What’s the Correct Measure of Retirement Income Adequacy?

By Ted Godbout • November 17, 2017 • 0 Comments
Current measures of the adequacy of retirement income provide diverse answers about the state of retirement income security in the U.S., but what is the correct level?

Should the retirement replacement measure be based on meeting your basic needs in retirement, or is it maintaining your preretirement standard of living? A new report by the Congressional Budget Office dissects the current methods used for measuring the adequacy of retirement income and provides a framework for further analysis.

Defining Adequacy

There currently are wide-ranging estimates about the state of retirement income security, partially stemming from the different analytical choices that researchers use in developing adequacy measures, such as which definition is used, which age cohorts are analyzed and how income and wealth are counted.

The CBO notes that the adequacy of retirement income generally has been defined in two main ways: whether it satisfies basic needs and whether it allows retirees to maintain their pre-retirement standard of living. If the analysis simply seeks to determine how many retirees would be able to afford essential living expenses, then researchers would apply the first definition, which generally considers retirement income to be adequate if it exceeds a poverty threshold.

Economists and financial advisers generally use the second definition in measuring retirement adequacy because large drops in consumption in retirement are typically considered undesirable, the report notes. Yet, while that threshold is commonly used as the target replacement rate, it is not a clear-cut measure.

Defining adequacy as maintaining a preretirement standard of living equates that standard of living with preretirement consumption, the report notes. But because data on that consumption is not readily available, researchers approximate it by relying on preretirement income. And most researchers agree that people need less than 100% of their preretirement income to maintain 100% of their preretirement consumption.

Moreover, the CBO notes that the vast majority of studies use self-reported data because that information is widely available, but income is known to be underreported, particularly from employer-sponsored pensions and other retirement accounts.

So what’s the correct level? The CBO explains that researchers typically conclude that having at least 70% of preretirement income allows people to maintain their preretirement consumption, but add that that target level has been criticized because target replacement rates can vary greatly depending on individual circumstances.

In general, the CBO notes that researchers conclude that fewer than one-tenth of retirees will have income below the lowest basic needs threshold — the poverty threshold — while a much larger fraction of people are projected to have income that will fall short of maintaining their preretirement standard of living.

As an example of the wide-ranging estimates, the CBO notes that one study projects that only about 6% of workers in their 40s and 50s would have future retirement income below the poverty threshold, but a recent analysis by the Center for Retirement Research at Boston College finds that nearly half of working-age U.S. households were “at risk” of not being able to maintain their living standard in retirement.

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