1. ©2016 by McGraw-Hill Education Limited.
PUBLIC PENSIONS
Chapter 11
©2016 by McGraw-Hill Education Limited.

2. Learning Objectives
Explain how an annuity can be used to smooth consumption.
Explain the problem of adverse selection in the market for annuities.
Describe the moral hazard problem known as the Samaritan’s dilemma.
State the difference between pay-as-you-go pension financing and a fully funded pension.
Illustrate the wealth substitution effect on savings in a diagram of the life-cycle model.

3. Learning Objectives (cont)
Summarize the evidence on the effect of a pay-as-you-go pension system on savings.
Distinguish between the Old Age Security program and the Canada/Quebec Pension Plan.
Summarize the factors leading to increased contribution rates in the 1998 reforms to CPP.
Describe why the CPP program has led to an intergenerational redistribution.

4. Introduction
The Canadian retirement income system rests on three “pillars”:
The Old Age Security program
The Old Age Security (OAS) pension and the Guaranteed Income Supplement (GIS)
The Canada and Quebec Pension Plans
The Canadian Pension Plan (CPP), Quebec Pension Plan (QPP), and earnings related pension schemes
Tax-assisted private savings and pensions
The Registered Pension Plan (RPP) and the Registered Retirement Savings Plan (RRSP)

5. Public Intervention in the Provision of Retirement Incomes
LO1, LO2
Public Intervention in the Provision of Retirement Incomes
Adverse selection in the market for annuities
Annuity
Consumption smoothing
Asymmetric information
Adverse selection
Paternalism
Redistribution
Miscalculation and decision-making costs

6. Public Intervention in the Provision of Retirement Incomes (cont)
LO3, LO4
Public Intervention in the Provision of Retirement Incomes (cont)
The Samaritan’s dilemma
Moral hazard
Inflation indexation
Pay-as-you-go financing versus fully funded pension

7. Growth of Total Wages and Salaries and Real Interest Rates
Figure 11.1

8. Effects of Public Pensions on Economic Behaviour
Savings Behaviour
Wealth substitution effect
Public pension wealth
Retirement effect
Bequest effect

9. Budget Constraint for Present and Future Consumption
LO5
Budget Constraint for Present and Future Consumption N
|Slope| = 1+r
Future consumption (c1) D
I1 + (1+r) S
(1+r)S
Endowment point (A) B I1
(1+r)B S F
I1 - (1+r) B M
I0 - S I0
I0 + B
Present consumption (c0)
Figure 11.2

10. Utility-maximizing Choice of Present and Future Consumption
Future consumption (c1) E1
c1*
iii ii A i I1
Saving M
c0* I0
Present consumption (c0)
Figure 11.3

11. Crowding out of private saving due to Public Pension
LO7
Crowding out of private saving due to Public Pension N
Future consumption (c1) E1
c1*
iii R ii A i I1
(1+r)T T
Saving before Public Pension M
c0*
I0T I0
Present consumption (c0)
Saving after Public Pension
Figure 11.4

12. Effects of Public Pensions on Economic Behaviour (cont)
LO6
Effects of Public Pensions on Economic Behaviour (cont)
Empirical evidence on savings
Retirement decisions
Implications

13. The Old Age Security Program
LO7
The Old Age Security Program
Old Age Security (OAS)
Guaranteed Income Supplement (GIS)
Universal versus targeted income transfers
Population aging

14. Percentage of the Population Aged 65 and Over
Figure 11.5

15. The Canada Pension Plan
LO7
The Canada Pension Plan
Canada Pension Plan (CPP) and Quebec Pension Plan (QPP)
Retirement benefits
A contributor age 65 is entitled to a pension based on the following:
CPP pension = 0.25 x (average YMPE for the previous five years) x (average ratio of pensionable earnings to YMPE)
where YMPE is the yearly maximum pensionable earnings
Disability benefits
Survivor benefits

16. Contributions
A self-employed individual whole pensionable earnings are less that the YMPE made contributions according to the following:
CPP contribution rate x (pensionable earnings – YBE)
where YBE is the year’s basic exemption

17. Analysis of the CPP Contribution Increases
Table 11.1

18. LO8
The 1998 Reforms to the CPP
Table 11.2

19. The 1998 Reforms to the CPP (cont)
LO8
The 1998 Reforms to the CPP (cont)
Financing and investment changes
Benefit changes
Assessment

20. Intergenerational redistribution through the CPP
LO9
Intergenerational redistribution through the CPP
Table 11.3

21. Chapter 11 Summary
Canada’s retirement income system consists of three pillars: Old Age Security, the Canada and Quebec Pension Plans, and tax-assisted private savings and pensions.
Public provision of pensions can be justified on the basis of market failure including adverse selection in the market for annuities, paternalism, redistribution, decision-making costs, the Samaritan’s dilemma, and the absence of inflation indexation with private pensions.
With pay-as-you-go financing, the current working generation pays the pension of the retired generation.
Pay-as-you-go financing is superior to a funded pension scheme when the growth rate of total real wages and salaries exceeds the real interest rate on assets held in pension funds.

22. Chapter 11 Summary (cont)
Pay-as-you-go pensions may reduce private saving, the wealth substitution effect, or increase saving, the retirement and bequest effects.
The percentage of retired older workers has increased dramatically since the 1950s, and the introduction of the public pension programs may have contributed to this trend.
CPP contribution rates increased sharply with the 1998 reforms because of population aging, the slow-down in the growth rate of real wages, the enhancement of benefits that occurred in the 1970s and 1980s, and increases in disability claims.
The CPP has resulted in a large intergenerational transfer of income.