PROspective Vol I No VI June 2010
In a recent paper for the University of Michigan Retirement Research Center, economists John Karl Scholz and Ananth Seshadri said: “The rule of thumb that (income) replacement rates should be above 70 percent to maintain living standards in retirement is conceptually flawed.”*
If the 70% rule of thumb is flawed, why is it flawed and what should income replacement ratios be?
We asked John Karl Scholz to help us understand the research.
Chuck Miller: Much of your recent research has concerned retirement income replacement ratios. How did you become interested in this area?
Dr. Scholz: Over the past few years my colleague, Ananth Seshadri, and I have been looking at fundamental factors affecting the wealth accumulation of American households. Our work started by looking at the implications of the workhorse model for economists studying consumption/saving decisions – the lifecycle model – for Americans’ wealth accumulation. The intuition behind the lifecycle model is straightforward. Households maximize their well-being, given available resources, by equating the discounted marginal utility of consumption across time. Two phrases in the previous sentence are likely unfamiliar to those who have not studied economics. “Discounted” just addresses the idea that due to impatience or other factors, money (or consumption) in the future is likely less valuable to us than money (or consumption) today. “Marginal utility” addresses the idea that we are interested in equating the last unit of satisfaction that we get from our consumption each period. If I get much more satisfaction from the last unit of consumption this year, for example, than I did from last year’s consumption, I would be better off moving some of last year’s consumption to this year. I would lose relatively little happiness, since the bang-for-buck of last year’s consumption was low. But I would gain a lot, since the bang-for-buck of this year’s consumption is high. We were able to examine the implications of the lifecycle model using a very rich dataset on Americans born between 1931 and 1941.
We were surprised to find that in 1992, which was the first year that we had wealth data for sample members, they overwhelmingly had accumulated as much or more than what our lifecycle model suggested they needed to accumulate in order to maintain their living standards in retirement. Our work on replacement rates reflects our interest in doing some more applied work as part of this broader research project.
One way to frame our interest in replacement rates is the conventional wisdom that Americans are preparing poorly for retirement. The more rigorous studies arriving at this conclusion will use replacement rates – the idea that people need to replace 70 to 85 percent (or more) of pre-retirement income to be comfortable in retirement. Many households do not have sufficient resources to meet that goal.
But if our previous results are correct, that people tend to be doing fine with their retirement preparation, something is wrong with the conventional wisdom. The data are collected using the best available practices. Therefore, we felt it was worth looking more carefully at the replacement rate idea. Our ultimate goal is to “replace” the replacement rate with measures that might provide more useful financial targets for households. Our work along these lines is ongoing.
CM: What has been the replacement ratio “rule of thumb” and is the rule grounded in real research?
JKS: As mentioned, a common financial planning rule of thumb is that households need to replace between 70 to 85 percent of preretirement income to be financially secure.
The replacement rate rule of thumb has some apparent logic to it. Target replacement rates are thought to be less than 100 percent for three main reasons. First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement.** Accounting for these diminished income needs, conventional financial planning advice suggests that people need to replace at least 70 percent of pre-retirement income in retirement to maintain accustomed living standards.
In fact, when we calculate the median replacement rate that arises from our lifecycle model, applied to a sample of households born before 1954, it is 0.68 – very close to the 70 percent rule-of-thumb. The problem, however, is that the range of “optimal” replacement rates is much larger than the 70 to 85 percent range commonly discussed. Some households should be saving more. Many can comfortably save less.
CM: Where does the rule come up short? What are some of the factors the rule fails to consider?
JKS: A large number of factors will affect optimal target replacement rates. Optimal rates will be larger for couples than for singles. The evolution of average tax rates will have a substantial effect on optimal replacement rates. The reduction in average tax rates over the period we study, particularly for affluent households, implies that replacement rates for high-income households are lower than they otherwise would be absent the tax changes. Of course, if taxes increase in the future, replacement rates will need to reflect tax increases that will be borne by high-income households. Earnings shocks, particularly those incurred after children have left the household will also have substantial effects on optimal target replacement rates. Shocks to earnings are common and persistent, which makes durable rules of thumb difficult to formulate.
Perhaps the biggest and most straightforward-to-understand limitation arises because of children. Financial planning rules of thumb do not vary with the number of children in a family. But the resources needed to equate the discounted marginal utility of consumption in retirement for parents (assuming an intact married couple) is smaller if household resources during the pre-retirement period were devoted, in part, to raising four children than if the couple was childless.
Put differently, an otherwise equivalent household with many children will have a smaller optimal replacement rate than their childless counterpart. Conceptually, the ages when children are born, due to the interactions of credit constraints and optimal consumption profiles, and the timing of income realizations, will also affect target replacement rates.
CM: How can someone calculate their retirement income needs if so many factors are involved?
JKS: The most useful advice is to carefully track the expenses you currently have, and then engage in the introspection needed to anticipate what expenses you will have upon retirement. Ideally, spend a month or more living on this “retirement budget.” It is then reasonably straightforward to calculate the amount of wealth needed to maintain this standard of living in retirement. To do this well, you need a good understanding of your social security benefits, pension benefits, retiree health insurance coverage, and expected longevity. You need to think about your desired/expected retirement date. A good financial planner can provide help with many of these issues – many are excellent, but some also are not. So you need to take responsibility and understand what they are saying and doing.
*What Replacement Rates Should Households Use?;
*What Replacement Rates Should Households Use?;John Karl Scholz and Ananth Seshadri; University of Michigan Retirement Research Center; September, 2009; p 3
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