The Danger of the CPP Breakeven Calculation
The Canada Pension Plan (CPP) is a key source of retirement income for most Canadians. However, many underestimate the value of delaying the start of their benefits. In exchange for waiting, the monthly benefit will increase, but it can be hard to know if this is worth it. To try and figure this out, a breakeven calculation is often used. This seems to help clarify the decision, but it can lead people to start their benefits too soon. Don't let this simple calculation mislead you into giving up over $100,000 of lifetime income.
CPP Retirement Benefits
The amount you receive from CPP in retirement is based on:
Your contributions during your working years
The age at which you start receiving benefits
The default age for starting CPP is 65, but you can begin payments as early as 60. The tradeoff is that the payments will be smaller for the rest of your life. The reduction is 0.6% for each month, or 7.2% per year, that you start before age 65. This means that if you start at 60, your CPP will be permanently reduced by 36%.
There is also an option to delay your CPP in exchange for larger payments. The increase is 0.7% for each month, or 8.4% per year, that you wait after age 65. The maximum deferral benefit tops out at a 42% increase at age 70.
Effect on max CPP
The max CPP benefit in 2023 at age 65 is $15,679.
If someone with max CPP started at age 60, their benefit would be reduced to $10,043.
If they instead waited until age 70, their benefit would increase to $22,264.
By waiting, they will get an extra $12,221 per year for the rest of their lives.
Work history and contributions
Years in which you have low or no contributions to CPP may reduce how much you receive in retirement. So if you retire before starting your CPP, the years of employment may slightly reduce the value of deferral. Be sure to read up on the CPP dropout provision to see if you will avoid this reduction.
The CPP Breakeven Calculation
So what is the breakeven calculation?
If someone starts CPP at 60, they will have a head start over someone who waits for a bigger monthly cheque. But those increased payments will eventually allow the patient person to catch up. The breakeven calculation estimates the age at which that happens.
The simple version of the calculation includes only the CPP payments themselves, but inflation and investing returns can also be factored in.
Here is a simple example of someone who is near the max:
As shown in the chart, the person who waited until 65 would catch up at age 73. If they live beyond this age, waiting to start later would be the optimal choice. If they don't reach this age, then starting early would have been better.
Note: Inflation has been left out of the illustration because CPP income increases each year along with the Consumer Price Index.
Depending on the assumptions used for inflation and rate of return, the breakeven age is typically in the mid-70s to early 80s.
There are plenty of online calculators if you'd like to try it yourself.
Seems simple enough, so why is this a problem?
Don't Break Your Retirement
There are 3 main problems with the breakeven calculation:
It leads people to start benefits early. Research suggests that this type of breakeven calculation leads people to start their benefits too soon. This happens despite the average life expectancy being greater than the breakeven age. Life expectancy for a 60-year-old is 85.8 for men and 88.5 for women.
It ignores the risk protection benefits of CPP. Sources of guaranteed lifetime income like CPP help protect Canadians against longevity risk.
The assumptions aren't guaranteed. It may be possible to take the early CPP payments and invest, but there is no guarantee of good investment returns. On the other hand, CPP is dependable and increases each year with inflation.
The Lifetime Loss Calculation
A better way to think about this decision is to calculate the "Lifetime Loss" of starting CPP early.
This equals:
(Expected lifetime CPP when starting at 70) - (Expected lifetime CPP when starting at 60)
Here is the earlier example which also includes waiting until 70:
If this person was a 60 year old woman, she can expect to live to about 88.
Here is the calculation for her Lifetime Loss:
(Expected lifetime CPP when starting at 70) - (Expected lifetime CPP when starting at 60)
(Total CPP at 88 = $404,700) - (Total CPP at 88 = $278,400)
Lifetime Loss = $126,300
The Lifetime Loss calculation was created by Bonnie-Jeanne MacDonald, PhD and Director of Financial Security Research at the National Institute on Ageing.
I highly recommend taking a look at her report which introduces the calculation. Examples which illustrate employment gaps and earning post-retirement CPP benefits are included.
The Risk of Dying Early
But what if I wait to start CPP and die before collecting any money?
There is a small, yet very real, chance that this could happen. But at the same time, we have to think about the risk of living to a very old age.
Parents sometimes consider taking CPP early to have more savings to leave to children in case they die early. On the other hand, they don't want to become a financial burden in old age.
CPP and Your Retirement Plan
The decision of when to start CPP is just one part of a complete retirement plan. Other factors, including the CPP Post-Retirement Benefit may influence when you would want to start receiving benefits.
In some circumstances, starting CPP at 60 might be the right choice. If you’d like to try to figure out your retirement income, check out the best free retirement calculators in Canada.
The breakeven calculation can also be misleading in other aspects of retirement planning. Any decisions about lifetime income, such as whether or not to buyback pension credits, can be skewed when viewed through this lens. When in these situations, considering average life expectancy is key.
If you need help with this important decision, schedule a free call with me and we can talk about what you want your retirement to look like.