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What Replacement Rates Should Households Use?

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Abstract

Common financial planning advice calls for households to ensure that retirement income exceeds 70 percent of average pre-retirement income. We use an augmented life-cycle model of household behavior to examine optimal replacement rates for a representative set of retired American households. We relate optimal replacement rates to observable household characteristics and in doing so, make progress in developing a set of theory-based, but readily understandable financial guidelines. Our work should be a useful building block for efforts to assess the adequacy of retirement wealth preparation and efforts to promote financial literacy and well-being.

Key Findings

  • Common financial planning advice calls for households to ensure that retirement income fall between 70 and 85 percent of pre-retirement income in order to maintain pre-retirement living standards.
  • However, the common rules of thumb do not consider important factors that impact lifetime earnings and consumption, such as marital status, level of education, race, and number of children.
  • We find that 48 percent of married couples have an optimal replacement rate of less than 65 percent of pre-retirement income.

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Project

Paper ID

WP 2009-214

Publication Type

Working Paper

Publication Year

2009