Retirement Security: Better Information on Income Replacement Rates Needed to Help Workers Plan for Retirement
Released: 2016-03-01T00:00:00

Letter

Background

Some key sources of retirement income are Social Security benefits, defined benefit plans, defined contribution plans, Individual Retirement Accounts (IRAs), as well as personal savings. In recent years, employment-based retirement plan coverage, especially in the private sector, has shifted from defined benefit to defined contribution plans. Under “traditional” defined benefit plans, workers typically receive benefits—based on factors such as salary and years of service—in the form of a lifetime annuity that provides a guaranteed monthly payment. Defined benefit plans are, in most cases, financed by employers, who are responsible for managing plan assets. Defined contribution plans and IRAs are two primary types of retirement savings vehicles in which benefits accrue in the form of account balances, which grow from contributions made by workers (and sometimes by their employers) and investment returns. Workers and employers who contribute to retirement savings accounts generally receive favorable federal tax treatment, such as tax deductions for contributions and tax-deferred or even tax-free returns on investment. In addition to tax advantages, defined contribution plans and IRAs provide portability of savings and transparency of known account balances. However, they also place the primary responsibility on individuals to participate in, contribute to, and manage their accounts throughout their working careers. Moreover, individuals must manage their savings throughout retirement, including deciding whether and how to convert an account balance into an income stream, in order to avoid running out of money.

This shift in responsibility is further compounded by the low levels of financial literacy in the United States. As we have previously reported, numerous studies have found that many Americans lack basic financial literacy, including an understanding of fundamental investment concepts, such as the benefits of compounding interest and risk diversification and the potential impact of inflation. We concluded that such basic financial literacy is necessary for making well-informed decisions and evaluating recommendations. Financial literacy research has also pointed to the need to educate individuals to improve their investment decision-making and savings outcomes. For example, one study found that a large percentage of American workers has not conducted meaningful retirement planning, even when retirement is in the near future. Another study found that most workers acknowledge they do not know as much as they should about retirement planning and that many workers actually guessed at their retirement savings needs. Further, our past work has found that ensuring income in retirement requires workers to make difficult choices and that workers may not have sufficient information to determine which choices are in their best interest.

Many studies have evaluated the retirement readiness of workers and the economic well-being of retirees. These studies have used a variety of benchmarks for assessing retirement readiness or well-being, including assorted measures of retirement saving, income, consumption, wealth, and standard of living. Economists broadly agree that a conceptual benchmark measure for adequate retirement saving is an amount that will, along with other sources of retirement income, allow a household to maintain its pre-retirement standard of living into retirement. A key concept underlying such a measure is the lifecycle model of savings, which suggests that individuals will adjust their saving and spending to ensure a consistent level of consumption over their lifetime.

Income replacement rates, measured as a percentage of pre-retirement income, are one common method for analyzing the retirement readiness of individuals and providing information to help individual workers plan for retirement. Plan sponsors and researchers have long used them to assess the adequacy of pension plan benefit levels. Replacement rates can also show the extent to which individuals are able to replace their pre-retirement earnings with other sources of income in retirement, such as Social Security benefits, pension benefits, or retirement savings. While there is no consensus about how much income is required to ensure a stable standard of living, economists and financial planners generally agree that many retirees do not need to replace 100 percent of their pre- retirement income to maintain their standard of living because most retirees probably have reduced expenses relative to when they were working. For example, spending on transportation may be reduced for those who no longer need to commute to work. As a benchmark of how much income will be needed in retirement, a target replacement rate can help alert workers about how much to save as well as how long to work or how much to spend. However, while a replacement rate provides an individual with important information for developing a long-term savings goal, it does not provide a plan for achieving it. Converting a target replacement rate to a savings plan—such as how much to set aside from each paycheck—over a number of years is a complicated exercise and may prove daunting, especially in light of the limited financial literacy of many Americans.

DOL is responsible for providing guidance on retirement income savings for workers. The Employee Retirement Income Security Act of 1974, as amended (ERISA), directs the Secretary of Labor to “maintain an ongoing program of outreach to the public designed to effectively promote retirement income savings by the public.” With regard to replacement rates specifically, ERISA also directs the Secretary of Labor to establish a website that includes a “means for individuals to calculate their estimated retirement savings needs, based on their retirement income goal as a percentage of their preretirement income.”

Mid-Career Households Spent More than Older Households, and Spending Patterns Varied by Expenditure and Income Level

Older Households Spent about 20 Percent Less than Mid-Career Households in 2013

Based on our analysis of 2013 CE data, mid-career households had one of the highest spending levels, while older households generally spent less. More specifically, in 2013, mid-career households—those aged 45- 49—spent an estimated average of about $58,500, while young retiree households—those aged 65-69— spent about $46,800, or 20 percent less overall (see fig. 1). We also analyzed spending across two broader age groups: pre-retirement households (aged 50-64) and post-retirement households (65-79) (see table 1). We found that the difference in spending between broader age groups was similar to the comparison between mid-career and young retiree households using 5-year age groups. The estimated average total spending for post-retirement households was about 77 percent of the spending levels for pre- retirement households.

Spending was lower among mid-retiree and older retiree households compared to mid-career and young retiree households (see table 2). For example, mid-retiree households (aged 75-79) spent an average of around $34,700, or 26 percent less, than young retiree households. Average spending for older retiree households (aged 80 and older) was slightly less than mid-retiree households at around $31,400, although differences were not statistically significant.

The patterns in total spending may, in part, reflect variations in average household size and priorities. The average household size for mid-career households was about 2.9 people as compared to about 2.1 people for young retiree households. The average household size was approximately 1.7 people for mid-retirees and 1.5 people for older retirees. Patterns in spending may also be affected by the age composition of other members of the household. Lower spending for older households could also be indicative of different priorities. For example, one large relative difference in spending was attributable to the personal insurance and pensions category. Mid-career households may be more concerned with contributions toward retirement resources than older households who could already be retired. Moreover, we found that in 2013, age groups varied in how much they spent, including on basic needs, such as food, and non-essential items, such as entertainment. Such fluctuations in spending have implications for the resources households will need to maintain their standard of living. More specifically, spending levels are indicative of how households allocate resources based in part on different needs and lifestyle preferences, and are an important consideration when planning for retirement.

Housing Was the Top Expense Regardless of Age, and Older Households Spent More Out-of-Pocket on Health Care

While the share of spending was relatively consistent across age groups in some categories, there were larger variations by age for other categories. On average, housing was the largest spending category for all age groups. For example, households aged 45 and older consistently spent about a third of total expenditures on housing. More specifically, young retiree households spent about 83 percent of the amount that mid- career households spent for housing, on average (see fig. 2). However, the composition of homeowners varied widely by age group. For example, the proportion of homeownership without a mortgage for young retiree households was three times higher than for mid-career households. Housing expenditures include expenses such as maintenance, operations, and utility costs that can be incurred regardless of ownership status.

In contrast to other spending categories, health care was a larger expense for older households. For example, young retiree households spent an average of around $4,900 on health care, compared to about $3,500 for mid-career households. Older retiree households spent a large share on health care—15 percent of total spending—which was more than double the share that mid-career households spent on health care.

The age at which expenditures peak also shows how spending patterns varied. For example, the amount a household spends on apparel was estimated to peak at age 42, which was significantly younger than for entertainment, where the amount a household spends was estimated to peak around age 52. Spending on items such as apparel and transportation may be more relevant during a household’s working years. Further, spending in some categories may increase with age as households have more time or resources for certain expenses, such as recreational activities.

Unlike for Other Households, Spending Was Relatively Flat Across Low-Income Households Regardless of Age

Spending levels across age groups were relatively similar for low-income households, while spending levels were more variable for high-income households (see fig. 3). More specifically, the difference in average total spending for low-income households between the mid-career and young retiree age groups was not statistically significant, while the difference across these same age groups was over $20,000 for the highest income quartile.

Though low-income households had much lower overall spending than mid- or high-income levels, they spent a larger share on necessities like housing and food, which could have implications for their respective replacement rates. Low-income young retiree households had an average of around $23,500 in out-of-pocket spending, with 39 percent spent on housing and 19 percent on food. In comparison, high-income households in the same age group spent about $82,200, of which 31 percent was spent on housing and 12 percent on food. While spending levels provide information on consumption, expenditures do not necessarily equate to a household’s level of consumption. For example, a household could consume the same amount of food at different expenditure levels based on the difference in cost between preparing food at home versus eating out. Additionally, households may spend money on goods they are not consuming themselves, such as charitable contributions or gifts. Alternatively, some low-income families may receive benefits from public assistance programs that allow for higher levels of consumption than out-of-pocket spending indicates. For example, households may be eligible for programs that offset some of the costs of certain expenses, such as reduced-price school lunch or subsidized housing. Nevertheless, with a substantial portion of spending going toward basic expenses, households with limited resources may not have much flexibility to adjust spending levels. Consequently, a household’s socioeconomic status could affect the level of resources required to plan for future spending needs.

Spending, Household Characteristics, and Earnings Are Key Factors Used by Researchers and Financial Professionals to Develop Target Replacement Rates

Changes in Spending Are Important to Account for When Deciding How Much Income Should Be Replaced in Retirement

We found that accounting for how a household’s spending may change in retirement is an important step in determining a target replacement rate— that is, a recommendation for how much pre-retirement income an individual or household needs to replace in retirement. According to the articles and reports we reviewed, assumptions need to be made about the direction and size of a number of expenses, including housing, health care, entertainment, and consumer goods. For example, a retired household may spend less on housing if it pays off a mortgage or downsizes at retirement (see table 3). Alternatively, spending on housing may increase if a retiree moves into specialized senior housing. The amount a retired household will spend on health care may fluctuate because health care costs can be variable and premiums and out-of- pocket medical costs may rise. Further, spending on entertainment and consumer goods may also fluctuate, according to the articles and reports we analyzed. Entertainment spending could increase because retirees have more leisure time, or alternatively, it is possible that it decreases due to the prevalence of entertainment-related senior discounts. In addition, spending on consumer goods and services, such as ready-to- eat foods or car repairs, may be less in retirement than before because retired households have more free time to engage in in-home production, which includes activities like cooking and household chores and repairs. Moreover, consumer durables purchased prior to retirement, such as furniture or household appliances, may continue working well into retirement and may not need to be replaced.

Further, researchers make assumptions about why overall spending might change in retirement and the role of socioeconomic status, or income level, before retirement. For example, some researchers have proposed that consumption, for which spending is a proxy, declines in retirement and households are generally content with consuming less as retirement progresses. Alternatively, households may aim to smooth their consumption over their lifetime and, thus, the goal in retirement is to maintain the same level of consumption or spending as prior to retirement. Under this theory, households that spend less in retirement may do so because of income constraints. Some researchers have explored the role that socioeconomic status plays in determining target replacement rates. They have found that targets may vary by income level. Lower-income households may need a higher replacement rate because they spend a relatively high proportion of their income on nondiscretionary items, such as food. Theoretical perspectives about spending could influence the assumptions used to calculate a target replacement rate.

Assumptions about households’ tax liabilities also affect estimates of how much income is needed to cover expenses in retirement, and target replacement rates. Not only do tax liabilities vary across households, they can also vary before and after retirement. For example, retirees may be in a lower tax bracket after retirement. In addition, Social Security benefits are partially or fully tax free, and according to some researchers, there are more income tax deductions for those aged 65 and older.

Household Size Also Affects Income Needs in Retirement

According to the articles and reports we reviewed, household characteristics, particularly household size, play an important role in determining a household’s expenses, its income needs in retirement, and a target replacement rate (see table 4). For example, the presence of children could also affect what a target replacement rate should be. Researchers do not agree on how having had children affects a retired household’s income needs. According to some researchers, retirees will focus on maintaining spending on themselves and will not need to replace income that went toward their children’s consumption. Further, some researchers have hypothesized that after children move out, the household will save more; and because the household saves more, leaving less money to spend during its remaining working years, the percentage of income that needs to be replaced in retirement is reduced. On the other hand, other researchers have theorized that once children move out, households may not actually consume less. Instead, the parents may choose to use the money they had spent on their children on themselves. Thus, the percentage of income needed to be replaced in retirement may not be lower for retirees who had children versus those who did not.

However, household characteristics may not be static, making choosing a target replacement rate even more complex. For example, spouses may not retire at the same time. Further complicating matters is the fact that retirees may marry, divorce, or become widowed, changing the size of their household and the replacement rate needed to cover the household’s income needs.

Target Replacement Rates Can Vary by Pre- Retirement Earnings Level or if Different Definitions of Earnings Are Used

Low earners had the highest target replacement rates and high earners the lowest target rate, according to studies we reviewed. Some of the studies in our review developed different target rates for workers based on earnings level before retirement. While these studies did not use the same earnings-level groups, their conclusions were consistent. Specifically, Aon Hewitt projected that workers earning under $30,000 would need a 98 percent replacement rate and that workers earning $90,000 would need to replace 79 percent of their income. Lower earners may need a higher replacement rate for three reasons. First, as discussed earlier, they may spend a relatively high amount of their income on non-discretionary items. Second, research has shown low- income households save less than higher-income households. Thus, the reduction in saving in retirement will be less substantial for low-income households and they may need a higher replacement rate. Third, because low-income households pay little in taxes, they receive little in the way of tax saving in retirement.

In addition, how pre-retirement earnings are defined and calculated can have important implications for target replacement rates. More specifically, developers of target replacement rates must decide upon a period of earnings to use (see table 5). Two options cited by the articles and reports in our review are final average earnings and average earnings over the course of a career. A final average earnings measure uses the average of annual earnings for a period of time leading up to retirement. Career average earnings measures, on the other hand, use the average of annual earnings over the course of someone’s career, adjusted for inflation or wage growth. Furthermore, because different definitions of earnings can affect the final target replacement rate, it is important to understand how earnings were calculated and indexed. For example, adding up separate replacement rates provided by defined benefit plans and Social Security benefits to come up with a total replacement rate may not be accurate if the two rates did not use the same type of pre-retirement earnings or index these earnings the same way.

Other decisions may need to be made about how to account for work histories or changes in earnings or phased retirement. For example, women often have shorter careers than men. They tend to take a greater number of breaks from the labor force to care for children and elderly relatives. As a result, a replacement rate that uses career average earnings could be distorted by these breaks. In addition, changes to earnings late in a career can have a substantial effect on target replacement rates if final average earnings are used to calculate pre- retirement income. Phased retirement could also change a target replacement rate, depending on how it is incorporated into the calculation. For example, if workers phase into retirement by reducing their hours and earnings over a number of years, then using the average of the final 5 years of earnings could result in a much lower measure of pre-retirement income than using career average earnings. Similarly, how retirement income is defined can have implications for target replacement rate recommendations. For more information on how the definition of retirement income and other factors can affect target replacement rates, see appendix IV.

Some Financial Professionals Recommend Target Replacement Rates While Others Question Their Usefulness

Six of 14 (or 43 percent) of the service providers, consultants, and financial planners who responded to our questionnaire recommend a target replacement rate to plan participants or clients. Four of the six developed customized replacement rate targets for plan participants and used information such as asset levels, expected spending, and household composition to calculate target rates. One service provider told us it uses answers to five multiple-choice questions that ask about lifestyle preferences and spending patterns, along with information about retirement accounts, to calculate customized target replacement rates for most plan participants. Two other respondents reported using simplified “rules of thumb.”

The remaining eight service providers, consultants, and financial planners do not recommend a retirement replacement rate and questioned their usefulness for plan participants or clients. For example, according to one consultant, using a set rate or a rule of thumb is not appropriate for everyone. In addition, two financial planners told us that income needs in retirement are typically expense- or goals-based or income-based. Further, they explained each household’s income needs are unique and may change over time.

Researchers have also cited concerns about the usefulness of replacement rates in their current form. In particular, a 2011 report by MacDonald and Moore found that any one target rate fits relatively very few individuals. Further, the authors explained that there is no consensus on the best approach to estimate replacement rates and that its conceptual grounding in past research has often been weak.

The number of different replacement rates cited in the literature also calls into question the extent to which replacement rates are useful. We identified about 500 references to target replacement rate recommendations in 52 articles and reports (see fig. 4). These recommendations were either cited as rules of thumb or analysis results. The recommendations ranged from 43 to 476 percent of pre-retirement income, with the majority of the references being between 70 and 85 percent of pre-retirement income; the median recommended target replacement rate was 77 percent.

Despite their inherent limitations, particular groups of workers may find replacement rates to be a useful planning tool, making it important that these groups receive clear information on replacement rate recommendations, according to the articles and studies in our review. For example, target replacement rates may be more useful for low- and middle-income households in part because they are more likely to face budget constraints in retirement and will likely need a higher replacement rate compared to high-income households. Also, many individuals lack basic financial knowledge, and lower- and middle-income individuals scored lower on a recent national financial capability assessment. Replacement rates may also be useful for younger individuals because they can use a replacement rate as a metric to estimate if their projected retirement savings are reasonable.

Further, the 2011 MacDonald and Moore report concluded that the replacement rate literature is becoming more sophisticated and capable of providing better guidance. It found that incorporating some individual characteristics—such as income and family size—could improve the usefulness of replacement rate calculations. Customizable replacement rates could be one alternative to universal target replacement rate recommendations. We found that there are numerous calculators and tools available online to help individuals determine how much they need to save, but research has found wide variability in how such programs work and in the outcomes they produce. Given that variability, some researchers have expressed concern that individuals may be unable to identify tools that are relevant for their individual circumstances. With regard to target replacement rates, we found some online tools that used target replacement rates in calculations did not permit users to adjust the value of the rate. Though we also found several that allowed users to adjust the rate used and provided additional—but still concise— information to help users select an appropriate rate. For example, AARP’s retirement saving calculator provides replacement rate defaults corresponding to three different lifestyle options as well as the ability to adjust the replacement rate to any whole number.

Limited Explanation of Replacement Rates in Department of Labor Retirement Planning Materials May Leave Workers Uncertain about How to Use Them

DOL’s Employee Benefits Security Administration (EBSA) provides guidance on retirement income savings for workers via a number of publications available in print and online. For example, EBSA provides a brief and simple explanation of retirement replacement rates in retirement planning materials and guidance for workers. Among EBSA’s retirement planning publications is one that is intended to help younger workers understand how much they need to save for retirement. The publication includes worksheets to help workers calculate their savings needs and it is available in print and as an interactive online tool. This document notes that replacement rates might vary depending on an individual’s circumstances (see fig.5).

The publication notes that no rule of thumb is appropriate for all individuals and also includes information that some expenses may change in retirement and descriptions of some lifestyle choices that may affect how much income workers need to replace (see fig. 5). Despite DOL’s appropriate acknowledgement of such considerations, its worksheet for calculating how much to save each year assumes a fixed replacement rate of 80 percent. The worksheet assumes that Social Security benefits will provide about 40 percent of pre-retirement income and the remaining 40 percent would need to come from savings. While the previous page explains that the replacement rate provided is an estimate and the user may need more or less depending on their circumstances, “x .40” is pre-printed in the worksheet for users to calculate the amount of savings needed when they retire (see fig. 6).

Similarly, in the interactive online version of Savings Fitness, the fixed target replacement rate is coded into the calculation and cannot be changed. DOL officials told us that they worked to balance accuracy with simplicity by presenting information in a concise manner that will not overwhelm users. Specifically, they said that they did not make the rate adjustable in order to limit user flexibility and prevent too wide a range in assumptions. They also indicated that they limited the information on factors that could affect replacement rates to keep the document from being too complex and cluttered. ERISA calls for DOL to provide on its website “a means for individuals to calculate their estimated retirement savings needs based on their retirement income goal as a percentage of their preretirement income”. While the planning tool allows workers to estimate their savings needs based on a percentage of their preretirement income, they are constrained in setting an individual retirement income goal as the replacement rate is preset by DOL. Without the ability to adjust the replacement rate used in the tools, workers may over- or under-estimate how much they need to save for retirement.

In addition, the Savings Fitness explanations provided concerning the replacement rate in the calculation do not include specific information on demographic groups that studies suggest generally need higher or lower replacement rates, such as low-income and single workers. For example, one study found that the median optimal target replacement rate for singles was 55 percent compared to 75 percent for married couples. Also, we found no discussion in the EBSA materials about how much the replacement rate provided might need to be adjusted for the examples of circumstances that might affect an individual’s desired replacement rate. For instance, though it suggests that someone who wants to travel extensively will need more money in retirement, there is no information on how to adjust the replacement rate to account for such a situation. Such information and guidance could help workers assess whether they need to customize the rate used in their own calculations.

Academic and industry-based researchers consistently state that there is no one-size-fits-all target, and some note that averages can be misleading and dangerous for personal planning purposes. They also highlight particular demographic groups that often need higher or lower income replacement (married vs. single; with/without children; by income level). Financial literacy research highlights the necessity of using relatable examples and realistic scenarios, targeting by income, and tailoring communications as effective means of educating and motivating. For instance, one review of retirement planning software suggests that such tools should provide the user assistance in setting a target replacement rate and should recognize the different needs of those with and without children. Similarly, an ERISA Advisory Council report cited research that found that communications specifically targeted to participants based upon their interests, background, and/or economic status were more successful than providing general communications.

Conclusions

Income replacement rates may be a helpful gauge for younger workers who have time to contribute more to retirement plans or adjust their saving. They can also be a useful metric for low- and middle-income households that may find they need to plan for replacing a substantial portion of their pre-retirement income in retirement. These households, in particular, may find they need to spend a sizable portion of their retirement income on basic needs, such as housing and health care. Social Security’s progressive benefit structure will help these households, but they will need other sources of income in retirement through defined contribution plans, pension benefits, or other means to make up the difference. At the same time, however, reports and articles we reviewed demonstrate that developing a customized replacement rate requires careful consideration to appropriately balance all of the underlying assumptions, including those related to determining pre-retirement and retirement income. The wide range of recommended target replacement rates cited in research indicates that there is no rule-of-thumb that will work for everyone.

Given these factors, workers may have difficulty understanding what target replacement rate to use based on their circumstances. Further, workers may have trouble operationalizing this information into a realistic savings strategy. This difficulty could be compounded by challenges in understanding how to convert defined contribution account balances into a potential income stream. If workers are unable to translate retirement account balances into income replacement goals, the benefit of replacement rates as a metric or guide is limited.

Despite their complexity, replacement rates are used in some of the retirement planning tools produced by the financial industry to give workers a general sense of their progress toward achieving a secure retirement. DOL’s tools, however, lack targeted information and guidance that could help different groups of workers make reasonable adjustments to the replacement rates used in estimating their savings needs. This type of clarifying information is particularly important given the challenges workers may face in understanding the multitude of factors that could affect a target replacement rate. Additionally, DOL’s tools do not provide flexibility to allow a user to customize or compare rates. Stating a rule-of- thumb target replacement rate, for example, and then using it in planning tools without an option to adjust it, may inadvertently and implicitly endorse a “right” rate. Without additional information and guidance on how to estimate how much money they will need in retirement and the flexibility to adjust the rate used in the calculations, workers could over- or under-estimate how much they need to save. As a result, they may give up on saving if estimates seem unattainable or they could unknowingly save too little. In both cases, workers could reach retirement without adequate savings.

Recommendations for Executive Action

To help workers make appropriate adjustments to the replacement rates used in calculating their specific retirement income needs, the Secretary of Labor should take the following two actions: Include in its retirement planning tools information about examples of individual circumstances that research has shown to result in higher or lower income replacement needs (e.g., household characteristics and income level) and guidance on the direction and magnitude of the changes attributable to such circumstances as well as those due to particular lifestyle choices.

Modify its retirement planning tools to allow for some user flexibility in adjusting the replacement rate used in calculating retirement income needs.

Agency Comments and Our Evaluation

We provided a draft of this product to the Department of Labor (DOL), Department of the Treasury, Social Security Administration, and Consumer Financial Protection Bureau. DOL provided written comments which are reprinted in appendix VI. DOL also provided technical comments that were incorporated as appropriate. The Social Security Administration (see letter in app. VII), the Department of the Treasury, and the Consumer Financial Protection Bureau did not have any comments on our report.

In its written comments, DOL generally agreed with our findings and recommendations. In its response, DOL cited steps taken by the Employee Benefits Security Administration (EBSA) to ensure that retirement planning materials balance key information with usability of the tools, including working with key stakeholders and experts to develop and test materials. DOL also noted that EBSA has worked to identify the most common circumstances relevant to replacement rates to help make workers aware of the possible impacts, rather than to create an individualized tool. To address our recommendations for providing more information on using replacement rates and modifying tools to allow for more flexibility, EBSA plans to make two changes by June 2017. First, EBSA plans to add an example about replacement rates specifically for married couples. Second, EBSA plans to add options to its online retirement savings rate tool to allow users to adjust their income replacement rate and their Social Security replacement rate within an accepted range. We agree that additional information on using replacement rates and increased user flexibility will further help workers make appropriate adjustments in calculating their specific retirement income needs.

We are sending copies of this report to the appropriate congressional committees, the Secretary of Labor, the Secretary of the Treasury, the Acting Commissioner of the Social Security Administration, and the Director of the Consumer Financial Protection Bureau. In addition, the report is available at no charge on GAO’s website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me at (202)-512-7215 or jeszeckc@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made major contributions to this report are listed in appendix VIII.

Appendix I: Objectives, Scope, and Methodology

To analyze consumption in retirement and how target replacement rates are defined and used to assess retirement readiness, we examined (1) whether and how spending patterns have varied by age; (2) the key factors used to develop target replacement rates for how much income workers need to replace in retirement; and (3) the usefulness of information on replacement rates provided to workers by the Department of Labor. This appendix provides a detailed account of the data sources used to answer these questions and the analyses we conducted. The appendix is organized into three sections. Each section presents the methods we used for the corresponding objective. Specifically, section I describes the information sources and methods we used to analyze whether and how spending patterns have varied by age. Section II describes the information sources and methods we used to identify key factors used to develop target income replacement rates for retirement. Section III describes the information sources and methods we used to examine the information on replacement rates provided by federal agencies.

Section I: Analyzing Spending Patterns Using Consumer Expenditure Survey Data

Consumer Expenditure Survey

To understand how spending patterns varied by age, we analyzed data from the 2013 Consumer Expenditure Survey (CE). This was the most recently available data at the time of our review. CE is a program that consists of two ongoing surveys, the Quarterly Interview Survey and the Diary Survey, that provide information on the buying habits of American consumers, including data on their expenditures, income, and consumer unit characteristics. The survey data are collected for the Bureau of Labor Statistics (BLS) by the U.S. Census Bureau. Based on our interest in conducting a broad analysis of spending patterns, we chose to use the Interview Survey rather than the Diary Survey, since the Diary Survey is designed to capture information on small, frequently purchased items. In contrast, the Interview Survey is designed to collect data on major items of expense, which respondents can be expected to recall for 3 months or longer. In practice, the Interview Survey collects detailed data on an estimated 60 to 70 percent of total household expenditures. In addition, global estimates are obtained for food and other selected items, which account for an additional 20 to 25 percent of total expenditures. The Interview Survey does not collect expenses on housekeeping supplies, personal care products, and nonprescription drugs, which contribute about 5 to 15 percent of total expenditures. Thus, up to 95 percent of total expenditures are covered by the Interview Survey.

CE uses a probability sample of households designed to be representative of the total U.S. non-institutionalized civilian population. Prior to 2015, the sampling frame was generated from the 2000 Census of Population. The Interview Survey is a rotating panel survey. According to a BLS official, consumer units in each panel complete four interviews conducted every 3 months and are then dropped. Each month new consumer units enter the survey as other consumer units complete their participation. The quarterly target sample size for the Interview Survey is 7,060 participating sample units. Data are weighted to adjust sample estimates to national population estimates. The results for our weighted data represent approximately 125.7 million households. We also accounted for the number of months a household is interviewed. Sample surveys are subject to two types of errors, sampling and non-sampling. Sampling errors occur because observations are not taken from the entire population. To estimate sampling error, we calculated 95 percent confidence intervals. Total expenditure data estimates reported have 95 percent confidence intervals that are within +/- 17 percent of the estimate itself, and additional confidence interval information on individual spending categories are provided in appendix III. We followed BLS guidance and estimated standard errors using a replicate weight methodology, which involved taking the variance across 44 separate values of differently weighted estimates. Non-sampling error can be attributable to many sources, such as differences in interpreting questions, inability or unwillingness of the respondent to provide correct information, and mistakes in recording or coding data. These non- sampling errors can influence the accuracy of information presented in the report, although the magnitude of their effect is unknown.

We found the 2013 CE Interview Survey data to be reliable for the purposes of our report. To assess reliability, we reviewed survey documentation, compared results to published tables, and interviewed agency officials to ensure the variables we analyzed were reliable for our purposes. Estimates produced in this report may differ from published BLS tables. For our analysis, we only analyzed Interview Survey data, whereas BLS integrates some Diary Survey data into published tables. For the purposes of our analysis, we used different age groups than those in BLS published tables, which can also account for differences. Additionally, averages for some income and expenditure items in CE publications differ from those derived from Interview Survey public-use microdata because some variables are top coded or suppressed for public-use files.

Cross-Sectional Spending Analysis

We compared estimates for average household spending levels and shares of expenditure categories across 5-year age groups. Expenditure data are tracked for each consumer unit, which can comprise (1) all members of a household related by blood, marriage, or other legal arrangement, (2) a person living alone or sharing a household but who is financially independent, or (3) two or more persons living together who make joint expenditures. For the purposes of this report, we refer to consumer units as households. Households were included in age groups depending on the age of the reference person of the consumer unit. The reference person is the first member mentioned by the respondent when asked to identify the name of the person or one of persons who owns or rents the home.

We defined spending as direct out-of-pocket expenditures. In our analysis, each household had an observation for each expenditure type. Indirect expenditures, which may be significant, may be reflected elsewhere. For example, consumer units with members whose employers pay for all or part of their health or life insurance would have lower direct expenses for these items than those who pay the entire amount themselves. All monthly expenses were summed to obtain quarterly estimates for each household. In cases where no expenditure was reported, the expenditure was coded as a zero. We then multiplied expenditures by four to annualize quarterly expenditure estimates. Households in the four quarters of data were then averaged to obtain annual expenditures. To analyze the shares of different categories of spending, we grouped detailed level expenditures into broader categories, such as health and housing, based on BLS’s aggregation method. One exception was that we combined some broad expenditure categories into an “other” category for reporting purposes.

The personal insurance and pensions category includes private pensions. According to BLS officials, private pensions capture contributions to defined benefit, defined contribution, and individual retirement accounts. CE expenditure variables do not include payments on loans, such as principal payments on home mortgages because BLS considers these data as shifts in assets and liabilities, and would be captured in outlays.

Outlays include out-of-pocket expenditures plus spending that “stays within the consumer unit” such as paying down principal on a loan. The figures in this report that are based on our analysis of the Consumer Expenditure Survey reflect data that are defined as expenditures in BLS documentation. However, since mortgages can play an important role in homeownership, we conducted an additional analysis where we added lump sum and mortgage principal payments to housing expenditures to understand the difference between housing outlays and expenditures. We found that including mortgage outlays does not substantially alter the spending patterns observed. For information on home mortgage outlays, see appendix II. Property taxes are included in housing expenditures. Lastly, income tax estimates are separate from expenditure variables. In 2013, CE started using the National Bureau of Economic Research TAXSIM program to estimate tax liabilities because it can be difficult for respondents to accurately recall and estimate income taxes.

We also analyzed expenditure levels by age-specific income quartiles. The income quartile thresholds for each age group are presented in table 6.

We also analyzed spending patterns by age for expenditures related to long-term care services since long-term care costs may be a particularly salient issue for older households. Specifically, we looked at spending on long-term care insurance; care in convalescent or nursing home; adult day care; and care for elderly, those who are incapacitated, individuals with disabilities, etc. However, there are challenges with measuring household spending for long-term care because there is uncertainty surrounding the extent to which households will need long-term care services and how they will finance these costs. Since many people may not have spending in this area, average spending levels are not necessarily indicative of the potential costs people may face. Thus, to better understand how long-term care costs would factor into retirement considerations, we compared the results of four academic studies that studied the potential effect of these costs on retirement resources. We selected these articles based on our general literature search results and citations in relevant studies. See appendix V for more information on long-term care costs.

Regression Analysis

Using the same CE Interview Survey data, we analyzed whether there were differences in spending patterns by category using a regression analysis. Specifically, we estimated the following aspects of spending patterns: (1) the age at which the expenditure category is at its maximum, and (2) whether there is a significant relationship between age and expenditures. Our regression model tested the effect of age on expenditures while controlling for education, race, and ethnicity. We used the natural log of expenditures as the dependent variable in order to obtain results for the percentage effect of age on expenditures rather than the absolute effect. Based on the results of our cross-sectional analysis, which showed a parabolic pattern in expenditure levels by age, we used a quadratic form of age. We included a limited set of control variables that were not affected by age so as to capture the effect of age as well as other characteristics that may change with age. Because we used cross- sectional data, the results may not accurately describe how an actual cohort might behave over time.

Our regression model is represented by the following equation: Ln(expenditure) = α + β1*age + β2*age + control variables. We then solved for the age at which expenditure is maximized by taking the first derivative with respect to age, and solving for the age at which the first derivative is equal to zero, - β1/(2∗β2).

Section II: Identifying Key Factors Used by Researchers and Financial Professionals to Develop Target Replacement Rates

To identify key factors used to develop target replacement rates, we (1) analyzed articles and reports published in academic journals or by research centers or international organizations and (2) gathered information from financial firms through questionnaires and interviews. To identify the range of target replacement rates recommended to U.S. workers, we catalogued references to such recommendations in the studies we selected for review. Our analysis focused on total replacement rates, that is, the ratio of all income in retirement—including from Social Security, pension benefits, and retirement savings—to pre-retirement earnings. We sought to identify a number of considerations that researchers, policy makers, and financial professionals incorporate into their assumptions when developing, calculating target, or evaluating replacement rates. However, because analyzing the merits and disadvantages of each consideration was outside the scope of our work, GAO is not endorsing any of the considerations presented in this report.

To select articles and reports for our analysis, we used ProQuest, WorldCat, and PolicyFile to search various library databases such as EconLit and ABI/INFORM Global. We also searched the OECD library. We also reviewed websites of research centers and industry organizations that work on retirement security issues, such as the Center for Retirement Research at Boston College, the University of Michigan Retirement Research Center, the Society of Actuaries, the Employee Benefit Research Institute, and the World Bank. We also reviewed written statements of witnesses at congressional hearings held by the House Committee on Ways and Means; House Education and the Workforce Committee; Senate Committee on Finance; Senate Committee on Health, Education, Labor and Pensions; and Senate Special Committee on Aging. Our ProQuest and PolicyFile searches generated 555 results. Our OECD library searches generated 35 results and our web searches generated another 40 results. We reviewed relevant abstracts, when available, to determine which articles (1) contained information on target replacement rates or assumptions needed to calculate a replacement rate and (2) were published in or after 2005, and reviewed those articles. We selected 59 articles and reports for analysis (see bibliography at the end of this report for the list of reports and articles selected). We performed these searches and identified articles from January 2015 through January 2016. We included reports published by international organizations because these reports include detailed information on assumptions and methods used to calculate replacement rates. These reports generally use replacement rates primarily for cross-country comparisons. For example, the OECD’s Pensions Outlook calculates replacement rates for cross-country comparisons. This OECD report considers several definitions of pre-retirement earnings to compute replacement rates and shows the proportion of workers in a given country who may fail to reach the OECD average replacement rate and the country-specific target replacement rate, if any.

To gather information from financial industry firms, we used a combination of questionnaires and interviews. To determine which firms to contact, we relied on suggestions from several researchers and actuaries who have studied replacement rates. We collected information from 14 firms—7 service providers, 3 retirement services consulting firms, and 4 financial planners. While these firms provided valuable insight into target replacement rate recommendations, our findings are nongeneralizable. We asked the firms to respond to a questionnaire we developed, either by completing the questionnaire and sending it back to us or by going through the questionnaire during an interview. The questionnaire asked about how, if at all, the firm uses replacement rates in its work. If the firm uses target replacement rates, we asked a series of questions about the origin of the target rate used by the firm, when and how it was developed, and the various economic and demographic factors considered, if any, when the firm developed the replacement rate. For example, the questionnaire asks about individual or household demographic factors, economic factors specific to an individual or a household, and macroeconomic factors, like inflation and wage growth. If the firm does not use a target replacement rate, we asked about alternative measures it uses in lieu of replacement rates.

To identify target replacement rates recommended to U.S. workers, we reviewed our selected studies for (1) references to rules of thumb for income replacement rates in retirement, (2) references to target rates recommended by other researchers or organizations, and (3) target replacement rates recommended or developed by the report’s authors. For this particular part of analysis, we excluded articles and reports written by international organizations because of our focus on recommendations for U.S. workers.

Section III: Assessing the Usefulness of Information on Replacement Rates Provided by Federal Agencies to Workers

To identify the information on replacement rates provided to workers by federal agencies, we interviewed officials and reviewed relevant retirement planning materials produced by the Department of Labor (DOL), the Social Security Administration (SSA), and the Consumer Financial Protection Bureau (CFPB). We also interviewed officials at all three agencies. In addition to reviewing documents provided to us by agency officials, we conducted web searches to identify any additional relevant materials. We also reviewed the websites of the Pension Benefit Guaranty Corporation, the Securities and Exchange Commission, and the Administration on Aging for retirement planning documents that might contain references to replacement rates. We included these agencies because of references we found in DOL and SSA retirement planning materials. Although we found references to replacement rates in SSA and CFPB documents, we focused our review on DOL materials as DOL is required by law to provide a means of calculating retirement savings needs using a replacement rate. and 2013 Advanced Notice of Proposed Rulemaking on Pension Benefit Statements for remarks specific to the provision of information about replacement rates or pension benefits in individual benefit statements.

See 29 U.S.C. § 1146(d).

Appendix II: Home Mortgage Outlays

Housing is unique from most spending categories in that certain financial aspects of homeownership are considered an asset for households, and financing plays an important role in purchasing a home. For several age groups, we found that a large portion of households owned a home with a mortgage (see fig. 7).

While certain out-of-pocket expenses associated with homeownership, such as mortgage interest payments and property taxes, are captured by the Consumer Expenditure Survey (CE) expenditure variables, mortgage principal payments are not included in expenditures. Rather, payments of mortgage principal are considered a shift in a household’s assets and liabilities. To get a sense of the household’s total outlays for housing, we conducted an additional analysis of 2013 CE data on owned and vacation home mortgage principal and lump sum payments, referred to here as mortgage outlays. When mortgage outlays were added to housing expenditures, the share of spending on housing increased somewhat (see table 7).

Mortgage outlays were larger for some age groups than others. For example, estimated average mortgage outlays were around $3,000 for mid-career households (aged 45-49). However, for some age groups, such as households aged 75 and older, average mortgage outlays were quite small. While mortgage principal payments are an important expense for some households, their inclusion does not substantially alter the spending patterns observed. More specifically, housing was a major household expense across all age groups regardless of whether or not mortgage outlays are included.

Appendix III: Confidence Intervals for Select Spending Estimates

The tables below provide the underlying spending estimates and confidence intervals for table 1, table 2, and figure 2.

Appendix IV: Other Factors That Could Inform Target Replacement Rates

We identified four factors from the articles and reports we reviewed in addition to spending, household characteristics, and pre-retirement earnings that raised important considerations for developing the underlying assumptions behind a target replacement rate. As shown in table 11, these four factors are (1) the income to be replaced, (2) sources of income in retirement, (3) saving patterns, and (4) risks.

Appendix V: Long-term Care Costs and Effect on Retirement Resources

Based on the studies we reviewed in table 12, long-term care (LTC) is an important consideration for retirement, particularly since a majority of users for these services are elderly. About 70 percent of those aged 65 and older are likely to need long-term services and supports at some point in their lives. However, it is difficult to plan for LTC costs as part of income replacement in retirement because of challenges in determining spending needs, high service rates, and limited government coverage for financing costs. Average LTC spending is not necessarily indicative of the potential costs individuals may face because the distribution of costs is skewed. While many may not require LTC services, those who do may have significant spending. For example, in our analysis of 2013 Consumer Expenditure Survey data, we found that only 3 percent of households we analyzed had out-of-pocket spending on LTC-related expenses. Estimated expenditures were sizeable in some age groups for those who had spending on these services. For example, households aged 80 and older that did have long-term care expenses spent an average of about $6,900 in 2013. Further, LTC service rates can be expensive. According to 2015 Genworth Cost of Care Survey data, the national median annual service rate for nursing homes was $80,000 and was $46,000 for full-time home health care. Although government programs can help individuals finance LTC costs, coverage from these programs is limited. For example, Medicaid does provide coverage for some long-term care services, but coverage is limited to individuals who are within certain eligibility categories and meet functional and financial criteria. Individuals who pay for an extended stay in a nursing home can quickly deplete their resources for retirement and subsequently quality for Medicaid.

To understand how the potential for LTC costs affects retirement adequacy, we reviewed four academic studies (see table 12). The results show that incurring long-term care costs can have a negative impact on retirement readiness, particularly for low- and middle-income households.

Appendix VI: Comments from the Department of Labor

Appendix VII: Comments from the Social Security Administration

Appendix VIII: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the contact named above, Kimberley Granger (Assistant Director), Jennifer Gregory (Analyst in Charge), Mindy Bowman, and Amrita Sen made key contributions to this report. Also contributing to this report were Benjamin Bolitzer, David Chrisinger, John Dicken, Gustavo Fernandez, Alexander Galuten, Mark Glickman, Isabella Johnson, Kathy Leslie, Mimi Nguyen, Oliver Richard, Frank Todisco, Walter Vance, and Seyda Wentworth.

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