Your Ultimate Guide to The CPP: Part I – How Payments are Calculated
For many of us, our Canada Pension Plan (CPP) benefits will make up an important portion of our retirement income. We pay into it all our working lives and expect to receive it when we retire.
Even so, many Canadians don’t entirely understand how it works and there are a lot of misconceptions. We agonize over when to take it. We overestimate how much we’ll get. Some people believe their benefits depend on their five highest-earning years, or their last five years.
The Canada Pension Plan pays out retirement pensions, survivor benefits and disability benefits.
In this and the next three posts I’ll guide you to everything you ever wanted to know about CPP but didn’t know who to ask.
A brief history
The CPP was established in 1966 by the federal government under Lester B. Pearson. It is a national public plan that covers eligible people in all provinces except Quebec.
Quebec wanted their pension monies to be under their control and so became the only province with its own program. The provincial plan is referred to as the Quebec Pension Plan (QPP) and it’s for those who work or have worked in Quebec.
It’s often described as CPP/QPP but since the features are similar, I will refer to the plan as the CPP.
When the CPP was created the contribution rate was 3.6% of pensionable earnings to be shared by employers and employees. Self-employed persons were on the hook for the full amount. These first deductions were so small they were unsustainable to fund the retirement costs of the baby boom generation who were just beginning their working years. Also, life expectances were starting to increase substantially.
The contribution rate rose steadily and now it stands at 10.5% of pensionable earnings.
The people running the plan have taken significant steps to increase the chances of the plan having the financial resources to pay the promised benefits. The first significant change occurred when contributions were increased to build up a surplus cash reserve for the future.
The second change was the creation of the CPP Investment Board to allow funds to be segregated from general government revenue and invested into market-based securities. Before that point, the federal government had simply loaned out the money we had paid into the plan to the provinces at piddling interest rates.
CPP is now in a strong financial position ($420 billion in assets) and is projected to be self-sustaining for at least 75 years.
In June 2016, more changes were made. The original design was to replace 25% of your average work earnings up to a limit. Now CPP contribution rates will continue to climb yearly until 2023 and the full enhancement will occur in 2065 when CPP income will be boosted to 33% of average pre-retirement income.
CPP payments are adjusted annually for increases in the cost of living based on the Consumer Price Index (CPI), so your payment may gradually increase each year.
How is CPP calculated?
The CPP is a contributory plan. That means the amount you receive is based on what you have contributed to the plan during your working years in Canada and for how long you made those contributions.
Contributions are mandatory once you reach the age of 18 and earn over $3,500 a year up to the Yearly Maximum Pensionable Earnings (YMPE) which is currently $58,700. The earning ceiling is set every January and is based on increases in the average wage in Canada. If you earn, or have earned, more than the YMPE annually you probably noticed there were no CPP deductions taken from your paycheque after that amount.
CPP contributions are no longer required after you reach the age of 70 (even if you’re still working) or if you become disabled.
Canada Pension Plan includes drop-out provisions that automatically remove no- and low-income months from the calculation of pension benefits. Here’s how they work:
General low-income drop out provision
The general drop-out is available to everybody who is applying for the CPP benefit. This provision excludes 17% of your lowest-income months from the calculation. For a 47-year contribution period (from 18 to 65) that would exclude 8 years of your lowest earnings.
Someone retiring and starting CPP at age 60 would have a shorter contributory period – 42 years – and 17% of that total would be 7.14 years dropped out.
Child-rearing drop out provision
Anyone who was primarily responsible for raising a child (or children) from birth to the age of seven is eligible for the child-rearing drop-out if it caused you to stop working or to earn a lower income.
Either spouse or common-law partner can apply for the Child Rearing Drop Out, but it can’t be used by both for the same period of time.
You won’t get this automatically. You should apply for it at the same time as you apply for your CPP pension. The application form (ISP1000) includes a section on child rearing that you can fill out. You can still apply for retroactive payments if you are already collecting CPP (form ISP1640).
You will need to provide an original or a certified true copy of your children’s birth certificates as well as their Social Insurance Numbers. You may also be required to provide proof of the date of entry into Canada for children born outside the country.
Any periods when you received a CPP disability pension will be dropped out.
The calculations for the child-rearing and disability drop-out periods take place first before the general low-income drop-out is calculated.
Then, the 17% drop-out is applied if more than 120 months of earnings remain.
At this point, you may be wondering how “low income” is calculated, as someone aged 60 now may have started working in the late 1970s, when salary amounts were much lower than they are today. (Federal minimum wage in 1978 was just $2.90 per hour.)
In order to calculate whether a month qualifies as a “low-income” month for the 17% drop-out calculation, all your past earnings are updated to current values using the Yearly Maximum Pensionable Earnings.
Essentially, each year of past earnings is calculated as a fraction of the YMPE that was in effect for that year, and then that ratio is updated to the current YMPE in order to determine which months are excluded in calculating your CPP retirement benefit. If you contributed the maximum, it will have the letter ‘M” next to that year.
To see the Yearly Maximum Pensionable Earnings from 1966, check this chart here
Finding out your expected CPP benefit
Financial planning tools always enter the maximum CPP benefits that can be received with corresponding reductions for early payments.
But, only 6% of new CPP pensioners get the maximum amount, so don’t count on it.
The current maximum monthly CPP benefit is $1,175.83 if you start at age 65. The average monthly payment amount for new beneficiaries is $672.87, or about 57%. On average, men get a third more than women.
Most people do not receive the maximum amount either because:
- They have not contributed to the CPP for at least 39 years between the age of 18 and 65, or
- They have not contributed the full rate during their working years for at least 39 years.
Add to that the trend of more and more people retiring before the age of 65 and taking early CPP payments at a lesser rate.
Request your CPP Statement of Contributions from your My Service Canada account. You can also have a copy mailed to you by calling them at 1-877-277-9914.
The Statement of Contributions is not entirely accurate because it’s based on two assumptions:
- You’ll keep working until at least age 60.
- You’ll continue to have the same working income from now until you retire.
Also, it doesn’t include the child drop-out period.
It will, however, give you an estimate of what your pension would be if you were 65 today, if you apply at age 60 and if you wait until age 70.
If you’re mathematically inclined, you can total your best 39 years (in terms of a percentage of the YMPE), divide by 39 and multiply by $1,175.83.
Or, you can try this free calculator.
How to apply for CPP
In order to start receiving CPP pension you must fill out an application. You may get one in the mail six months before you turn 65. If you elect to take your pension at a different age apply six to twelve months before you want your pension to begin.
Applications are available online using your My Service Canada account.
If you apply after you turn 65, you can get retroactive payments for up to 11 months.
Your CPP calculated by Service Canada is based on income and contribution data obtained from your tax filings with the CRA which may have a lag time. Service Canada may not have your employment income data and will catch up with a retroactive adjustment a few months later.
If you think your pension amount needs updating, ask Service Canada for a detailed letter explaining your CPP pension calculation. The letter should state which your years of income and contributions are incorporated, so you should be able to tell if any input years are missing and then be able to address the difference.
CPP pension sharing
The Canada Pension Plan allows spouses to share their CPP with each other. How it works is both spouses give each other half of their CPP. The amount depends on how long you lived together and your total contributions during that time – most often it’s a 50/50 split.
The total payout won’t change, but couples may get to keep more of it if splitting the pension puts more income in the hands of the spouse in a lower tax bracket.
To qualify for Canada Pension Plan sharing, both spouses must be eligible to collect CPP, which means they both have to be over the age of 60.
The spouses must apply to split Canada Pension Plan and agree to it in writing.
Once the amount is split, the spouses can apply to unsplit at a later date. In the case where one of the spouses passes away, the surviving spouse’s CPP goes back to their original amount.
Also, CPP credits earned by divorcing partners during their time together from 1977 onward may be subject to division.
Everyone who has been separated or divorced should be aware that CPP credit-splitting often reduces one spouse’s CPP by more than it increases the other spouse’s CPP, especially if the lower-income spouse claims the child-rearing dropout.
The bottom line
Imagine celebrating at your retirement party without a clue as to how much you can expect to receive in pension income. It sounds incredible, but many people who will end their career in a few years are in just that situation.
When planning for retirement it’s important to have at least some idea of the income you’ll be receiving. One source of income that’s often over-estimated is your Canada Pension Plan benefits.
Planning your retirement income requires some understanding of how much you will get from CPP. You can find out an estimate of your CPP benefits by looking at your Statement of Contributions from Service Canada.
The CPP is reliable, inflation-protected income paid as long as you live. Unlike personal savings which are subject to financial markets and inflation, CPP benefits provide you with a predictable pension.
It’s not enough to retire on, but it can be considered as a major piece of anyone’s retirement income flow.