The Retirement Income Deficit

What is the financial magnitude of the nation’s retirement income crisis?  Retirement USA asked the respected non-partisan Center for Retirement Research at Boston College to calculate the figure that represents our current retirement income deficit – that is, the gap between the pensions and retirement savings that American households have today and what they should have today to maintain their standard of living.   Using the data from the Federal Reserve Board’s Survey of Consumer Finances, the Retirement Research Center has calculated that figure at $6.6 trillion.

The deficit figure covers households in their peak earning and saving years—those in the 32-64 age range—excluding younger workers who are just beginning to save for retirement as well as most retirees.  It takes into account all major sources of retirement income and assets:  Social Security, traditional pension plans, 401(k)-style plans, and other forms of saving, and housing. 

The measure assumes people will continue to work, save, and accumulate additional pension and Social Security benefits until they retire at age 65, later than most people currently retire.  It also assumes that retirees will spend down all their wealth in retirement, including home equity.  The deficit is thus in many respects a conservative number.

The Center calculated the Retirement Income Deficit for Retirement USA in a three-step process.

Step 1: The Center first calculated a replacement rate — projected retirement income as a percent of pre-retirement income — for each household in a representative sample.

Step 2: Next, it compared that projected replacement rate with a target rate that would allow the household to maintain its standard of living in retirement.

Step 3: Finally, if the projected replacement rate was less than the target rate, it estimated how much additional savings each household would need today to close the retirement income gap, and then summed these amounts across households.

Data

The Retirement Income Deficit uses data from the Federal Reserve’s Survey of Consumer Finances, a survey of a representative sample of U.S. households, which collects detailed information on households’ assets, liabilities, and demographic characteristics.  This survey has been conducted every three years since 1983.  It questions households about their income, wealth, retirement plan coverage, and other variables and provides a comprehensive snapshot of American families’ financial position.

The Center for Retirement Research updated 2007 survey data to take into account recent declines in stock and housing values.  Earlier surveys were also used in order to track historical patterns in wealth and pension benefit accumulation.  In addition, the Center used Social Security earnings records from the Health and Retirement Study in order to construct lifetime earnings profiles used to estimate Social Security benefits.  The Study is conducted by the University of Michigan’s Institute for Social Research.

Methodology

The Retirement Income Deficit is based on methodology developed by the Center for Retirement Research for its National Retirement Risk Index (NRRI), which measures the share of households at risk of not being able to maintain their standard of living in retirement.  The initial steps in calculating the Retirement Income Deficit and the NRRI are identical.

The first step is projecting a replacement rate – retirement income as a share of pre-retirement income – for each household in the sample.  These projections assume people will continue to save and accumulate pension and Social Security benefits until they retire at age 65. Individual components of retirement wealth and income are estimated separately, based on historical accumulation patterns from the Survey of Consumer Finances, taking into account differences between birth cohorts and individual households as described in the original NRRI report, Retirements at Risk: a New National Retirement Risk Index (for updated index numbers, see The National Retirement Risk Index: after the Crash).

For financial assets, such as 401(k) balances, projections are based on observed wealth-to-income ratios by age group from earlier surveys. Income from defined benefit pensions and Social Security is estimated directly.  To calculate future defined benefit income requires projecting benefits for those with defined benefit pension coverage and projecting both coverage and benefits for those currently expected to pick up coverage over their work life. These projections take into account the fact that defined benefit pension coverage is declining, but that workers tend to become covered later in their careers.

Social Security benefits are based on estimated lifetime earnings profiles.  For housing, projections take into account the equity households could extract through reverse mortgages as well as the rental value that homeowners receive from living in their homes rent free. Although the take-up of reverse mortgages remains very low, the income from such a mortgage is included to reflect the maximum income available to the household.

The second step is comparing the projected replacement rate for each household to a target replacement rate that would allow the household to maintain its pre-retirement standard of living in retirement.  Target replacement rates are less than 100 percent because retired households typically pay lower taxes, are no longer saving for retirement, and have somewhat lower expenses than younger households.  The targets vary depending on household type (single male, single female, married with two earners, and married with one earner), income group (low, middle, and high), defined benefit pension coverage, and home ownership.

Finally, for each household with a gap between the projected and target replacement rate, the Center for Retirement Research estimated the additional savings or pension benefits each household would need today to close the future income gap, then summed these amounts across households.

The Retirement Income Deficit and the NRRI also differ in certain respects.  Most important, of course, the NRRI is a measure of households at risk, and the Retirement Income Deficit is a measure of the size of the aggregate shortfall.  In addition, the NRRI considers a household “at risk” only if it falls short of its target by more than 10 percent.  The Retirement Income Deficit, in contrast, includes all households with projected shortfalls.

Assumptions

In many ways, the Retirement Income Deficit is a conservative measure of the aggregate shortfall in retirement savings and pension benefits.  It assumes that households retire at 65,[1] tap their housing wealth through a reverse mortgage, and convert financial assets into lifetime steams of income by purchasing inflation-indexed joint-and-survivor annuities.  In other words, it assumes all savings are depleted.

In practice, most households retire before 65, do not access most of their housing wealth, and do not annuitize.  The fact that most people retire before 65 means they receive reduced Social Security benefits, their 401(k) plan and other savings have less time to grow, and they have to support themselves over a greater number of years.  And because few people annuitize their financial wealth, including the proceeds from a reverse mortgage on their home, they need additional savings to insure against longer-than-average life spans.

The measure also assumes no cuts in Social Security beyond the scheduled increase in the Normal Retirement Age and that the recent market downturn will not speed up the decline in defined benefit pension coverage.

The Retirement Income Deficit assumes an inflation-adjusted 3 percent rate of return to calculate the present value of future income gaps.  This is similar to the 2.9 percent real Treasury bond interest rate assumed by the Social Security Trustees, but is lower than the 4.6 percent real rate of return the Center uses to calculate pre-retirement income from assets for both the NRRI and the Retirement Income Deficit.[2]  The rationale is that 4.6 percent is the Center’s “best guess” estimate of the real rate of return on 401(k) savings and other assets, but that households should probably not count on a rate of return higher than 3 percent above inflation, given that the return on Treasury Inflation-Protected Securities (TIPS) is currently 1.87 percent.[3]  If the higher 4.6 percent return is used as a discount rate, the Retirement Income Deficit shrinks somewhat to $5.2 trillion.  If the lower 1.87 percent rate of return is used, the deficit increases to $7.9 trillion.




[1] The assumption is that single individuals and the older member of a couple claim benefits at 65. The younger spouse is assumed to claim at the same time as the older spouse, but no earlier than 62.

[2] Note that the Center does not project forward asset values using an assumed rate of return but rather bases accumulations on historical wealth-to-income growth patterns as households approach retirement.