How Useful Are Replacement Rates in Planning for Retirement?

Without the ability to adjust factors used in replacement rate planning tools, workers may over- or under-estimate how much they need to save for retirement, the Government Accountability Office (GAO) concludes in a new report.   

The GAO noted that researchers and financial industry professionals develop target replacement rates—the percentage of income to aim for in retirement—based on certain key factors, including spending, household characteristics, and pre-retirement earnings. GAO’s analysis of literature about replacement rates found that calculating an appropriate replacement rate can be complex.

For example, there is debate over whether households that have raised children should target a lower replacement rate than households that have not. In addition, a worker’s pre-retirement earnings could be defined as earnings at the end of the worker’s career or as average earnings over the course of the career.

In addition, GAO found that household spending patterns varied by age, with mid-career households (those ages 45 to 49) spending more than older households. For example, according to 2013 survey data from the Bureau of Labor Statistics (BLS), mid-career households spent an estimated average of around $58,500, while young retiree households (those ages 65 to 69) spent about 20% less. GAO also found there was not a significant difference in average spending between mid-career and young retiree households in the lowest income quartile, compared to an approximately $20,000 difference for the highest income quartile. “These variations in spending patterns have implications for the resources households need to maintain their standard of living in retirement,” GAO said.

The GAO said the information and tools on replacement rates that the Department of Labor (DOL) provides may be too limited to help workers understand how to use such rates for retirement planning.  The DOL’s Employee Benefits Security Administration’s (EBSA’s) website provides information and tools to help American workers better plan for retirement, including a tool to help workers calculate their retirement income needs as a percentage of pre-retirement income.

While EBSA’s materials note that a target replacement rate can vary based on individual circumstances, they do not include specific examples of demographic groups that research indicates can result in higher or lower income replacement needs, or how much a replacement rate might need to be adjusted for those groups or for other individual circumstances. Without additional information, workers may not understand how to adjust target replacement rates when planning for retirement. Further, EBSA’s worksheet and online tool for calculating how much to save use a default replacement rate with no opportunity for a user to adjust the rate based on individual circumstances.

The GAO recommended that the DOL provide additional examples and guidance about using a replacement rate for estimating retirement savings needs in its planning tools, and modify the planning tools so the rate can be adjusted. According to the report, the DOL generally agreed with the GAO’s recommendations and plans to add information and provide options for adjusting replacement rates in its planning tools by June 2017.