Retirement Income Replacement Research Articles

Practical Applications of The Use and Value of Financial Advice for Retirement Planning

<h3>Practical Applications Summary</h3> In <b>The Use and Value of Financial Advice for Retirement Planning</b>, from the Winter 2020 issue of <b><i>The Journal of Retirement</i>, W. Van Harlow</b>, formerly of <b>Empower Retirement</b>; <b>Keith Brown</b> of the <b>University of Texas</b>; and <b>Stephen Jenks</b> of <b>Empower Retirement</b> examined the characteristics of individuals who received professional advice for retirement planning and the economic value of the results. The authors surveyed more than 4,000 working households to assess their demographics as well as their investment and behavioral characteristics. The results reveal that the retirement income replacement earned by advised households tends to be 15 percentage points higher than that of unadvised households. <b>TOPICS:</b>Retirement, quantitative methods, portfolio construction

Practical Applications of The Use and Value of Financial Advice for Retirement Planning

Practical Applications Summary In The Use and Value of Financial Advice for Retirement Planning, from the Winter 2020 issue of The Journal of Retirement, W. Van Harlow, formerly of Empower Retirement; Keith Brown of the University of Texas; and Stephen Jenks of Empower Retirement examined the characteristics of individuals who received professional advice for retirement planning and the economic value of the results. The authors surveyed more than 4,000 working households to assess their demographics as well as their investment and behavioral characteristics. The results reveal that the retirement income replacement earned by advised households tends to be 15 percentage points higher than that of unadvised households. TOPICS:Retirement, quantitative methods, portfolio construction

The Use and Value of Financial Advice for Retirement Planning

Offering professional advice around the retirement planning process represents an important component of the financial services industry. We examine the demographic, investment, and behavioral characteristics of individuals who obtain this advice as well as the economic value that it ultimately adds. Using a survey of more than 4,000 working households, we find that wealth and income levels are positively correlated with the decision to engage a professional advisor, as are such factors as marital status, age, and education level. To assess the value added by this advice, we develop a unique metric of retirement income replacement which incorporates health-based life expectancy and household-specific financial circumstances. The approach estimates the percentage of annual pre-retirement income that a household will be able to spend each year in retirement. We establish the unconditional finding that advised households generate significantly larger proportions of post-employment spending (both gross and net of Social Security benefits) than do non-advised households. Controlling for additional explanatory factors, we find that an advisor adds more than 15 percentage points of income replacement in retirement. These findings support the conclusion that obtaining and implementing financial advice in the retirement planning process leads to a demonstrable increase in the level of sustainable retirement spending. TOPICS:Retirement, quantitative methods, portfolio construction Key Findings • Households using financial advisors are, on average, wealthier, have higher incomes, married, more highly educated, more confident in their retirement planning, and more disciplined in their financial process. • A new metric to quantify the value of financial advice is developed focusing on retirement income replacement and incorporating health-based life expectancy and household-specific financial circumstances. • Regression and nearest-neighbor matching methods to control for confounding variables both indicate a significant lift of approximately 15 percentage points in the retirement income replacement score resulting from the use of a financial advisor.

How Much Should the Poor Save for Retirement? Data and Simulations on Retirement Income Adequacy Among Low-Earning Households

Both policymakers and members of the public are concerned regarding the adequacy of U.S. households’ retirement savings. In response, proposals have been made to expand Social Security benefits and to establish state government-run retirement plans for private sector employees. In both cases, the largest effects would be on low-earning households, who currently have low rates of retirement plan coverage and participation and who rely heavily upon Social Security benefits in retirement. However, there has been little systematic analysis of the retirement saving needs of low-earning households other to point out that they currently save little. But this leaves open the possibility that low savings are appropriate given Social Security’s progressive benefits. I explore these questions in two ways. First, I present a variety of data on the retirement saving and retirement incomes of low-earning households. While these households save little, their retirement incomes have risen steadily over the past decades and their poverty rates dropped significantly, seemingly as a result of rising real Social Security benefits. Low-income retiree express less satisfaction with the adequacy of their retirement incomes than other retirees, but their self-assessed retirement income adequacy has increased in recent years. Second, I present a simple model to calculate the household wealth and saving rates necessary for stylized earners to achieve income-specific retirement income replacement rate targets, net of scheduled Social Security benefits. For very low earners, roughly the poorest quintile of the earning distribution, little savings are necessary on top of Social Security. For earners above that level saving requirements increase, but are likely achievable so long as an earner has access to a retirement plan and participates in it.

The Life Cycle Model, Replacement Rates, and Retirement Income Adequacy

The key insight of the life cycle model in economics is that a household’s consumption at any given time is determined not so much by its current income as by the total income available to the household over its lifetime. A replacement rate can be a useful tool in approximating the life cycle model’s predictions for how households prepare for retirement. The Social Security Administration’s Office of the Chief Actuary (SSA OACT) publishes two different calculations of retirement income replacement rates, each of which finds that Social Security benefits replace about 40% of a typical retiree’s pre-retirement earnings. Some interpret these figures as indicating that Social Security benefits are insufficiently generous and that U.S. households’ total retirement saving is inadequate. But SSA OACT’s two methods for calculating replacement rates both violate the life cycle model in a meaningful way. SSA OACT’s career-average earnings replacement rates, in which lifetime earnings are first indexed upward by the rate of economywide wage growth, exaggerates by roughly one-fifth the real value of earnings available to a household for consumption over its lifetime. This overstatement lowers a household’s measured ability to replace their pre-retirement earnings. SSA OACT’s final-earnings replacement rates effectively compare Social Security retirement benefits to pre-retirement earnings only in the years in which the individual worked, ignoring the life cycle model’s prediction that household consumption is a function of long-term average earnings, including years in which a household member was not employed. A replacement-rate calculation more consistent with the life cycle model would compare retirement income to an average of real earnings calculated over a significant number of years. Such an approach would find substantially higher replacement rates for the typical retiree. It is important both for Social Security policy and the analysis of overall retirement savings adequacy that replacement-rate calculations build on the insights of the life cycle model that guides most economic analysis of retirement saving.

How Much Should DC Savers Worry about Expected Returns?

Many defined contribution (DC) savers and plan sponsors implicitly assume that future long-term capital market returns will be similar to those observed in the favorable markets of the past few decades. In recent history, an unexceptional savings rate of 8% each year over one’s career, together with other common industry assumptions, would have allowed DC savers to reach a target retirement income replacement ratio of 75%. Unfortunately, current market yields indicate that both stocks and bonds may deliver lower returns in coming years. This may impact savers significantly: We quantify that roughly 2% lower expected returns could almost double the savings rate required over one’s working career to achieve this same 75% replacement ratio. We conclude by briefly describing some investment strategies that may help enhance portfolio returns. <b>TOPICS:</b>Retirement, portfolio construction

Social Security Retirement Income Replacement Rates

One of the main retirement income concerns is adequacy, which is generally measured as the percentage of preretirement income replaced by the retirement benefit. For defined-benefit pension plans the replacement rate or ratio is measured against some measure of final income. For Social Security (more accurately OASDI), however, the Social Security Administration uses a complex measure of career-average earnings. Since Social Security is the main, and often the only, source of retirement income for many millions of Americans, the question of adequacy is paramount. The benefit formula is heavily skewed in favor of lifetime low-income earners. In addition, Supplemental Security Income (SSI) and state augmentations add to the retirement income of low-income claimants. The combination of OASDI and SSI benefits result in retirement income that, while not overly generous, is adequate. This article examines the origins and development of OASDI and SSI with a focus on benefit adequacy.

Survey response in probabilistic questions and its impact on inference

We develop a panel data model of expectations of a continuous outcome variable elicited on a percentage-chance scale. The model explains the location and dispersion of the subjective distributions by socio-economic covariates and unobserved factors. Moreover, it accounts explicitly for non-response, non-informative focal answers, and recall and rounding errors. We apply the model to the expected retirement income replacement rate of Dutch wage workers. We find that incorporating these features of the answering process increases the size and significance of relationships with covariates. The estimates indicate substantial rounding but few focal answers. Respondents tend to stick to a certain answering strategy: non-response, rounding and especially non-informative focal answers are characterized by substantial unobserved heterogeneity across individuals.

Probabilistic survey questions and incorrect answers: Retirement income replacement rates

We study responses to subjective retirement income replacement rate expectations questions in a survey of Dutch employees. One out of three respondents is unable to provide probabilities satisfying the requirements of a cumulative distribution function. We show that using probabilistic survey questions yields an endogenous sample selection when these individuals are removed from the sample, biasing the results toward more pessimistic expectations and excess uncertainty in the replacement rate. These biases are most prevalent for less-educated individuals.

Bridging the Gap: Anticipated Shortfalls in Future Retirement Income

Determining an appropriate and desirable income replacement rate is one of the keys to developing a successful personal financial plan for retirement. In the present investigation, we examined workers’ expectations of the pre-retirement income they believed would be necessary in order to have a “good” retirement relative to the income they anticipated they would receive. Analyses revealed an expected income shortfall, the magnitude of which was positively related to one’s income and age. Sex was also related to the magnitude of the expected shortfall, with women anticipating a larger financial discrepancy than men. Finally, a sex by marital status interaction emerged in which single women were found to have a larger shortfall than single men and married individuals of both sexes. Findings are discussed in terms of the importance of interventions aimed at educating workers to understand the value of selecting a reasonable retirement income replacement rate.

Behavioral economics perspectives on public sector pension plans.

We describe the pension plan features of the states and the largest cities and counties in the U.S. Unlike in the private sector, defined benefit (DB) pensions are still the norm in the public sector. However, a few jurisdictions have shifted toward defined contribution (DC) plans as their primary savings plan, and fiscal pressures are likely to generate more movement in this direction. Holding fixed a public employee's work and salary history, we show that DB retirement income replacement ratios vary greatly across jurisdictions. This creates large variation in workers' need to save for retirement in other accounts. There is also substantial heterogeneity across jurisdictions in the savings generated in primary DC plans because of differences in the level of mandatory employer and employee contributions. One notable difference between public and private sector DC plans is that public sector primary DC plans are characterized by required employee or employer contributions (or both), whereas private sector plans largely feature voluntary employee contributions that are supplemented by an employer match. We conclude by applying lessons from savings behavior in private sector savings plans to the design of public sector plans.

Assessing Adequacy of Retirement Income for U.S. Households: A Replacement Ratio Approach

The retirement income replacement ratio is projected using the Federal Reserve's Survey of Consumer Finances. On the basis of lognormal portfolio projections and current portfolio allocation, at least 44 per cent of pre-retired households will not be able to maintain 70 per cent of permanent income standard in retirement. Households planning to retire later and taking a high financial risk in savings and investments have a higher projected replacement ratio. Households having a high proportion of non-housing assets held in equity or bonds have a higher projected replacement ratio than those having a high proportion in cash equivalents.

Probabilistic Survey Questions and Incorrect Answers: Retirement Income Replacement Rates

We use probabilistic survey questions to analyze the determinants of individuals’ expected value of and the uncertainty in the retirement income replacement rate. We find that the expected replacement rate is U-shaped in age and is substantially lower for highereducated individuals. Uncertainty in pension income decreases with age, but increases with education. An important aim of this paper is to investigate if the use of probabilistic survey questions yields an endogenous sample selection by removing individuals that provide answers incompatible with probability theory. We find that not accounting for endogenous sample selection biases the results toward more pessimistic expectations and excess uncertainty in the replacement rate. These biases are most prevalent for less-educated individuals.

Behavioral Economics Perspectives on Public Sector Pension Plans

We describe the pension plan features of the states and the largest cities and counties in the U.S. Unlike in the private sector, defined benefit (DB) pensions are still the norm in the public sector. However, a few jurisdictions have shifted towards defined contribution (DC) plans as their primary savings plan, and fiscal pressures are likely to generate more movement in this direction. Holding fixed a public employee‘s work and salary history, we show that DB retirement income replacement ratios vary greatly across jurisdictions. This creates large variation in workers‘ need to save for retirement in other accounts. There is also substantial heterogeneity across jurisdictions in the savings generated in primary DC plans because of differences in the level of mandatory employer and employee contributions. One notable difference between public and private sector DC plans is that public sector primary DC plans are characterized by required employee or employer contributions (or both), whereas private sector plans largely feature voluntary employee contributions that are supplemented by an employer match. We conclude by applying lessons from savings behavior in private sector savings plans to the design of public sector plans.

Replacing Income in Retirement for the Newly Retired: A Distributional Analysis of Gross and Net Replacement Rates

Income replacement after retirement is an increasingly important economic policy area of social concern. This study examines three different measures of replacement income, including the effect of taxes on the estimated replacement rates of new retirees in the Health and Retirement Study. An analysis of replacement rates on average and in different parts of the distribution shows that married, older, and voluntary retirees have the highest replacement rates and that income from pensions and Social Security still form the majority of retirement income replacement.

Trends and Projections in Income Replacement during Retirement

This article calculates retirement income–replacement rates for all labor market cohorts across the last 25 years and describes the changing contributions made by private pensions, social security, and assets. The factors on which replacement rates are sensitive include position in the income distribution, the use of after‐tax instead of pretax incomes, the changing family composition of households between their pre‐ and postretirement years, and differential underreporting of income by age. The debate about reforming the U.S. retirement income system starts from a base where the current system offers high income‐replacement rates for most households, especially low‐income households.

Tax Reform and Retirement Income Replacement Ratios

Tax Reform and Retirement Income Replacement Ratios Introduction Wage, or income, replacement ratios are of great importance to employers in the private sector, the Social Security Administrator, other federal and state government agencies, and legislative and regulatory leaders as they formulate plans and policies regarding the implementation or modification of retirement income programs. Employees and other members of the consuming public also have a keen interest in knowing the percentage of preretirement salary that is needed to maintain, or continue, their preretirement standard of living into their retirement years. Updated information on income replacement rates is specially critical to that segment of the population that, because of personal circumstances, currently is (or should be) contemplating savings and investment decisions relative to their own future retirement. Financial planners, accountants, lawyers, insurance professionals, and actuarial/benefit consulting firms also have a vested interest in research studies focused on the wage replacement issue since these advisors are frequently called upon to provide retirement planning and personal financial planning advice to their respective clientele. With the enactment of the Tax Reform Act (TRA) of 1986, even greater significance is attached to whether derived wage replacement ratios are still appropriate. While the income tax provisions of TRA '86 will not be fully pased-in until 1990, the majority of the key changes as they relate to reductions in both number of marginal tax brackets and permissible itemized deductions were implemented for the 1988 tax year. Since TRA '86 involves such a radical departure from the old income tax laws, e.g., a reduction in both (1) individual tax rates and (2) the number of tax brackets from 15 (ranging from 11 percent to 50 percent) to three (15 percent, 28 percent, and 33 percent), it is imperative that there be a new examination of the income replacement issue where the new income tax provisions are incorporated into the determination ratios. It is probable that the wage replacement issue will need to be reexamined every time there is a change in the tax law as major as that emobodied in TRA '86. In examining the wage replacement issue, this study defines the wage replacement level as the amount of retirement income that will maintain the individual's preretirement standard of This definition of wage replacement has received considerable support in recent years as the most appropriate measure for use in pension and retirement planning. The President's Commission (1981, p. 41) stated . . . that individuals should be able to maintain their preretirement standard of living during retirement years. Retirees should not have to experience a sudden drop in their standard of living. This study makes no attempt to analyze the relative merits of alternative income replacement definitions, in contrast to the standard-of-living maintenance approach selected for use here. In other words, no effort is made here to ascertain whether retirees could live comfortably on a level of income that is below the amount necessary to maintain preretirement standard of living (i.e., a needs approach). Absolute income adequacy standards in the form of needs-based wage replacement objectives are usually established at levels meeting minimum (basic) standards of income adequacy. Two such approaches are the Bureau of Labor Statistics retired couples' budgets and the federal government's official poverty level. n1 Finally, this study examines wage replacement rates through the analysis of savings data and consumer expenditure patterns which are factored into the replacement ratio calculations along with the new tax provisions. Prior Research Pension and employee benefit planning texts routinely discuss the concept of wage replacement ratios and retirement income objectives that employers should consider in their retirement plan decision-making processes. …