% withdrawal rate on $339k.
If you aren't getting a salary but are getting the same total income, you would need to be using other forms of income that may have lower taxes. For example at an average income level small-business dividends seem to potentially reduce the amount you pay to the government by $4000-5000 which gives you the investment amount. And if you had no other investment plans a TFSA would hold it nicely but we all have that maxed out already
Since an annuity with CPI adjustment seems to be the closest substitute for CPP benefits it sounds like it's at least comparable unless there's a big tax effect somewhere (but it doesn't give you the benefits of government backing and the possible election of a socialist government when you're 64). I wouldn't consider it risky to buy an annuity or withdraw under 4% from a portfolio annually.
In addiion to all of MoneyGal's points, it seems to me OP is comparing present value of CPP with future value of a 40-year stream of investments.
You're right that applying the correct model is essential. What I tried to do is take a model similar to what you would do when comparing expensive life insurance products with "buy term and invest the rest".
With option #1 you hand money every year to a wise and benevolent partner (that also has the power to change the rules at any time). After accumulating 40 years of value this way you start to get money back for as long as you live.
With option #2 you keep your money and put it into a portfolio every year. After accumulating 40 years of value this way you can withdraw from it using a fixed or variable withdrawal rate, or hand it over to a wise and benevolent partner (that can't change the law) and get money every year as long as you live.
Other than that it uses inflation-adjusted numbers everywhere and assumes the CPP rules stay the same in relative terms. It's hard to see the CPP benefits increasing significantly unless we manage to produce a lot more contributors or practice political timing. They could be reduced or delayed. Do you see any specific points where one of the options doesn't match what the other is doing?