Deciding to retire is not a decision taken lightly by most people. It is a decision that involves a lot of changes, transitions, and often affects more than just one person. One key component in deciding the timing of retirement is the availability of retirement income. A key part of retirement income for a lot of Canadians is CPP.

There are three key pillars of retirement income in Canada: Personal savings, Pensions, and government benefits. Personal savings include RRSPs, TFSA, and non-registered investments. Pensions would only be applicable to those that have employer-sponsored pension plans. Lastly, government benefits include Canada Pension Plan (CPP) and Old Age Security (OAS). Within CPP and OAS there are additional benefits that apply to a more select group.

Below, we want to focus on CPP. We look at what CPP is, how retirement benefits are calculated, and go through an interesting exercise looking at when the most opportune time to start CPP is.

CPP Basics

CPP is a taxable monthly retirement benefit. It is designed to replace part of your income when you retire. CPP is funded by contributions from people and businesses currently working and operating in Canada.

If you are an employee, your CPP contribution (5.45% of your wage up to a max of $61,600) is automatically submitted by your employer. Your employer also makes a CPP contribution of 5.45%.

If you are self-employed you must make the full 10.9% contribution.

CPP Retirement Benefit Eligibility

Eligibility for CPP retirement benefits is less complicated than that of OAS. To qualify you must:

• Be at least 60 years old
• Have made at least one valid contribution

Valid contributions can come in several ways. Obviously, contributions for work you did in Canada count. However, you can also receive CPP credits from a former spouse at the end of a relationship.

Furthermore, CPP contributions can be made even if you are working abroad. There are some countries that have a Social Security agreement with Canada. This allows you to earn CPP credits while not working in Canada.

How CPP is Calculated

So we know that contributions are simply a percentage of your income up to a maximum yearly amount. The amount of benefit that is received depends on several factors:

• The age you decide to start receiving CPP
• How much you contributed to CPP and for how long
• Your average earnings throughout your working life

There are two components of your CPP; the basic component and the enhanced component. The basic component is based on the best 32 years of earnings. The enhanced component is calculated using your best 40 years.

There is a total of 47 years of potential CPP contribution (age 18-65). Of those potential 47, your best 40 are used in the calculation. However, more years can be dropped if you took time off work for reasons of disability or child-rearing.

By dropping the years where income was really low, it enhances your benefits. The maximum benefit that is paid out to anyone aged 65 in 2021 is $1,203.75/month.

Delaying vs. Taking Early

Although CPP is typically applied for at age 65, it does not have to start then. You can apply to have CPP start as early as age 60 or delay applying till as late as age 70.

If you do decide to start receiving CPP earlier than age 60 there is a penalty. This penalty comes in the way of a 0.6% decrease for every month prior to your 65th birthday. For example, if you were to turn 65 in 29 months, your CPP benefits would be reduced by a total of 17.4% (0.6% * 29 = 17.4%).

On the other hand, if you delay receipt of benefits, you are rewarded. For each month you delay receiving CPP you receive a 0.7% increase. For instance, if you delayed for 33 months your benefit would increase by 23.1%.

This is a big decision when entering retirement years. Applying for CPP at the most optimal time can add a significant amount of value to a person’s estate.

Three main factors

When making the decision to take CPP there are 3 main factors to consider: Income need, longevity, and external rate of return.

Income Needs

This should be the primary factor considered when making a decision on the timing of CPP. Is there an income need now? If you do not receive CPP, will it reduce your quality of life or put you into a negative financial position?

The answer to this question will be different for everyone. Some people might be very reliant on CPP and will not have saved anything for retirement. Others will not be reliant on it at all and have saved up more than enough.

If income is needed then CPP should be taken. If Income is not needed then it becomes a matter of when is the best time to take CPP. This means that we have to consider the other two factors.

Longevity

Longevity refers to how long you will live in retirement. There isn’t a longevity risk (the risk of outliving benefits) when it comes to CPP as benefits are guaranteed monthly until your passing. Rather, the longevity of your retirement is a key component of the optimal timing of benefits.

The rule of thumb is that the longer your life expectancy is the better it is to defer receiving CPP. This means someone who is expected to live to 75 is better suited to taking CPP at 65 rather than 70. However, someone who is expected to live to 95 is likely better suited to taking CPP at 70.

Longevity is a bit hard to nail down and there are so many uncertainties. However, actuaries have done a lot of work on this and there are some good mortality table resources available. Once life expectancy has been determined the last factor, external rate of return needs to be considered.

External Rate of Return

External rate of return refers to the rate of return that one can generate outside of CPP. These would be returns generated in your pensions, RRSPs, TFSAs, etc. You might be wondering how a person generates a return on their CPP.

Earlier we mentioned that by delaying CPP your benefit increases. Based on the earliest start date of 60, each month of deferring benefits increases the amount you receive by 0.6% up until age 65. Deferring further after age 65 increases the monthly benefit by 0.7% per month deferred.

This is essentially a 7.2% annual return from age 60 to 65 and an 8.4% annual return from age 65 to 70.

If a return larger than the those mentioned above can be generated, then taking CPP earlier is generally a better option. This allows more money to stay invested for longer in the investments generating the best return. The reverse is also true. If your external rate of return is lower than those mentioned above, delaying CPP becomes more beneficial.

CPP Timing Example:

Let’s assume that John has been working hard his entire life and has been a diligent saver. He has been able to sock away more than $1.6 million for his retirement income need. In addition, he has his house fully paid for and no debt. John is now 62 years old, with his wife Jane age 57, and after discussions with his financial planner, he has decided he would like to retire.

John’s family has a history of living long and reasonably healthy lives. Based on mortality tables, John and the planner agree to use a mortality age of 95. John also agreed to use projections of 6% rates of return for his investments and a 2% rate of inflation.

Based on current expenditures and retirement lifestyle goals, there is an income need of $7,500 a month ($90k annual) throughout retirement. Aside from the need for $7,500/month, John also wants to know the most optimal time to take CPP.

The Calculations

To figure this out for John we input all his information into our planning software; age, assets, liabilities, assumptions, income needs, etc. For the first calculation, we assumed that John starts CPP immediately. This resulted in an estate upon their passing of $1,646,888 in today’s dollars.

This tells us that the income need of $7,500/month should be easily doable granted the assumptions hold true. We then needed to figure out if age 62 is the optimal time for CPP to start and if 65 is the optimal time for OAS to start. To do this delayed the start date of both CPP and OAS until we found the combo that made the largest estate.

Our projections told us, that based on our assumptions the optimal time for CPP was age 70 and the optimal time for OAS was 69. By delaying until this time it created an estate worth $1,763,525 in today’s dollars. That is an increase of $116,637 in estate value just by delaying government benefits.

John was also curious what the difference was if all the assumptions stay the same but his life expectancy was only 85. We went through the same process above and found that if John takes CPP now and OAS at 65 it will create an estate of $1,457,425 in today’s dollars.

We then found that the optimal time to take CPP was 69 and OAS was 66. By delaying the estate increased to $1,486,866. For a net increase of $29,441.

Important notes

It is crucial to remember how the three factors above were applied in this example. John had more than enough assets to sustain his retirement lifestyle and didn’t immediately need the income from CPP. John also had a long life expectancy. Had he had a lower life expectancy like 85, the benefits of delaying government benefits decrease substantially.

Lastly, we assumed a very modest 6% rate of return. If John’s investments were generating returns of 10% annually, the optimal time to take both CPP and OAS is at age 65. The higher the returns generated, the better it was to take CPP earlier.

We also provided calculations based on what John could spend if he didn’t want to leave an estate to his heirs, and what John could spend if he had rates of return of 0% with 2% inflation.

Conclusion

Please remember that this process is reliant on assumptions and that reality is likely to play out differently. However, with just a couple hours of work, we were able to show a potential increase of more than $100,000 to John’s estate. This didn’t require any work by John. It was just a matter of deferring government benefits.

Such a simple decision is able to add thousands of dollars to your estate. Make sure you are sitting down with your financial planner prior to retirement to see when you should be applying for government benefits. Don’t have a financial planner? Reach out to us.

Leave a comment down below, did you realize making a simple decision like this could add so much to your estate? Were you shocked to see that John’s net estate was more than $116,000 larger? Let us know your thoughts.

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