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Measuring retirement income adequacy: calculating realistic income replacement rates
Abstract and Figures
A key weakness of many retirement income models is that they use average estimates for life expectancy, and, consequently, provide workers with only a 50 percent chance of having adequate income in retirement. The Employee Benefit Research Institute (EBRI) has developed a new model - the EBRI/ERF Retirement Security Projection Model® (RSPM) - that incorporates a wide range of data in order to produce a far more inclusive and refined projection of likely retirement income. In projecting retirement income needs, the new EBRI model incorporates three of the most critically important, but difficult-to-model, retirement risks: investment risk, or how individuals' assets will perform during retirement; longevity risk, or how long an individual expects to live; and catastrophic health care costs, which have the potential to wipe out retirement savings. The EBRI model finds that the amount of money Americans will need for an adequate retirement varies widely based on individual factors and often is substantially higher than previously estimated. This paper presents the results obtained by utilizing the concepts already adopted by RSPM for the entire population of certain age cohorts and applying them to stylized examples. These results will provide useful information for individuals attempting to include such crucial factors as longevity, investment, and health care risk into their retirement planning process. This paper is the second of a two-part series measuring retirement income adequacy. A "Part 1" paper by EBRI (VanDerhei, EBRI Notes, September 2004) reviewed how replacement rates have traditionally been used to establish minimum targets for future retirees by calculating the amount needed to provide the same amount of after-tax income in retirement as that received prior to retirement after adjusting for differences in savings, age, and work-related expenses.
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... This definition emphasizes the need to grow or accumulate assets for the members to receive meaningful benefits to smooth out the consumption pattern in retirement. This is even though pension fund income need not be the only source of income in retirement (VanDerhei, 2006). Unless the pension fund industry can generate sufficient income replacement wealth for retirement, investment in pension funds by individuals and institutions is a waste of resources. ...
... Since pension funds are intended to provide income in retirement, Mitchell & Turner (2010) argue their performance should be evaluated against the income replacement rate (IRR) generated. This is a ratio of annual retirement benefits to the pre-retirement annual income in the active work life of the pension beneficiary (VanDerhei, 2006;OECD, 2009). ...
... Even though pension fund income is never meant to be the only source of income in retirement (VanDerhei, 2006), Boateng (2015) argues that it is the main source of retirement income for many retirees the world over. VanDerhei (2006) further provides that individuals should target an income replacement rate of not less than 75% in retirement. ...
... As argued above, old age insecurity is a risk that can only be realized in the long-run, so the projected replacement rate might vary significantly from the real replacement rate 30 years from now, and it might still not be enough for maintaining a decent old-age life. Studies have continued to argue over what parameters to use and what would be the optimal target replacement rate (e.g., Vanderhei 2006;Scholz and Seshadri 2009;Macdonald et al. 2016). Second, and more importantly, even if the actual risk environment remains constant across time, individuals may still experience and interpret the investment risks differently. ...
... There is a considerable portion of citizens who think their income replacement rate will be above 75% but still perceive not having enough money during retirement. This contradicting picture echoes some skeptics who argue that 70% is not an adequate replacement rate for retirement (e.g., Vanderhei 2006;Scholz and Seshadri 2009;Macdonald et al. 2016). In sum, even though it is far from perfect to claim rising retirement insecurity with only two waves of data, the trend goes upward from the available evidence. ...
... Hurd and Rohwedder (2008) included consumption patterns for the estimation of expected pension earnings. VanDerhei (2006) and Bajtelsmit et al. (2013), among others, incorporated broader economic assumptions in the estimation of expected pension income. compared pre-and postretirement standard of living with the use of comprehensive replacement rates. ...
... It should be noted that the replacement rate ratio and its variants as measurements of pension adequacy have their limitations and drawbacks. They have been scrutinized for being overly simplistic and arbitrary, not having a universal definition, and not accounting for time horizon (Van Derhei 2006;Borella and Fornero 2009;see Bajtelsmit, Rappaport, and Foster 2013). However, replacement rate ratios are still the most widely used measurements of pension adequacy, especially in the EU context. ...
This paper depicts the relationship between the EU and pensions by demonstrating the EU’s indirect pressure on pensions – spill-over from the Economic and Monetary Union (EMU) – reflected through economic and fiscal policy coordination mechanism. Concretely, the paper examines how compliance with the fiscal and economic policy guidelines deriving from the European Semester shape prospects for pension adequacy in the euro area countries. Pension adequacy is understood as the ratio of available income in retirement relative to available income during employment. The results point to three empirically relevant economic-fiscal policy models/configurations under which adequate pensions are observed. The models are not universally based on compliance with the policy guidelines under the Semester and they differ in terms of the type of policy which is potentially conducive for adequate pensions. Diversity of the models thus implies that compliance with the guidelines works for some euro area countries whilst for others it does not. Consequently, the shaping prospects or the safeguarding capacity of the Semester’s policy guidelines in terms of adequate pensions are modest. The main method used in the paper is fuzzy-set qualitative comparative analysis (fsQCA).
... También hay investigadores que afirman que los cálculos de la Tasa de Reemplazo son excesivamente simplistas y potencialmente inexactos, porque a menudo se basan en metodologías limitadas a la sustitución del flujo de efectivo previo a la jubilación después del ajuste por impuestos, ahorros y gastos relacionados con la edad y/o el trabajo (Van Derhie, 2006). ...
Informe del Instituto de Actuarios, que ha sido elaborado, discutido y validado por una comisión generada por dicho Instituto, en la que también han participado profesionales ajenos a la profesión actuarial.
... Hurd and Rohwedder (2008) included consumption patterns for the estimation of expected pension earnings. VanDerhei (2006) and Bajtelsmit et al. (2013), among others, incorporated broader economic assumptions in the estimation of expected pension income. compared pre-and postretirement standard of living with the use of comprehensive replacement rates. ...
This document is the basic textbook for the course of Social Security in the Master Programme of Economics at the University of Malaya
... Por otra parte, algunos investigadores consideran la tasa de reemplazo una medida imperfecta (Chybalski & Marcinkiewicz, 2016) porque su enfoque se realiza desde una perspectiva unidimensional, ya que tiene en cuenta un único indicador, y al tiempo estática, porque relaciona dos variables originadas en un mismo momento temporal, la fecha de jubilación. Además, hay investigadores que afirman que los cálculos de la tasa de reemplazo son excesivamente simplistas y potencialmente inexactos, porque a menudo se basan en metodologías limitadas a la sustitución del flujo de efectivo previo a la jubilación después del ajuste por impuestos, ahorros y gastos relacionados con la edad y/o el trabajo (Van Derhie, 2006). ...
... Hurd and Rohweder (2008) included consumption patterns for the estimation of expected pension earnings. VanDerhei (2006) and Bajtelsmit et al. (2013), among others, incorporated broader economic assumptions in the estimation of expected pension income. Borella and Fornero (2009) compared pre-and postretirement standard of living with the use of comprehensive replacement rates. ...
This study introduces a comprehensive evaluation tool to study the performance of pension schemes. The Pension Scheme Performance Index (PSP-Index) suggests the following factors: education infrastructure growth rate (∆V1), training program growth rate (∆V2), diet improvement growth rate (∆V3), health coverage growth rate (∆V4), life expectancy growth rate (∆V5), pension coverage growth rate (∆V6), labor market demand growth rate (∆V7), total tax collection growth rate (∆V8), and capital expansion growth rate (V9). PSP-index attempts at the standardization of performance measures that have typically applied in pension schemes irrespective of their type and level of development. The model investigates pension scheme performance of five ASEAN-member countries—Singapore, Malaysia, Indonesia, Thailand, and Philippines.
... Hurd and Rohwedder (2008) included consumption patterns for the estimation of expected pension earnings. VanDerhei (2006) and Bajtelsmit et al. (2013), among others, incorporated broader economic assumptions in the estimation of expected pension income. compared pre-and postretirement standard of living with the use of comprehensive replacement rates. ...
This monograph is divided into ten chapters. The first chapter presents a general description of each chapter respectively. The second chapter introduces the basic principles of social security. Its objective is rather to provide a brief outline of the concepts and the principles as well as the description of the established institutional framework. In particular, it presents the institutional structure of social security as well as its basic blueprint along with its recent developments. The taxonomy of pension arrangements is presented by giving emphasis on its legal status, format, type of arrangement, and type of coverage. The third chapter places the development of social security in a historical context. A particular emphasis is given to the history of European social security systems, which shaped social security systems worldwide. To complement the historical analysis, this chapter introduces the theoretical approaches and concepts have emerged in the social security field. The traditional classification of welfare states is being addressed through a path-dependency perspective. Finally, the welfare states are described briefly under cultural, social, economic, and political prism, pinpointing their deficiencies and mapping their patterns.
The fourth chapter examines the evolution of social security research from a theoretical and empirical perspective. This is done through an extensive review and analysis of publications from the Journal of International Social Security Review published by Wiley within a 50-year period (1967-2017). It was observed that at a different period in time, the social security research focused on different national and international issues that invoked different social welfare programs and pension systems approach (public or private) to facilitate the explanation of its final socio-economic impact into different social groups in the same country or region respectively. The fifth chapter explores the concept of pensionomics as a prospective tool for pension evaluation. This chapter suggests a paradigm shift: a multidisciplinary synthesis of differing perspectives in evaluating pension overall performance based on past work on pension evaluation, incorporating non-economic variables with significant impact on economic growth and social development. This chapter suggests a new analytical tool called “Pensions Consistency (PC) Index” that identifies the level of consistency as well as the strengths and weaknesses within any pension system. The new conceptual framework focuses on building inter-sectoral and holistic policies able to respond to the new multidimensional dynamic environment.
The sixth chapter examines the impact of welfare reforms on the sustainability of public pension schemes. This chapter reviewed past and current literature and practices of various countries to evaluate the effectiveness of reforms used from the aspect of structural and systemic parameters focusing on sustainability and distributive impartiality. This theoretical review concludes that there is no ideal pension scheme but there are reforms that have shown to be beneficial to the sustainability and distributive impartiality of pension systems and such reforms should be applied in combination to suit the economic dynamism of each individual country. The seventh chapter formulates an analytical framework to analyze whether pension growth can be a determinant of economic growth. The Pension Scheme Performance Evaluation Model (PSPE-Model) intends to study the performance of pension schemes from a macroeconomic perspective. The PSPE-Model tests whether the marginal optimum national pension system coverage critical point based on the national productivity growth performance is simultaneously determined by the efficient coordination of private and public pension system programs coverage and the national productivity level. The model investigates the marginal optimum national pension system coverage critical point of two Asian countries, Japan and Malaysia.
The eighth chapter explores how inflation and the exchange rate can affect the real value of any pension plan system in the long run. In our case, we focus on the specific pension plan system of the Employees Provident Fund (EPF). Nonetheless, we use a new model that is entitled “The EPF Real Value Box –EPFRV Box”. The EPFRV Box facilitates the graphical visualization of the inflation/exchange rate impact on the Employees Provident Fund (EPF). In essence, the EPFRV Box is applied to the Employees Provident Fund (EPF) of Malaysia to evaluate the impact of inflation and exchange rates on the Malaysian EPF real value from 1980 to 2030. Finally, the main objective is to apply the EPFRV Box to extend the significance of the impact of inflation and the exchange rate on any pension plan system (in this case EPF) beyond mere theory, using them as practical instruments to solve retirement and pensioner’s problems. The ninth chapter formulates a comprehensive pension fund framework for enhancing system capacity to manage economic and social risks. The National Social Protection Fund (NSPF) attempts to quantify the informal sector, incorporated under a unified national protection scheme. The new protection mechanism consists of two sub-funds: The National Integral Social Security Fund (NISSF) and the National Education Fund (NEF). NISSF encompasses all economically active Malaysian population, including the informal workforce, whereas the NSPF captures the economically inactive young population. Simulation findings indicate that education, health, and income redistribution can improve the livelihood of the vulnerable population groups in Malaysia.
Finally, the tenth chapter proposes a new model based on a group of indicators to evaluate the social security plans performance of ASEAN-members (Singapore, Malaysia, Indonesia, Thailand, and the Philippines). The first section presents a general review of all possible indicators applies in the evaluation of social security plans performance. Secondly, we present a new indicator, “The Social Security Plans Performance Index (SSPP-Index)” is intended to offer policymakers and researchers an additional analytical tool to study the coverage, efficiency, effectiveness, trend, and future of any social security plan as a whole. The SSPP-Index can be applied to the study of any social security plan and not constrained by geographical area or development stage of the social security plan on the study. The SSPP-Index is a simple and flexible indicator. The third section summarizes the results on the ASEAN-Members social security plans performance under the application of the SSPP-Index.
Pensions are the main source of income in old age. Their main value is provided, in most countries, by public pension systems. Therefore, one of the main challenges for governments and policymakers is to enable people to smooth consumption over the life cycle in an appropriate scale. This implies that pensions must be sufficient to prevent poverty and social exclusion, or even to provide enough income allowing to maintain the previous standard of living, and also to limit the gender gap between men and women. In recent years there has been a wave of reforms of public pension systems with the main objective to improve their financial sustainability both in the medium and long term. Many of the measures carried out within these reforms have negative effects on the adequacy of pension systems because they involve, in one way or another, e.g. a decrease in the replacement rate, a lower indexation. Therefore, reconciling the objectives of sustainability and adequacy is a priority challenge for pension policymakers in the coming years. Because of that, the aim of this chapter is to explore the concept of adequacy, different means of its measurement, the indicators used in cross-country studies on adequacy and how that measurement at different moments of time can help to take action in one way or another.
This paper is the first of a two-part series intended to sort through some of the issues and variations in determining whether the post-World War II baby boom generation is likely to achieve an "acceptable" standard of living in retirement. A recent study by Hewitt Associates shows that the typical 401(k) participant is well-positioned to replace 85-95 percent of preretirement income when current Social Security, existing profit-sharing, and defined benefit plans are taken into account. The study examined the projected preretirement income replacement levels across 62 large companies of the 960,000 employees who were actively participating in their 401(k) plans as of January 1, 2003. The overall average replacement ratio for the Hewitt analysis drops from 95 percent under the high medical coverage assumption to 83 percent under the medium assumption and 80 percent under the low medical coverage assumption. This is true for employees retiring at a "normal" retirement age of 65, and who are relying primarily on Medicare for their health care benefits. Employees retiring at an earlier age will experience an even larger financial setback.
American retirees will have at least $45 billion less in retirement income in 2030 than what they will need to cover basic expenditures and any expense associated with an episode of care in a nursing home or from a home health care provider. The aggregate deficit in retiree income during the decade ending 2030 will be at least $400 billion. These findings are from an analysis by the Employee Benefit Research Institute (EBRI) in collaboration with the Milbank Memorial Fund, known as the EBRI-ERF Retirement Security Projection Model.
This paper builds on the model scenarios presented in Holden and VanDerhei ("Can 401(k) Accumulations Generate Significant Income for Future Retirees?" ICI Perspective, Vol. 8, no. 3, and EBRI Issue Brief 251, November 2002; and Appendix: EBRI/ICI Accumulation Projection Model, ICI Perspective, Vol. 8, no. 3A, November 2002 - Appendix). It presents new scenarios that examine the role that 401(k) accumulations might play in retirement by analyzing certain factors that influence outcomes for 401(k) participants, including: plan design, through automatic enrollment; tax policy, through catch-up contributions; and individuals themselves, through saving in IRAs when not offered 401(k) plans.
Professional retirement planning advice relies to a great extent on the determination of how much retirement income can be provided by systematic withdrawals from an investment portfolio. Because future investment returns, inflation rates, and how long a retiree will live are unknown, one cannot know, with certainty, how much income a retirement portfolio can ultimately provide. Recent research has incorporated uncertainty regarding investment returns and inflation in estimating maximum safe portfolio withdrawal rates. However, uncertainty regarding length of life has not been fully considered. The goal of this article is to explore the sustainability of investment portfolio withdrawals using two distinct methodologies - historical analysis and Monte Carlo simulations - to address the risk of extreme longevity. The article also examines whether annuitizing a portion of client assets makes it more likely that retirees can enjoy higher incomes over longer retirements. The results of the analysis may lead financial advisors to reconsider recommendations regarding the structure of their clients' investment portfolios in retirement.
To enable investors to spend down the assets in their defined contribution accounts more easily, the authors propose a decumulation benchmark comprising a laddered portfolio of TIPS for the first 20 years (consuming 88 percent of available capital) and a deferred life annuity purchased with the remaining 12 percent. This portfolio can be used directly by the investor (akin to indexing) or as a benchmark for evaluating the performance of a more aggressive strategy.
While many 401(k) participants at large companies can expect replacement of nearly 100% of preretirement income, not all workers participate in their 401(k) plan. Moreover, the authors show that even among participants, the extent of retirement preparedness depends on defined benefit (DB) plan coverage and retiree medical benefit generosity. Given recent trends in the elimination of DB plans and retiree medical subsidies and the voluntary nature of 401(k) participation, retirement income responsibility is increasingly shifting to workers. The authors discuss how employers might help workers meet their retirement income needs in this changing environment.
Compared to previous studies, the 2004 Replacement Ratio Study from Aon Consulting/Georgia State University shows an increase in the amount of income today's workers need at retirement to maintain their preretirement standard of living. After describing the study's replacement ratio findings, the authors estimate lump sums needed at retirement and required adjustments for both nonincreasing annuities and retiree medical expenses. They then describe steps innovative plan sponsors can take to encourage participants to understand and undertake their responsibility to acquire the substantial personal savings needed for a comfortable retirement.
This paper examines the cost of health insurance and health care expenses in retirement. It examines recent trends in private- and public-sector retiree health benefits and the impact of these trends on current and future retirees. It also presents options that retirees currently have to supplement the Medicare program, and provides estimates of how much those options will cost current and future retirees.
This study finds that on average those just past the usual retirement age are adequately prepared for retirement in that they will be able to follow a path of consumption that begins at their current level of consumption and then follows an age-pattern similar to that of current retirees. That pattern is similar to what would be found from a theoretically derived and estimated life-cycle model. Thus we do not find inadequate preparation for retirement on average or even at the median. This is not true, however, for all groups in the population. In particular, singles lacking a high school education are likely to be forced to reduce consumption: some 62% would have died with negative wealth had they followed the consumption path given by our data. Future research will show the extent to which this percentage is over-estimated because we did not account for differential mortality.
Conceptual and Measurement Problems in Contemporary Measures of Income Needs in Retirement
- Schieber
- J Sylvester
Schieber, Sylvester J. “Conceptual and Measurement Problems in Contemporary Measures of Income Needs in Retirement.” Benefits Quarterly. Vol. 12, no. 2 (Second Quarter 1996): 56–68