Measuring Economic Preparation for Retirement: Income Versus Consumption

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Abstract

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.

Key Findings

  • The income replacement rate (IRR), the ratio of income after retirement to earnings before retirement, was developed to help people plan financially for retirement. For many people, however, such a broad rule of thumb is simplistic and misleading. The IRR does not consider other sources of support in retirement such as financial wealth; in the case of married persons it does not have a good way of defining retirement.
  • We augmented the simplest of the IRR by including a drawdown of financial and IRA wealth; we defined and estimated a household IRR to more fully account for the advantages of dual-earner households in which joint ownership of resources results in savings. The augmented measures increased the percentage of the population economically prepared for retirement by as much as 20 percentage points over the simple measure.
  • We compared these extended IRRs with a measure of economic preparation based on consumption, which is theoretically preferable because consumption translates directly into well-being. Further, in the consumption-based measure, we accounted for the likelihood of events that impact spending needs many years into retirement. Our estimated consumption-based measure indicates retirement preparation at 59 percent for single persons and 81 percent for couples, well over the quantities derived from income replacement rates (46 percent for both single and married persons). Moreover, there is little relationship between the income replacement measures and the comprehensive consumption-based measures. Even when broadened in scope, the IRRs do not give good guidance to individual households.

Citation

Hurd, Michael D. and Susann Rohwedder. 2015 "Measuring Economic Preparation for Retirement: Income Versus Consumption." Ann Arbor, MI. University of Michigan Retirement Research Center (MRRC) Working Paper, WP 2015-332. http://mrdrc.isr.umich.edu/publications/papers/pdf/wp332.pdf

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Paper ID

WP 2015-332

Publication Type

Working Paper

Publication Year

2015