70–80% is a rule of thumb used by financial planners to set an income replacement rate for individuals to maintain the same standard of living in retirement as they had while working – but has it met its use-by date?
Michela Coppola: Welcome to you both. Marike, ladies first, the 70% to 80% rule – is it still valid?
Marike Knoef: On average it is a good approximation. However, there is a lot of heterogeneity. Some people have paid off their mortgage, others have not. Some people have children and spend relatively more money during their working life, others don’t. Some people have a low income and will need a 100% replacement rate to be able to fulfill their basic needs, while others have a high income and can do with less than 70%.
James Moore: It’s a heuristic and if you are a retirement planner dealing with laypeople without knowledge of the life-cycle model, you want something they can anchor on. The 80% rule allows you to make certain behavioral assumptions. First, when you go from pre- to post-retirement, you no longer save for retirement, so the replacement ratio can be reduced by that amount. So, if people were saving 10% pre-retirement, that brings you down to 90%. Second, if you pay down a home mortgage during your working years, you prefund a portion of your shelter consumption. That is 20%–25% of expenditure you can reduce. Third, differential tax treatment of retirement earnings as opposed to pre-retirement earnings plays a particular role in the U.S.. So it is pretty straightforward to understand the rationale why 70% to 80% is a good indicator.
Coppola: Recently some economists have concluded the income replacement rate is of little use in the modern world. While it may have been suitable when retirement income came largely from social security and DB schemes, it is ill suited for a time of DC and where people use other assets, such as savings or housing, to finance retirement. Is this too harsh?
Moore: Its weakness concerns how consumption bundles change during the life cycle. Consumption needs change towards and into retirement. Early in retirement, retirees no longer have work-related expenses; time is substituted for expenditure, so needs are fewer. But the further and further into retirement you go, increasing demand for medical care can raise that fraction of the mix substantially. So, the interesting question is whether 80% makes sense. There needs to be more research done on what the consumption bundle looks like 15 to 25 years into retirement.
Knoef: Well, the strength of the rule is its simplicity, but it is also a weakness. The world is full of very different people and households, so no one rule covers them all. In this sense, income replacement rate is of little use. In the Netherlands we find that the self-employed have very low income replacement rates, but relatively high savings and housing wealth. It is important to take this into account.
A second point is that while replacement rates show the situation at retirement, the period after is also important, as Jim mentioned. Pensions may decline after retirement because of cuts or because people opt for a high pension at the beginning and a lower pension later in retirement. Expenditures can also change during retirement, for example after one spouse is widowed. Expenditures also increase when health problems emerge or when the house needs maintenance. There is a lot of variation that the rule does not capture.
Coppola: Jim, you mentioned the life cycle. Some economists, such as Scholz and Seshadri, or more recently Hurd and Rohwedder, suggest using a closer approximation of the life-cycle consumption model to judge retirement preparedness of households, which might imply lower optimal replacement rates for many groups. What do you think of the merits of this?
Moore: It depends on the audience. Eighteen years ago, when I was doing research I found that roughly a third of the population was on track for retirement, a third was drastically undersaving and a third oversaving. As Marike noted, there is heterogeneity and any heuristic is not going to be appropriate for everybody, but it should be a first-order approximation. The work of a good financial planner is to think about the individual household and why you want to deviate from the rule.