2 Background

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The Canadian pension system has two major objectives: to alleviate poverty among the elderly, and to prevent a significant decline in living standards after retirement. (Task Force on Retirement Income Policy 1979). In order to achieve these objectives, the government intervened by creating public pension plans and by helping to finance private pensions with an array of tax incentives. The public pension schemes include Old Age Security programs, which pays a flat rate amount to all eligible Canadians aged 65 or more; the Canada and Quebec Pension Plans, which pay earnings-related benefits to workers based on contributions made during their working years. The Guaranteed Income Supplement provides an income-tested supplement to retirees with few or no private sources of income. Tax-assisted private pensions include employer- sponsored registered pension plans (RPPs) and individually based registered retirement saving plans (RRSPs). These tools have remained largely unchanged over the past 25 years and they are likely to become important sources of revenue for an increasing number of Canadians in the near future (Myles 2006).

Is our pension system effective in achieving the two objectives mentioned above? With respect to the first objective, it appears that Canada is doing well. For example, other studies have shown that the pension system has been relatively effective in keeping seniors out of low income (Myles 2000) and in improving the purchasing power among the elderly (Baldwin 2006).

Much less is known about the second objective, the extent to which pre-retirement lifestyles can be maintained after retirement. In the United States, studies based on longitudinal data have investigated the degree of income security among seniors, by using the concept of income- replacement rates. Replacement rates are based on income earned during retirement, expressed as a percentage of the level of income earned by individuals during their working years. Smith (2003), for example, calculates retirement income replacement rates over a period of 25 years and shows that (1) replacement rates change over the course of the retirement years; (2) that replacement rates are very sensitive to one's position in the income distribution; and, (3) that the pension system offered high replacement rates for low-income households.

What about Canada? Originally, the pension system was intended to provide an income replacement rate for the average worker corresponding to 60% or 70% of the level of earnings enjoyed prior to retirement. Public pensions were intended to pick up approximately 40% of the tab (Li 2006, Department of Finance 1995). Until very recently, however, it was not possible to assess the degree of income replacement following retirement. The lack of information about the degree of financial well-being after retirement partly stemmed from the absence of a dataset that could provide the opportunity to observe the income levels of a specific cohort of seniors over a sufficiently long period of time. This obstacle is now removed with the development of a rich longitudinal income dataset—Statistics Canada's Longitudinal Administrative Data base (LAD)—that makes it possible to track individuals for more than two decades.

In a short article, Gower (1998) made a courageous attempt to evaluate the degree of income security during retirement in Canada, using data from a LAD that was only 14 years old at the time. Gower selected a cohort of individuals who were aged at least 55 in 1992, who obtained at least 50% of their income from employment sources in that year, and who had no employment income by 1995. He computed income-replacement rates corresponding to the income level of 1995 expressed as a share of the income level they had earned in 1992. He found an average income-replacement ratio of 58% among all individuals, and also found that those that were in the bottom part of the income distribution in 1992 had much higher replacement rates in 1995 than those who were in the middle and in the top of the income distribution. However, Gower could not examine income-replacement rates in the long run, and did not examine the sources of income that contribute the most to the income security of seniors. To our knowledge, this paper is the first Canadian study that investigates income security over a long period of time following retirement.

We develop a number of statistics related to the degree of income security during retirement, very much in the spirit of Smith (2003). These include not only average replacement rates at various points of the income distribution but also an examination of the distribution of replacement rates, which vary considerably across individuals. We also provide new information about changes in the sources of income over the retirement years.

Another important aspect of income security is the degree of income instability, or year-over-year variation in income levels experienced by seniors. Morissette and Ostrovsky (2005) have shown that income instability varies considerably over the working life of individuals, with younger workers experiencing more instability and older workers experiencing more stability. Morissette and Ostrovsky also demonstrated that working individuals in the bottom of the earnings distribution experience more instability than other workers. This is important, as it suggests that seniors—and especially low-income seniors—may also experience considerable income instability which may create a good deal of anxiety and stress. We adopt the variance decomposition techniques used in Morissette and Ostrovsky to investigate the degree of income instability experienced by seniors at various stages of the retirement period. We also investigate if instability is higher among individuals that, prior to retirement, were in the bottom of the income distribution.