Tax Reform and Retirement Income Replacement Ratios

Field: Economics, Econometrics and Finance (Social Sciences)

Tax Reform and Retirement Income Replacement Ratios Introduction Wage, or income, replacement ratios are of great importance to employers in the private sector, the Social Security Administrator, other federal and state government agencies, and legislative and regulatory leaders as they formulate plans and policies regarding the implementation or modification of retirement income programs. Employees and other members of the consuming public also have a keen interest in knowing the percentage of preretirement salary that is needed to maintain, or continue, their preretirement standard of living into their retirement years. Updated information on income replacement rates is specially critical to that segment of the population that, because of personal circumstances, currently is (or should be) contemplating savings and investment decisions relative to their own future retirement. Financial planners, accountants, lawyers, insurance professionals, and actuarial/benefit consulting firms also have a vested interest in research studies focused on the wage replacement issue since these advisors are frequently called upon to provide retirement planning and personal financial planning advice to their respective clientele. With the enactment of the Tax Reform Act (TRA) of 1986, even greater significance is attached to whether derived wage replacement ratios are still appropriate. While the income tax provisions of TRA '86 will not be fully pased-in until 1990, the majority of the key changes as they relate to reductions in both number of marginal tax brackets and permissible itemized deductions were implemented for the 1988 tax year. Since TRA '86 involves such a radical departure from the old income tax laws, e.g., a reduction in both (1) individual tax rates and (2) the number of tax brackets from 15 (ranging from 11 percent to 50 percent) to three (15 percent, 28 percent, and 33 percent), it is imperative that there be a new examination of the income replacement issue where the new income tax provisions are incorporated into the determination ratios. It is probable that the wage replacement issue will need to be reexamined every time there is a change in the tax law as major as that emobodied in TRA '86. In examining the wage replacement issue, this study defines the wage replacement level as the amount of retirement income that will maintain the individual's preretirement standard of This definition of wage replacement has received considerable support in recent years as the most appropriate measure for use in pension and retirement planning. The President's Commission (1981, p. 41) stated . . . that individuals should be able to maintain their preretirement standard of living during retirement years. Retirees should not have to experience a sudden drop in their standard of living. This study makes no attempt to analyze the relative merits of alternative income replacement definitions, in contrast to the standard-of-living maintenance approach selected for use here. In other words, no effort is made here to ascertain whether retirees could live comfortably on a level of income that is below the amount necessary to maintain preretirement standard of living (i.e., a needs approach). Absolute income adequacy standards in the form of needs-based wage replacement objectives are usually established at levels meeting minimum (basic) standards of income adequacy. Two such approaches are the Bureau of Labor Statistics retired couples' budgets and the federal government's official poverty level. n1 Finally, this study examines wage replacement rates through the analysis of savings data and consumer expenditure patterns which are factored into the replacement ratio calculations along with the new tax provisions. Prior Research Pension and employee benefit planning texts routinely discuss the concept of wage replacement ratios and retirement income objectives that employers should consider in their retirement plan decision-making processes. …