Wednesday, February 17, 2016

New article: “Measuring Economic Preparation for Retirement: Income Versus Consumption”

This is an interesting article for several reasons. First, the authors – Michael Hurd and Susann Rohwedder of the RAND Corporation – use data from the Health and Retirement Survey to estimate the percentage of retirees who are able to maintain their pre-retirement standard of living throughout retirement. The authors find that about 55% of single individuals and 80% of married individuals are able to do so. The biggest shortfalls are among single, less-educated women. While these estimates are for current, not future, retirees, you would need a large decline in retirement saving – which we’re not currently seeing – to produce numbers like those from the National Institute for Retirement Security, which claims that about three-quarters of Americans are undersaving for retirement.

Second, the authors apply their findings to replacement rates, which measure retirement income as a percentage of pre-retirement earnings. Most financial advisors recommend a replacement rate of about 70%. The authors found that, in the real world, meeting a target replacement rate isn’t necessarily a great measure of whether you’re well-prepared for retirement. While replacement rates work well for single individuals, a 70% target replacement rate tends to underestimate the true retirement preparedness of married couples. Put another way, if the authors had judged the retirement security of their sample based on their replacement rates, they would have underestimated the degree to which those households are truly prepared for retirement.

I’m not sure this means we need to reject replacement rates as a method for estimating the adequacy of retirement income. I’ve argued for several relatively straightforward adjustments to replacement rates – based on marital status and the number of children in a household – that might make replacement rates a better predictor of true retirement income adequacy.

Measuring Economic Preparation for Retirement: Income Versus Consumption
Michael Hurd and Susann Rohwedder
WP 2015-332

The income replacement rate (income immediately following retirement divided by income immediately preceding retirement) has become widely used as a measure of economic preparation for retirement. Yet a number of relevant issues are not adequately captured by the replacement rate concept. These include nontraditional transitions from full employment to full retirement, nonparallel transitions by the members of a married couple, and the ability to finance consumption out of savings. In this paper we estimate several measures of the income replacement rate that address some of these issues. Then we compare these income replacement rates with a consumption-based measure of economic preparation that takes into account the ultimate consequences for the retirement-to-death consumption path. Broadly speaking, the measure finds whether a household has, with high probability, the resources to finance a trajectory of spending from shortly following retirement until death. Our preferred measure of the income replacement rate somewhat understates the percentage of single persons adequately prepared for retirement, but it grossly understates the percentage of married persons adequately prepared. Furthermore, there is little relationship between the income replacement rate and our consumption-based measure. The implication is that the income replacement rate is of little use for assessing economic preparation for retirement: the chances that someone with a low income replacement rate is well prepared are not much different from the chances that someone with a high income replacement rate is well prepared.

Download: Research Briefs (PDF) | Full Paper (PDF)

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