Measuring Economic Preparation for Retirement: Income Versus Consumption

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.