Lifetime Earnings, Social Security Benefits, and the Adequacy of Retirement Wealth Accumulation

Article excerpt

Summary and Introduction

The United States has traditionally depended on the so-called three-legged stool-Social security, private pensions, and additional personal saving-to finance retirement, but all three legs are becoming increasingly creaky. Social security and Medicare face long-term financial shortfalls, because of a combination of the imminent retirement of the baby-boom generation, generally lengthening life spans, and rising health care costs and per capita health care expenditures, which are projected to continue increasing in the coming decades. The trend in pensions from defined benefit to defined contribution plans brings with it a set of opportunities but also a set of risks for future retirees. Aggregate saving rates have been extremely low in recent years, and evidence shows that some households save very little, especially in the form of financial assets.

The extent to which households are already saving adequately for retirement is thus an important issue for policymakers, especially as they deal with issues like Social security reform. It is also a central issue in academic research that aims to understand the forces that shape the way people make forward-looking decisions on saving.

Despite the importance of the question, there is significant controversy about how well households are preparing for retirement. Researchers have taken a wide variety of approaches to examine the issue, including measuring changes in household consumption at the time of retirement, calculating the annuitized value of existing wealth, comparing the wealth accumulation patterns of current and previous generations, and comparing the results of simulation models of optimal wealth accumulation with households' actual saving behavior. Each approach generates useful information, but each also has shortcomings that may limit the applicability of the results.1

This article provides new evidence on the adequacy of household wealth accumulation. The research departs from most of the previous analyses in two key ways. First, whereas most simulation models of optimal wealth accumulation assume that earnings are nonstochastic, this research follows earlier work (Engen, Gale, andUccello 1999) in deriving optimal wealth accumulation patterns for households in a stochastic life-cycle model that allows for uncertainty in earnings and mortality. Uncertainty about future earnings implies that there will be a distribution of optimal wealth-to-earnings ratios, rather than a single benchmark ratio, among households that are otherwise observationally equivalent (that is, households that are similar on the basis of age, education, pension status, marital status, and wage history). This finding fundamentally changes the interpretation of observed saving patterns relative to a nonstochastic model. In particular, it implies that some households should be expected to exhibit low ratios of wealth to lifetime earnings, even if every household is forwardlooking and makes optimal choices. The notion that low levels of saving could still represent adequate replacement rates is reinforced by the notion that the federal government provides Social Security payments and Medicare benefits to retirees.

The second way in which this analysis departs from most of the previous research is to base the measures of adequate wealth accumulation on lifetime earnings rather on than current earnings.2 There are several reasons to believe that using data on lifetime earnings will prove useful in studying the adequacy of saving. Most importantly, lifetime earnings are almost certainly more closely correlated with economic well-being during working years and desired economic status in retirement than are earnings in any particular year. In addition, use of lifetime earnings may help clarify who is saving too little. For example, Mitchell, Moore, and Phillips (1998) andEngen, Gale, and Uccello (1999) found that, controlling for other factors, it was less likely that households with higher current earnings were saving adequately for retirement, when adequate saving was defined as having a sufficiently high ratio of wealth to current earnings. …