Income replacement ratios in the Health and Retirement Study.

This article describes the income replacement ratio as a measure of retirement income adequacy and identifies several issues analysts must consider when calculating a replacement ratio. The article presents the income replacement ratios experienced by participants in the original sample cohort of the Health and Retirement Study (HRS), who were born between 1931 and 1941. Replacement ratios are shown by the respondent's birth cohort, age when first classified as retired in the HRS, and preretirement income quartile. Median replacement ratios fall as the retirement period grows longer. Introduction Income typically falls in retirement, and the timing and extent of that decline concerns policymakers. Social Security benefits and the tax preferences granted to pensions and retirement savings plans represent a substantial commitment of the nation's economic resources to assuring that retirees can maintain a satisfactory standard of living. If income from Social Security, pensions, and savings do not allow retirees to maintain their preretirement standard of living (or a slightly more modest one), they will face difficult and perhaps unexpected choices about reducing or eliminating certain kinds of expenditures. Some retirees might become more dependent on their adult children for financial support. Others might apply for means-tested benefits, placing further strains on a federal budget that already runs substantial annual deficits. Assessing the adequacy of retirement income is necessarily a subjective process. The federal poverty threshold provides one measure of income adequacy. However, because its primary purpose is to determine eligibility for means-tested benefit programs, the poverty threshold represents only a minimally adequate income.1 Although the poverty threshold-or a multiple of the threshold-is a useful benchmark for some income analyses, retirement income is more typically viewed in terms of how it compares with income before retirement. Financial advisors often suggest that near-retirees should estimate the fraction of preretirement income they will need to be reasonably comfortable and independent in retirement. The income replacement ratio-retirement income expressed as a percentage of preretirement income-has become a familiar metric among financial planners and economists for assessing the adequacy of retirement income. If the ratio exceeds a given target, an individual or couple is likely to have enough income to maintain the preretirement standard of living. Exactly what this target ratio should be, however, and which measures of income to include in calculating the ratio, continue to be debated. The proportion of preretirement income needed to maintain one's standard of living in retirement varies according to individual circumstances. Lower-income workers typically need a higher replacement ratio than average-income workers because they spend a higher proportion of their income on necessities such as food, clothing, housing, transportation, and medical care. Higher-income workers, too, may need higher replacement ratios to maintain their preretirement standard of living, especially if their retirement plans include substantial spending on recreation and leisure activities. For some households, a replacement ratio of 65 percent may be adequate, while others may require a replacement ratio of 90 percent or more to maintain their desired standard of living. Of course, before one can evaluate the adequacy of any income replacement ratio, it is essential to know which sources of retirement income and preretirement income-the numerator and denominator of the ratio, respectively-will be used to construct the ratio. Although the income replacement ratio is a relatively simple concept, it can be difficult to construct. For example, because hours of work and total annual earnings can change from year to year, the preretirement income component ideally should reflect average annual income over several years. …