Thursday, October 23, 2008

New paper: Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income

I have a new paper out in the Social Security Bulletin co-authored with Glenn Springstead, of the Office of Retirement and Disability Policy at SSA. The paper is entitled "Alternate Measures of Replacement Rates for Social Security Benefits and Retirement Income" and looks at the ways in which we measure retirement income adequacy. Here's the summary, followed by some notes:

Discussions of retirement planning and Social Security policy often focus on replacement rates, which represent retirement income or Social Security benefits relative to pre-retirement earnings. Replacement rates are a rule of thumb designed to simplify the process of smoothing consumption over individuals' lifetimes. Despite their widespread use, however, there is no common means of measuring replacement rates. Various measures of pre-retirement earnings mean that the denominators used in replacement rate calculations are often inconsistent and can lead to confusion.

Whether a given replacement rate represents an adequate retirement income depends on whether the denominator in the replacement rate calculation is an appropriate measure of preretirement earnings. This article illustrates replacement rates using four measures of preretirement earnings: final earnings; the constant income payable from the present value (PV) of lifetime earnings (PV payment); the wage-indexed average of all earnings prior to claiming Social Security benefits; and the inflation-adjusted average of all earnings prior to claiming Social Security benefits (consumer price index (CPI) average).

The article then measures replacement rates against a sample of the Social Security beneficiary population using the Social Security Administration's Modeling Income in the Near Term (MINT) microsimulation model. Replacement rates are shown based on Social Security benefits alone, to indicate the adequacy of the current benefit structure, as well as on total retirement income including defined benefit pensions and financial assets, to indicate total preparedness for retirement.

The results show that replacement rates can vary considerably based on the definition of preretirement earnings used and whether replacement rates are measured on an individual or a shared basis. For current new retirees, replacement rates based on all sources of retirement income seem strong by most measures and are projected to remain so as these individuals age. For new retirees in 2040, replacement rates are projected to be lower, though still adequate on average based on most common benchmarks.

Here's a quote from a SSA publication that motivated this paper for me:

"Most financial advisors say you'll need about 70 percent of your pre-retirement earnings to comfortably maintain your pre-retirement standard of living. Under current law, if you have average earnings, your Social Security retirement benefits will replace only about 40 percent."

Here's the problem: financial advisors measure replacement rates by dividing your retirement income by your income immediately preceding retirement; say, income at age 65 divided by income at age 64. Social Security defines the replacement rate as the Social Security benefit divided by the wage-indexed average of your lifetime earnings. These are two different animals, so comparing Social Security's 40 percent average replacement rate to the 70 percent recommended replacement rate is apples and oranges.

In the paper we discuss the pros and cons of various ways of defining replacement rates. In the process, though, we also use the Social Security Administration's MINT microsimulation model to measure Social Security and total retirement income replacement rates for current retirees. This is cool because MINT is the best, most detailed model available for running these kinds of numbers. The table below shows the distribution of Social Security replacement rates compared to various definitions of pre-retirement income.

Table 4: Median Shared Benefit Replacement Rates for Retired Beneficiaries age 64-66 in 2005

Lifetime earnings quintile

Lowest

2nd

3rd

4th

Highest

Final Earnings

137%

77%

69%

53%

42%

PV Payment

62%

47%

42%

40%

36%

AIME

70%

52%

45%

41%

36%

CPI Average

82%

60%

53%

48%

42%

Source: MINT model, authors' calculations; N = 3,604. Numerator is shared benefit; denominator is shared value as defined in the text.


The next table shows replacement rates for total retirement income, which includes Social Security, pensions, asset income, earnings and co-resident income.

Table 5:
Median Shared Total Retirement Income Replacement Rates for Retired Beneficiaries age 64-66 in 2005

Lifetime earnings quintile

Lowest

2nd

3rd

4th

Highest

Final Earnings

381%

210%

185%

161%

143%

PV Payment

160%

111%

98%

108%

115%

AIME

176%

120%

106%

112%

112%

CPI Average

204%

141%

124%

130%

130%

Source: Authors' calculations, MINT model. Numerator is shared total retirement income; denominator is as defined in the text.

This last table is interesting, because it provides some perspective for those who are afraid that we're facing a crisis in retirement income. For instance, the median household has a total retirement income equal to 124 percent of their inflation-adjusted average income during their working years. (This may or may not be the best replacement rate measure to use, but it's easily understandable.) We find relatively few households with very low replacement rates, indicating that concerns over retirement income – while not invalid – may be overstated.

There are a few other interesting results as well, including the finding that – contrary to some views – replacement rates don't tend to decline as people age. Anyway, I hope folks will read this and find it interesting.

3 comments:

Anonymous said...

Could you tell me other information on pension replacement rate? I think your research on it is different form the Chinese ones which focus on "average replacement rate" while yours on "individual replacement rate".

Anonymous said...

you can answer me by E-mail:xylina1001@163.com

Andrew G. Biggs said...

Thanks for the question. I'm not totally sure of the distinction, although average replacement rates among the population of retirees -- even retirees whose pre-retirement earnings were similar -- can hide big differences in individual replacement rates. In this study we used a microsimulation model to calculate replacement rates for a large number of individuals, then cross-tabulated them by a number of criteria (earnings, etc.). If this doesn't make sense, though, I'm happy to follow up more if we can make the question clearer. Thanks.