October 4, 2013
By Nevin Adams, EBRI
“Replacement rates”—roughly defined as the percentage of one’s pre-retirement income available in retirement—arguably constitute a poor proxy for retirement readiness.
Embracing that calculation as a retirement readiness measure requires accepting any number of imbedded assumptions, not infrequently that individuals will spend less in retirement. While there is certainly a likelihood that less may be spent on such things as taxes, housing, and various work-related expenses (including saving for retirement), there are also the often-overlooked costs of post-retirement medical expenses and long-term care that are not part of the pre-retirement balance sheet.
That said, replacement rates are relatively easy to understand and communicate, and, as a result, they are widely used by financial planners to facilitate the retirement planning process. They are also frequently employed by policy makers as a gauge in assessing the efficacy of various components of the retirement system in terms of providing income in retirement that is, at some level, comparable to that available to individuals prior to retirement.
A recent EBRI analysis looked at a different type of measure, one focused on the years prior to the traditional retirement age of 65, specifically a post-65 to pre-65 income ratio. The analysis was intended to provide a perspective on household income five and 10 years prior to age 65 compared with that of household income five and 10 years after age 65, specifically for households that didn’t change marital status during those periods. Note that in some households at least one member continues to work after age 65 (part-time in many cases) and may not fully retire until sometime after the traditional retirement age of 65.
Based on that pre- and post-65 income comparison, the EBRI analysis finds that those in the bottom half of income distribution did not experience any drop in income after they reached 65, although the sources of income shifted, with drops in labor income offset by increases in pension/annuity income and Social Security.
That was not, however, the case for those in the top-income quartile, who experienced a drop in income as they crossed 65, with their post-65 income levels only about 60 percent of that in the pre-65 periods.
This is not to suggest that the lower-income households were “well-off” after age 65. Changes in marital status, not considered in this particular analysis, particularly in the years leading up to (and following) retirement age, can have a dramatic impact on household income.
The current analysis does, however, show that Social Security’s progressivity is serving to maintain a level of parity for lower-income households with household income levels in the decade before reaching age 65, and in some cases to improve upon that result—and it helps underline the significance of the program in providing a secure retirement income foundation.
The EBRI report, published in the September EBRI Notes, “How Does Household Income Change in the Ten Years Around Age 65?” is available online here.