Measuring and Communicating Social Security Earnings Replacement Rates

Abstract

Financial advisors commonly use earnings replacement rates to assist workers in their retirement planning. Policymakers and analysts use them to gauge the adequacy of Social Security benefits and other retirement income in allowing retirees to maintain preretirement living standards. In recent years, the Social Security trustees have regularly published replacement rates that have been widely interpreted as the extent to which Social Security benefits replace earnings of workers at various points in the lifetime earnings distribution. However, the trustees’ replacement rates are calculated differently than those generally used for retirement planning purposes, possibly leading to confusion among policymakers and others regarding how much of workers’ earnings are replaced by Social Security and how much those workers need to save on their own for retirement. Financial planners calculate replacement rates by comparing an individual’s retirement income to that same individual’s preretirement earnings, generally earnings in the years immediately preceding retirement. The Social Security Administration, by contrast, effectively calculates replacement rates by comparing retiree incomes to the incomes of contemporaneous workers. This latter measure is often used in other countries but differs both qualitatively and quantitatively from the more common replacement-rate calculations used for financial planning purposes. We find that replacement rates calculated on a financial planning basis are generally higher than those published by the Social Security trustees and that Social Security benefits generally replace somewhat more of individual workers’ earnings than the trustees’ rates suggest.