Miscalculating the retirement income you'll need


Article Highlights

  • Proposals to raise Social Security benefits use a dubious formula. That could spell big trouble.

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  • Financial advisers do not calculate replacement rates the same way the Social Security Administration does.

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  • An early retiree can match his pre-retirement consumption while receiving a lower replacement rate from SS and other sources of retirement income.

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It is now conventional wisdom that Americans face a retirement "crisis," in part because Social Security benefits are seen as inadequate. For instance, the Social Security Administration's website explains that "most financial advisers say you'll need about 70% of your pre-retirement earnings to comfortably maintain your pre-retirement standard of living." It then notes that "under current law, if you have average earnings, your Social Security retirement benefits will replace only about 40%."

That line of thinking is misleading, often cited by progressives fighting benefit reforms that would address Social Security's $10 trillion shortfall. Here's why: Financial advisers do not calculate replacement rates the same way the Social Security Administration does. When the calculations are consistent, the replacement rate paid by Social Security comes closer to 60%, which substantially changes the retirement-income picture.

Financial advisers measure replacement rates relative to final earnings, generally meaning they divide the first year of retirement income by a worker's final year of working income, or average pay during the past five working years. The SSA, on the other hand, measures replacement rates relative to the wage-indexed average of lifetime earnings. "Wage indexing" increases past earnings to reflect the growth of average wages. These are very different numbers that produce very different outcomes.

By increasing the denominator, SSA's methods produce far lower replacement rates than the calculations of financial advisers. Our analysis of SSA data shows that the typical long-term employee who works until full retirement age receives a Social Security benefit equal to about 62% of his final earnings, defined here as the average of nonzero earnings in the five years before claiming Social Security benefits. For full-career workers with lower earnings, replacement rates average 70% of final earnings.

When including early retirees who receive reduced benefits, the typical replacement rate drops to 53% of final average earnings. But an individual who seeks to retire early must save a greater portion of his pre-retirement earnings, leaving less for consumption. Thus, an early retiree can match his pre-retirement consumption while receiving a lower replacement rate from Social Security and other sources of retirement income.

These distinctions may seem pedantic, but the underlying concepts are fundamental: Retirement plans are in theory designed to help retirees maintain their standard of living as they move out of the labor force. The SSA's wage indexing overstates an individual's pre-retirement earnings, which raises the bar for what counts as adequate retirement income.

Say you are retiring at age 65 this year and earned $20,000 in 1985. The purchasing power of that 1985 salary in 2014 dollars is $43,640. But in calculating replacement rates, SSA wage indexes that $20,000 for the growth of the economy, and so under that model you earned $53,281. Replacing 70% of $53,281 is a lot more difficult than replacing 70% of $43,640. SSA's wage indexing of past earnings in effect credits retirees with salaries that they never had, then deems retirement income inadequate if it fails to replace that nonexistent past salary.

There's a more consistent way to measure. If we calculate replacement rates relative to the inflation-adjusted average of total lifetime earnings, the typical retiree would receive a Social Security benefit equal to around 55% of his average lifetime income—and a low-income retiree would receive a replacement rate of around 70%.

These faulty replacement-rate calculations lead to profound errors. For example, analysts at the New America Foundation propose increasing Social Security benefits to raise replacement rates for an average worker from a supposedly inadequate 40% to 60%. This implies, however, that a typical worker could retire with a Social Security benefit that amounts to roughly 85% of his final salary, while a low-wage worker could retire at 140% of his final salary. If enacted, these changes would have disastrous effects on labor supply at older ages, not to mention the federal budget.

The issue here is not whether Social Security's benefit formula should be waged-indexed, which is an entirely separate issue that unfortunately uses similar terminology. Wage indexing of the benefit formula ensures that average replacement rates, however measured, remain roughly constant from one generation of retirees to the next.

Analysts are still debating whether to increase Social Security benefits, and figuring out how to return the program to solvency. But grappling with those problems requires fair, meaningful measurements of retirement income.

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