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The Journal of Retirement

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The Life Cycle Model, Replacement Rates, and Retirement Income Adequacy

Andrew George Biggs
The Journal of Retirement Winter 2017, 4 (3) 96-110; DOI: https://doi.org/10.3905/jor.2017.4.3.096
Andrew George Biggs
is a resident scholar at The American Enterprise Institute for Public Policy in Washington, D.C.
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Abstract

The key insight of the life cycle model in economics is that a household’s consumption at any given time is determined not so much by its current income as by the total income available to the household over its lifetime. A replacement rate can be a useful tool in approximating the life cycle model’s predictions for how households prepare for retirement. The Social Security Administration’s Office of the Chief Actuary (SSA OACT) publishes two different calculations of retirement income replacement rates, each of which finds that Social Security benefits replace about 40% of a typical retiree’s pre-retirement earnings. Some interpret these figures as indicating that Social Security benefits are insufficiently generous and that U.S. households’ total retirement saving is inadequate. But SSA OACT’s two methods for calculating replacement rates both violate the life cycle model in a meaningful way. SSA OACT’s career-average earnings replacement rates, in which lifetime earnings are first indexed upward by the rate of economywide wage growth, exaggerates by roughly one-fifth the real value of earnings available to a household for consumption over its lifetime. This overstatement lowers a household’s measured ability to replace their pre-retirement earnings. SSA OACT’s final-earnings replacement rates effectively compare Social Security retirement benefits to pre-retirement earnings only in the years in which the individual worked, ignoring the life cycle model’s prediction that household consumption is a function of long-term average earnings, including years in which a household member was not employed. A replacement-rate calculation more consistent with the life cycle model would compare retirement income to an average of real earnings calculated over a significant number of years. Such an approach would find substantially higher replacement rates for the typical retiree. It is important both for Social Security policy and the analysis of overall retirement savings adequacy that replacement-rate calculations build on the insights of the life cycle model that guides most economic analysis of retirement saving.

TOPICS: Social security, legal/regulatory/public policy, retirement

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The Journal of Retirement: 4 (3)
The Journal of Retirement
Vol. 4, Issue 3
Winter 2017
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The Life Cycle Model, Replacement Rates, and Retirement Income Adequacy
Andrew George Biggs
The Journal of Retirement Jan 2017, 4 (3) 96-110; DOI: 10.3905/jor.2017.4.3.096

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The Life Cycle Model, Replacement Rates, and Retirement Income Adequacy
Andrew George Biggs
The Journal of Retirement Jan 2017, 4 (3) 96-110; DOI: 10.3905/jor.2017.4.3.096
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  • Article
    • Abstract
    • REPLACEMENT RATES BASED ON CAREER-AVERAGE EARNINGS
    • REPLACEMENT RATES BASED UPON FINAL EARNINGS
    • THE TECHNICAL PANEL/CBO APPROACH TO CALCULATING REPLACEMENT RATES
    • APPROXIMATING REPLACEMENT RATES CALCULATED AT THE HOUSEHOLD LEVEL
    • CONCLUSIONS
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