Summary
An RSPM® Analysis
The U.S. retirement system includes two main pillars for private-sector workers: the federal old-age and survivors insurance program, Social Security, and the private, employment-based system that is primarily made up of defined contribution (DC) plans. Thus, it is important to understand how these two pillars or components work together to provide retirement income.
In this study, the Employee Benefit Research Institute’s Retirement Security Projection Model® (RSPM) is used to show how these components work together by calculating the expected replacement rate of each source and the resulting combined replacement rate. Examining how much each of these sources replace retirees’ average preretirement earnings shows that Social Security provides a larger share of income in retirement for those who earned less, while those who earned more can expect more from the DC system. However, the expected median replacement rates for both sources combined are similar across incomes.
- The share of replaced income from Social Security is larger for those with lower incomes, while the share from DC/individual retirement account (IRA) assets is larger for those with higher incomes. This is an essential feature of how the U.S. retirement system works, which allows for replacement rates to be similar across incomes but funded in different manners. Furthermore, those in the middle income quartiles can expect 35–45 percent of their average preretirement incomes to be replaced by DC/IRA assets.
- Increasing the age at which individuals retire improves the replacement rates of each income source for individuals across all incomes. At a retirement age of 67, the replacement rates of both DC/IRA assets and Social Security increase by 5–7 percentage points compared with a retirement age of 65.
- A hypothetical example of a 25 percent reduction in Social Security benefits across the board shows a significant decline in replacement rates across all incomes. However, the declines are significantly larger among the lowest earners, as Social Security is a much more important retirement income source for them. Consequently, any changes to the Social Security benefit formula that do not specifically preserve benefits for low lifetime earners would result in these earners having the largest reductions in their total replacement rates.
- The importance of continuously contributing to DC plans is shown by the difference between the expected replacement rates for those who contribute for the maximum number of years compared with those who do the minimum number, as a 40–52 percentage point difference in the replacement rates can result.
Even if Social Security benefits or the annuity value of the DC/IRA assets are changed, the same pattern emerges of the two components combined providing similar replacement rates across all incomes. Therefore, it is important to understand how both parts of this system work together in supplying retirement income, so a change in one part of the system should be considered together with the other as the combination of the benefits is what is ultimately important for retirees. Across-the-board changes to Social Security benefits will have a larger impact on lower-income workers than on the highest earners, while those with incomes in the middle would be most impacted by changes in both programs, as their retirement income is expected to have nearly equal shares from both components.