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Measuring Retirement Income Adequacy: Calculating Realistic Income Replacement Rates
EBRI Issue Brief #297
Paperback, 36 pp.
PDF, 1,161 kb
Employee Benefit Research Institute, 2006
• The limitations of traditional “replacement rate” calculations: For decades, “replacement rates” have been the primary “rule-of-thumb” measure used in the retirement planning process. However, replacement rate calculations are overly simplistic and potentially inaccurate because they often are based on methodologies limited to replacement of preretirement cash flow after adjustment for taxes, savings, and age and/or work-related expenses.
• Importance of investment, longevity and health risks: One of the biggest weaknesses of replacement rate models is that one or more of the most important retirement risks is ignored: investment risk, longevity risk, and risk of potentially catastrophic health care costs.
• A new “building block” approach: This Issue Brief illustrates the problematic nature of using conventional replacement rates for retirement planning through a “building block” approach: Building Block 1 focuses exclusively on investment risk; Building Block 2 introduces longevity risk into the planning process, in addition to the investment risk from the previous level; Building Block 3 introduces the risk of catastrophic health care costs into the calculations, in addition to investment and longevity risk.
• A more realistic way to calculate replacement rates: Building Block 3 represents the approach that will be used in a new Web-based planning tool to assist preretirees in their attempt to choose a meaningful replacement rate for purposes of retirement planning. This resource will be released in 2007 as a free online tool called the Ballpark E$stimate® Monte Carlo.
• The importance of probabilities: Some retirement planning models that, by default, use average values for longevity, investment, and health costs implicitly are using a 50 percent probability of success. Since most preretirees will want a higher probability of success, the Ballpark E$stimate®
• Individualized results: In reality, there is no “correct” single replacement rate. Even at a specified probability of success, an “adequate” replacement rate depends dramatically on the level of retirement expenditures, retirement age, gender, asset allocation, percentage of annuitization, and other variables detailed in this Issue Brief. Conversion of the savings needed to a multiple of final earnings that is needed in retirement savings can provide a clearer picture for some, so the Issue Brief presents that as well (see pages 11, 16, and 29).
• While replacement rates will be larger than those typically contemplated for some individuals, this Issue Brief explores how the purchase of annuities at the time of retirement may be used as an effective risk management technique in some cases to reduce these targets.
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