Replacement rate models of retirement spending

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Replacement rates are a simple way to estimate your spending needs in retirement. The gross (pre-tax) income you will need in retirement is calculated as:


 * Gross Income (retired) = Gross Income (pre-retirement) &times; Replacement Rate

As with any simplified method, its predicted retirement income might or might not be correct for you. This depends on how closely your individual situation matches the assumptions in the equation above.

The GSU/Aon RETIRE Project Report is the primary source of replacement rates for U.S. retirees. Aon Consulting publishes a summary and extension of this report in their Replacement Ratio Study&trade;. They calculated these replacement rates assuming that retirees want to maintain their pre-retirement lifestyle in retirement. They make some adjustments for expected spending changes spending (for example, work related expenses will disappear). These replacement rates depend on pre-retirement income and marital status. This article includes the main replacement rate tables from the latest Aon Consulting Replacement Ratio Study&trade;.

Both the RETIRE and the Aon Consulting reports are very explicit in pointing out that their replacement ratios are valid for the "average" retiree. They recommend that you adjust for your own specific circumstances.

You can find many popular articles that recommend replacement rates of 0.75 to 0.85 for retirement planning. Typically the author simply states that these are commonly accepted estimates, but they rarely supply references to show how they got these numbers. The GSU/Aon replacement rates are based on the Bureau of Labor Statistics' Consumer Expenditure Survey database, derived transparently.

The GSU/Aon replacement rates ignore whether there is enough income to maintain that level of spending throughout retirement. By contrast, many articles look at what levels of spending retirees can sustain across their retirement lifespan. These also use the term "replacement rate". Except in limited circumstances, these two definitions of replacement rates are not interchangeable. To help avoid confusion, think of them as desired replacement rates (GSU/Aon RETIRE) and achievable replacement rates (other than GSU/Aon RETIRE).

The replacement rate concept
Replacement Rates (also referred to as Wage Replacement Ratios or simply as Replacement Ratios) give you a simplified method to estimate your spending needs in retirement. The gross (pre-tax) income you will need in retirement is calculated as:


 * Gross Income (retired) = Gross Income (pre-retirement) &times; Replacement Rate

By rearranging this equation, the replacement rate is the ratio of (gross income received in retirement) divided by (a pre-retirement gross income):
 * Replacement Rate = Gross Income (retired) / Gross Income (pre-retirement)

Working with a ratio lets you easily see if you will be spending more or less in retirement than when you are working. Spending more in retirement has a ratio greater than one; spending less in retirement has a ratio less than one. It is expressed either as a decimal or as a percentage formats; for example, "0.70" or "70%".

Pre-retirement gross income is often your income just before retirement. This might be for the year immediately before retirement, or for an average of a limited number of years before to retirement. But there is no reason why you could not calculate a replacement rate using a gross income received many years before retirement. For example, the economics-inspired Life Cycle approach often averages pre-retirement income over an entire working lifetime.

Replacement rate definitions
Retirement planning literature uses two definitions of replacement rates: To prevent confusion, this article will use desired replacement rate and achievable replacement rate respectively.
 * 1) Desired retirement income
 * 2) Achievable retirement income

Desired replacement rates
You can use replacement rates based on a desired retirement income to develop retirement plans that target a specified lifestyle. Most often, the specified lifestyle is the one you had just before retirement. In this case, the replacement rate maintains an unchanged standard of living upon retirement. However, a retirement plan (and associated replacement rates) could also target an enhanced or a simplified retirement lifestyle. Replacement rates must account for tax (that is, depend on tax rates), because you fund retirement with after-tax money.

To be clear, there is no upfront consideration to whether or not you can sustain this desired lifestyle (that is, desired retirement income) across your anticipated retirement lifespan. Trying to live at your desired income level could deplete your personal savings prematurely! Regardless, desired replacement rates are used to determine a savings and/or investing approach which eventually reaches your target retirement lifestyle.

Achievable replacement rates
Replacement rates based on an achievable retirement income focus on pre-tax income sources actually available you. You find achievable replacement rates most commonly in studies of Retirement Preparedness, where the goal is to better understand a retiree's ability to generate post-retirement income. Some studies focus on a single source of retirement income, for example, only Social Security, or only pension income. When these studies give replacement rates, they consider only that source of income, relative to pre-retirement gross income. To give a realistic example, one study showed that Social Security benefits started at age 62 (in 2003) would have replaced 0.31 (31%) of the average recipient’s pre-retirement income. You can also add together several (or even all) sources of retirement income before calculating the corresponding achievable replacement rate. For example, you can calculate a total replacement rate from the sum of annuitized personal savings, Social Security benefits and pension benefits. Replacement rates using the same pre-retirement income in the denominator are additive: that is, the total replacement rate is the sum of the replacement rates from individual income streams.

When economists and social scientists study retirement preparedness, they want to estimate the total achievable replacement rate covering all sources of retirement income. Depending on assumptions, these achievable replacement rates can vary greatly. In a white paper, Blanchett reported that assumptions can cause replacement rates to vary widely, between 30% and 148%! An economics-inspired Life Cycle approach derives a special type of achievable replacement rate. The goal of this approach is to smooth consumption both before and after retirement. It must therefore generate a lifetime spending and saving plan. Specialized software usually does the calculations to create this lifetime plan. The ratio of the resulting smoothed spending rate to some measure of pre-retirement income (for example, the average income across the entire working lifetime) gives the Life Cycle replacement rate. A Life Cycle replacement rate example is shown below.

Relationship between desired and achievable replacement rates
Figure 1 shows the relationship between desired and achievable replacement rates. (Note: RR is used as an abbreviation for replacement rate on the vertical axis.)

In an article that deals with achievable replacement rates, Dalirazar and others show in their Table 1 that these rates increase as the percentage of pre-retirement income saved increases. This relationship makes perfect sense: the more you save before retirement, the higher the income you can maintain after retirement. The dashed line in Figure 1 shows this.

But for desired replacement rates, the relationship to savings is just the opposite. In Aon Consulting's Replacement Ratio Study, Appendix I, the equation for replacement rate will force these rates to drop as savings increase. The desired replacement rate calculation starts with the gross income immediately before retirement. Taxes and savings are then subtracted to arrive at the pre-retirement spending. The more that is saved, the less that will be left for spending. Aon then assumes that the same spending will be maintained in retirement (that is, the desired spending in retirement is the same as before retirement). As pre-retirement savings increase, the post-retirement spending is forced to drop. This causes the calculated replacement rate to drop as savings increase. The solid line in Figure 1 shows this relationship.

As the savings percentage just before retirement is increases, the achievable RR curve rises and the desired RR curve drops. Eventually they intersect, as shown in Figure 1. At this savings percentage the retiree will be able to achieve their desired retirement lifestyle most of the time. However, beware of being too confident in these results, because the achievable replacement rate depends on market returns.

Replacement rate properties
Additive. A total replacement rate can be split into its individual components (mathematically, it is "additive"). This is useful. It lets you combine both types of replacement rates in a single retirement plan. For example, suppose that you want a lifestyle corresponding to an 80% replacement rate. Further, suppose that your Social Security will only supply a 40% replacement rate. In this case, your personal savings must be able to safely supply the remaining 40% replacement rate (80% total – 40% Social Security = 40% from savings).

Inflation. You expect retirement spending to increase over time because of inflation. Therefore the "nominal" replacement rate (nominal retirement income divided by pre-retirement income) would also increase over time. But almost all approaches to retirement planning separate out inflation effects, so that the replacement rates being considered reflect only the relationship between real spending amounts. When retirement spending categories have strongly different inflation rates, it may be useful to separate out their real replacement rate components. For example, Steinberg and Lucas propose separating out medical spending from other spending in retirement. This give two replacement rates: a non-medical rate and a medical rate. This would let you apply different inflation rates to each spending component individually.

Taxes. Federal and state income taxes have a major impact on desired replacement rates. Changes in the tax code will lead to changes in the size of replacement rates, as well as how these rates vary as a function of gross income level. When taxes in retirement increase (for example, on Social Security or pension benefits), the gross income needed to meet desired retirement spending also increases. This directly increases the corresponding desired replacement rates. Higher income households tend to be affected more by this, because low income households typically owe little to no income taxes in retirement. Changes in state income taxes on retirement income are also a factor.

Achievable replacement rates are unaffected by future changes in taxes on retirement income. This is because these replacement rates do not depend on an implicit tax calculation. In general, this is the accepted approach. However, according to Scholz and Seshadri, changes in average effective tax rates do affect the Life Cycle replacement rate model.

Income vs. Spending. Replacement rates connect most closely to pre-tax retirement income rather than after-tax retirement spending. But you can derived absolute spending amounts from them. In fact, the more rigorous approaches to calculating replacement rates estimate absolute spending amounts as an intermediate step. Later sections of this article discuss approaches to calculating spending amounts from replacement rates.

Qualitative influences on desired replacement rates
It is quite common to find articles the recommend replacement rates less than 1.0 (100%). Factors making a lower retirement income (replacement ratio less than 100%) feasible include:
 * Reduction in payroll taxes. Without earned income, most retirees will no longer be paying a 6.2% OASDI or a 1.45% Medicare payroll tax on their salary.
 * Similarly to the disability component of OASDI, private disability insurance is no longer needed.
 * Similarly to the Social Security component of OASDI, the retiree is no longer saving for retirement. The part of pre-retirement salary that went into savings is no longer needed.
 * Increased federal Standard Deduction.
 * Partial taxation of Social Security benefits. Depending on their modified adjusted gross income, Social Security recipients might not owe any taxes on these benefits. At most, they will be taxed on 85% of these benefits.
 * State income taxes may be lower, because many retirees move after retirement, and many states fully exclude Social Security income from taxes. Other states have partial tax exemptions for pension and IRA income.
 * The retiree may move, probably to a lower cost-of-living state, and this would decrease their expenses.
 * Potential for higher medical deductibles. With lower taxable incomes, more of the medical expenses of older retirees will potentially exceed the 7.5% limit for itemizing.
 * Mortgage payments may stop. Many retirees pay off their mortgage at about the time of retirement, so they need less income.
 * Work-related expenses stop. What had previously been spent on commuting to work, special clothing and meal purchases is no longer required or is needed at a much lower amount.
 * Senior Citizen Discounts. Some purchases may cost 5-15% less due to special discount programs available to older people.
 * No dependent children. Many families are no longer spending for the education or living expenses of their children by the time they retire.

Not all retirement planners agree that a retiree's replacement rate will be less than 1.0 (100%). There are situations in which a rate of more than 100% might be appropriate. Factors making a higher retirement income (replacement rate more than 100%) necessary include:
 * Medical expenses. Medical expenses increase steadily with age for almost all retirees. Those retiring before becoming Medicare eligible may see a substantial increase in medical insurance premiums until age 65.
 * Travel, vacation and lifestyle changes. Soon after retirement many people increase their spending on special travel and extended vacations that were not feasible while they were still working.
 * Dependents. In some cases retirees may support adult children having physical or mental disabilities. In other cases the retiree's elderly parents may require partial or complete support, sometimes for expensive long-term health care.
 * Additional services. As retirees age they may need to hire people to help with chores that they can no longer accomplish independently. Such chores include yard upkeep, snow removal, minor house maintenance, and housekeeping. Sometimes a retiree's physical impairments may prevent them from driving themselves, requiring them to hire others to do so.

Thinking over the reasons cited for replacement rate reductions as well as increases, it is clear that the range of different retiree lifestyle and circumstances can easily lead to wide differences in the appropriate replacement rate. One retirement replacement rate does not fit everybody.

GSU/Aon RETIRE project
Aon Consulting teamed up with the Georgia State University's Center for Risk Management and Insurance Research to support the RETIRE Project. RETIRE is an acronym for Retiree Income Replacement. Georgia State University publishes the results as the GSU/Aon RETIRE Project Report. Aon Consulting publishes its summary and extension of the findings as the Replacement Ratio Study&trade;. The studies released in 2008 are the seventh update in the series. The primary question targeted by this study series is, "How much income will I need at retirement to maintain my standard of living?" The replacement ratios in this study assume no changes in lifestyle upon retirement. They are desired income replacement rates.

Methodology
The 2008 study derived its replacement ratios primarily from the Bureau of Labor Statistics'  Consumer Expenditure Survey for 2003, 2004 and 2005. The replacement rates were calculated based on data for 12,823 "working" households and 6,498 "retired" households.

The baseline calculation is for a married couple with one wage earner who retires at age 65 (that is, when Medicare eligibility begins). Their non-working spouse is age 62. The calculation starts with an average, pre-retirement gross (pre-tax) income. From this income it subtracts average taxes and retirement savings. This gives the average pre-retirement spending. It then converts this into after-retirement spending by either adding or subtracting retirement-related average changes in spending. Finally, it estimates post-retirement taxes and adds them to the average spending to arrive at an average post-retirement income. The final replacement ratio is the post-retirement income divided by the pre-retirement income. Appendix II and III of the study show these calculations in detail.

GSU/Aon replacement ratios
The baseline replacement ratios for pre-retirement incomes ranging from $20,000 to $250,000 are shown in the "Total Ratio" column of the following table. The table also shows the average Social Security benefit for each family, expressed as a percentage of pre-retirement income. The middle column, "From Private and Employer Sources", is the difference between the other two column entries (that is, it is derived, not directly calculated).

Significant points:
 * Total replacement rates are highest for the low income households, drop to a minimum for families with pre-retirement incomes of $70,000 to $80,000, and then rise again for extremely high income households.
 * Social Security benefits supply a much higher portion of the retirement income stream for lower income households than for higher income households.
 * Conversely, higher income families aiming to maintain their pre-retirement lifestyle in retirement will need to supply a correspondingly higher percentage of their income via pensions or private savings withdrawals.
 * In general, high-income individuals can maintain their pre-retirement lifestyle only by having substantial personal savings. Income from Social Security and employer pensions will typically not be nearly enough to maintain their lifestyle.

Besides the baseline scenario, the Aon study also calculates replacement ratios for other household types. The four types of households it considers are:
 * Baseline - a married couple with one wage earner who retires at age 65. Their non-working spouse is age 62.
 * Single person age 65
 * Married couple with one wage earner who retires at age 65. Their non-working spouse is also age 65.
 * Married couple ages 65 and 62. Both earn wages.

The following table shows the replacement ratios for all four scenarios.

Significant points:
 * The replacement rates for singles show less variation across income levels than for any of the married scenarios.
 * The replacement rates show minimal variations between the 3 married scenarios. Below the $60,000 pre-retirement income level there are no differences. This is supposedly because such retirees do not pay significant income taxes.

Adjustments to replacement ratios
The RETIRE and Aon Consulting reports are very careful to point out that their replacement ratios (shown in the tables above) are valid for the "average" retiree. They recommend that you adjustment for your own circumstances. Adjustments include:
 * Individual differences in savings rates. The calculation approach used in the GSU/Aon RETIRE study assumes an "average" savings rate in the years just before retirement. If a you or your family save more than average, you can maintain your preferred lifestyle by spending less than average. The replacement ratio should therefore be lowered to adjust for their higher saving rate. Conversely, if you or your family save less than average, you would need to adjust the replacement rate upward.
 * Differences in types of savings. Withdrawals from tax-deferred retirement savings accounts (for example, traditional IRA or 401(k) accounts) are taxed, leading to a larger desired replacement rate. But withdrawals from Roth IRAs or brokerage (taxable) savings do not increase taxable income and therefore lead to a lower replacement rate.
 * Changes in big-ticket spending items. Effective replacement ratios can be reduced for people who retire immediately after paying off their mortgage or immediately after finishing payments for a child's college expenses. Once again, their pre-retirement spending lifestyle was at a lower than average level.
 * Specifics of retiree medical coverage. The Aon study's baseline calculation assumes that medical expenses increase by somewhere between $1,000 to $1,500 upon retirement. But in some cases medical expenses might increase by a significantly larger amount. For example, retirement before Medicare eligibility will lead to much larger increases in medical insurance premiums. A similar effect can arise when people who had employer-subsidized medical insurance while working lose that support after retirement.

Medical expense changes at retirement can have a particularly strong effect on the replacement ratio. The Aon study illustrates this by recalculating these ratios under three different medical expense scenarios:
 * Best Case: essentially no change in medical expenses upon retirement.
 * Baseline Case: medical expenses are assumed to increase by about $1,000 to $1,500 annually, depending on income.
 * Worst Case: medical expenses are assumed to increase by $400 per month upon retirement. This $400 represents the approximate monthly costs of Medicare part B and D premiums, plus a premium for supplemental ("Medigap") coverage.

As this table shows, the total replacement ratio for lower income level families can be substantially shifted by their actual retirement medical expenses.

If your individual spending situation is different from the averages used in the Aon study, you could calculate personalized (individually adjusted) replacement ratios from scratch. The calculation would follow the procedure explained in the appendices of the Aon Consulting report. This calculation is essentially the same as used in the Current Spending approach to estimating a simple retirement budget; see Budget models of retirement spending.

Replacement rate changes with aging
Although often ignored, there are reasons to expect replacement rates to drop modestly over the course of retirement. Various surveys of retirement spending have shown that real spending in retirement typically drops steadily until at least the late 70's. For example Fisher and others analyzed the BLS Consumer Expenditure data and determined a "real dollar" median spending drop at retirement of 2.5%, followed by about a 1% per year median spending drop over the next 15 years. Such a spending drop would also cause replacement rates to decrease over time. At even older ages spending and associated replacement rates might continue dropping if the retiree has adequate Medigap and long-term care insurance. But without adequate medical insurance, end-of-life medical costs can jump significantly, increasing the corresponding replacement rates.

Tacchino has proposed two methods to factor in spending and replacement rate reductions with aging. If it is necessary to use one replacement rate for the entire retirement time period, a weighted-average of the various replacement rates might suffice. An alternative approach would be to use one replacement rate before age 75 and a second, lower rate afterwards.

Life Cycle replacement rates
The RETIRE and Aon Consulting studies showed how desired replacement rates can change depending on gross income, marital status and medical spending assumptions. This section looks briefly at the dependency on measurement time period.

The GSU/Aon RETIRE study calculated desired replacement rates assuming an equivalent consumption lifestyle immediately before and after retirement. If the time period of equivalent consumption is broadened, the replacement rates should change. This would be especially true if households tended to spend proportionally more on themselves just before retirement when compared to both early in life and after retirement. If this time period of equivalent consumption is expanded to cover the entire working and retirement lifespan, then the calculation should become effectively identical to that used by the Life Cycle approach.

From this perspective, replacement rates calculated using the Life Cycle approach are one extreme in a continuum of possible desired replacement rates. The GSU/Aon replacement rates are the other extreme. It is useful to compare a set of Life Cycle replacement rates to those published by Aon Consulting. The comparison uses Life Cycle replacement rates published by Scholz and Seshadri. These are shown in Table 4 below.

The first column in Table 4 categorizes households into income deciles: higher deciles represent higher gross incomes. Scholz and Seshadri chose to use two different pre-retirement gross incomes for the replacement rate calculations. The "Lifetime Income" column uses the real household income averaged over the entire working lifetime as the measure of pre-retirement gross income. The "Top 5 Earning Years" column uses the real household income averaged over the ninth through the fifth years before retirement (i.e. the years during which household income is usually maximized). Replacement rates calculated using the "Top 5 Earning Years" income are smaller, since for all income deciles except the lowest this is a larger average income.

Scholz and Seshadri did not give dollar amounts for each of their decile ranges in Table 4. But they did supply dollar amounts for the median (50%) incomes: about $35,000 for the Lifetime Income, and about $38,000 for the "Top 5 Years" income, both in 2004 dollars. From Table 1 above, the GSU/Aon median replacement rate for a $40,000 income is 0.85. This is substantially larger than either 50% decile Life Cycle replacement rate estimated from Table 4 (0.63 and 0.55). It is evident that the GSU/Aon replacement rates are systematically higher than the Life Cycle rates. As expected then, replacement rates also change depending on the time period covering the lifestyle equivalency.

On the whole, the GSU/Aon replacement rates are systematically higher than the Life Cycle rates. This suggests that a typical retiree tends to have a higher consumption lifestyle around the time period of retirement compared to earlier or later in life. After all, if they tended towards a steady consumption across their entire life, their replacement rates would be lower and closer to the Life Cycle approach values. This conclusion is consistent with the observation that real spending for the typical retiree drops steadily as they age. Looked at another way, this indicates that, on average, people tend to spend proportionally more on themselves during their maximum earning years just before retirement. For Life Cycle planning, this tendency is less than optimum. People would be happier if they smoothed their consumption over their entire lifespan.

Kotlikoff has pointed out several weaknesses in the GSU/Aon RETIRE study replacement rates when compared to the Life Cycle approach:
 * Replacement rates assume that a household's spending after retirement will remain the same as before retirement. In particular this ignores a number of new spending needs that can arise in retirement.
 * Replacement rates assume that a household's demographic composition will remain constant throughout retirement. This is inconsistent with the reduction in household unit size during aging that is shown in the Consumer Expenditure Survey data.
 * Replacement rates assume that in general a household's retirement saving pattern is consistent with consumption smoothing at the time of retirement. There is no reason to believe that this is true.

Calculating after-tax income from replacement rates
It is important to estimate your after-tax income in retirement, which is the money you have available to spend. This is your gross retirement income after subtracting federal and state taxes. The following two equations, when combined, show the connection between after-tax income and replacement rates.


 * Gross Income (retired) = Gross Income (pre-retirement) &times; Replacement Rate
 * After-tax Income (retired) = Gross Income (retired) &minus; Federal taxes &minus; State taxes

The first equation shows how the gross income in retirement is estimated by means of a replacement rate and a pre-retirement gross income. The second equation shows that the after-tax income, money available to spend in retirement, is related to the gross income in retirement by subtracting taxes. To estimate your federal and state taxes, you will need to identify all your combined sources of income. You need this because different sources of income often are taxed at different rates. Typical sources of retiree income include Social Security,  pensions, interest,  dividends, capital gains, withdrawals from tax-advantaged savings (for example, 401(k),  403(b), and  traditional IRAs), and withdrawals of tax-free savings (Roth IRAs, principal in bank or brokerage accounts, and so on).

The easiest way to calculate your federal and state taxes is using commercial software. The drawback is that this software uses current tax rates. What if you anticipate future tax rate increases and want to include this in your projected retirement spending?

In this case you will need to either use software or a tax spreadsheet that allows you to change the tax rate assumptions, or do the tax calculation by hand.