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

By Biggs, Andrew G.; Springstead, Glenn R. | Social Security Bulletin, April 1, 2008 | Go to article overview

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


Biggs, Andrew G., Springstead, Glenn R., Social Security Bulletin


Summary

Discussions of retirement planning and Social Security policy often focus on replacement rates, which represent retirement income or Social Security benefits relative to preretirement 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 preretirement 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.

(ProQuest: ... denotes formula omitted.)

Introduction

Individuals and policymakers both rely on the concept of replacement rates, which express retirement income as a percentage of preretirement earnings. Individuals use replacement rates as a rule of thumb in retirement planning. Policymakers use various replacement rate measures to analyze Social Security benefit adequacy under the current benefit schedule versus those that might be provided under alternate policies.

However, confusion exists regarding the use of replacement rates. Specifically, while the numerator in the replacement rate equation is easy to isolate-either total retirement income in the case of retirement planning or periodic Social Security payments in the case of policy discussions-there is no consensus on the proper way to measure preretirement earnings.

As a result, personal planning and policy discussions often mix different measures of preretirement earnings, which can lead to false conclusions about current or potential replacement rates (Steuerle, Spiro, and Carasso 2000). Specifically, it is commonly accepted that a replacement rate of roughly 70 percent is adequate for retirement income from all sources, and Social Security benefits typically account for a replacement rate of roughly 40 percent. However, the 70 percent replacement rate recommended by many financial advisors is generally measured relative to earnings immediately preceding retirement, but Social Security replacement rates are measured relative to a wage-indexed average of lifetime earnings. It is risky to draw conclusions based on replacement rates calculated using different denominators. To help clarify measures of replacement rates this article presents four alternative measures of preretirement earnings:

* Final earnings: the average of real earnings in the 5 years prior to claiming Social Security benefits. …

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