Financial planners recommend that retirees plan to replace 70 percent of their preretirement income to maintain their preretirement lifestyle. At the same time, they often note that Social Security will only replace about 40 percent of preretirement income. While it is easy to see the income that people gain at retirement, there are a variety of ways to measure preretirement income. In fact, financial planners often look only at income in the year prior to retirement, whereas the Social Security Administration uses average indexed earnings over a worker's whole lifetime. Most retires meet the guidelines set by financial planners.

Resident Scholar Andrew G. Biggs

Discussions of retirement planning and Social Security policy often focus on replacement rates, which represent retirement income or Social Security benefits relative to preretirement earnings. Replacement rates are a rule of thumb designed to simplify the process of smoothing consumption over individuals' lifetimes. Despite their widespread use, however, there is no common means of measuring replacement rates. Various measures of preretirement earnings mean that the denominators used in replacement rate calculations are often inconsistent and can lead to confusion.

Whether a given replacement rate represents an adequate retirement income depends on whether the denominator in the replacement rate calculation is an appropriate measure of preretirement earnings. This article illustrates replacement rates using four measures of preretirement earnings: final earnings; the constant income payable from the present value (PV) of lifetime earnings (PV payment); the wage-indexed average of all earnings prior to claiming Social Security benefits; and the inflation-adjusted average of all earnings prior to claiming Social Security benefits (consumer price index (CPI) average).

The article then measures replacement rates against a sample of the Social Security beneficiary population using the Social Security Administration's Modeling Income in the Near Term (MINT) microsimulation model. Replacement rates are shown based on Social Security benefits alone, to indicate the adequacy of the current benefit structure, as well as on total retirement income including defined benefit pensions and financial assets, to indicate total preparedness for retirement.

The results show that replacement rates can vary considerably based on the definition of preretirement earnings used and whether replacement rates are measured on an individual or a shared basis. For current new retirees, replacement rates based on all sources of retirement income seem strong by most measures and are projected to remain so as these individuals age. For new retirees in 2040, replacement rates are projected to be lower, though still adequate on average based on most common benchmarks. . . .

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Andrew G. Biggs is a resident scholar at AEI. Glenn R. Springstead works at the Office of Retirement and Disability Policy at the Social Security Administration.