If governments force Canadians to save more for retirement, voluntary private savings will shrink

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Appeared in the Financial Post

In recent years, there’s been a strong push to expand the Canada Pension Plan, and Ontario intends to launch an additional mandatory pension plan in January 2017. Yet the debate about expanding mandatory government-run pensions has largely overlooked the unintended effect on private savings.

Increasing mandatory retirement savings can reduce the amount households save voluntarily. After all, Canadians choose how much they save and spend based on their income and preferred lifestyle. If their income and preferences don’t change, and the government mandates higher contributions to government-run pension plans, they will simply reduce their private savings in RRSPs, TFSAs, and other investments. The result: overall savings won’t change much, or at all, but there will be a reshuffling, with more money going to forced (government) savings and less to voluntary (private) savings.

This “substitution effect” has been highlighted by standard economic theory and in international studies. But surprisingly, few in Canada are talking about it.

In a recent Fraser Institute study, we examined the effect on private savings when Canadians were forced to contribute more to the CPP in the past. Our analysis focused on major changes to the CPP between 1996 and 2004, when the total contribution rate rose from 5.6 per cent to 9.9 per cent of insurable earnings, as part of reforms to improve the program’s long-term outlook.

We found that past increases in the mandatory CPP contribution rate were followed by decreases in the private savings rate of Canadian households. (The analysis accounted for interest rate changes and demographic shifts in age, income and home ownership.) Specifically, with each percentage point increase in the total CPP contribution rate, we found a 0.895 percentage point drop in the private savings rate of the average Canadian household.

The results suggest that for every one dollar increase in CPP contributions, the average Canadian household reduced private savings by around one dollar. Again, that means they didn’t necessarily save more overall—they just saved differently.

Interestingly, the substitution effect was stronger among younger (under 30) and mid-career households (ages 30-49) and weaker among Canadians approaching retirement (age 50–64). It was also more dramatic among lower- and middle-income households than those with higher incomes.

The debate about mandatory expansion of the CPP, or any new provincial plan such as the upcoming Ontario Retirement Pension Plan, should address the consequences of reduced private savings—namely the loss in choice and flexibility available with this type of saving.

For example, with private voluntary RRSP savings, Canadians can tailor their investments, pull money out for a down-payment on a home or to upgrade education, transfer the money to a beneficiary in the event of death, or withdraw money in case of emergency. Not so with the CPP.

The key to providing retirement income through savings is a set of rules that allows for an optimal mix of savings for different people in different stages of life, and with different preferences. The benefits of a mandatory expansion of the CPP, or of similar provincial policies in Ontario or any other province, should be weighed against the costs, which as our analysis suggests will include a reduction in voluntary private savings.

This reality needs to be front and centre in the ongoing pension policy debate. Otherwise, we risk overstating the gains from expanding government-run pensions.

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