I’ve lost count of the surveys telling us that all Americans will suffer deprivation when they retire. I'm sure you have, too. A recent Harris Poll found that 74 percent of Americans worried about retirement. The National Retirement Risk Index now indicates that 53 percent of Americans are “at risk.”
So where are the riots? How did we miss The Million Wal-Mart Greeters March on Washington?
The answer isn’t that the riots will come unless we save more. The answer isn’t an xpansion of Social Security, either. The answer is much nerdier: The retirement income problem is mis-measured.
In a recent article, economists Andrew G. Biggs and Sylvester Schieber show that most of the tools for measuring retirement income have major flaws. We’re not talking about small flaws here. We’re talking about crippling flaws. Flaws so large that millions of people may be over-saving for retirement.
In a recent telephone interview Mr. Biggs focused on two main points. Both suggest that the conventional wisdom on underfunded retirements is wrong.
“The first point is that the Social Security Administration's model says that income replacement rates in the future will be pretty similar to the past,” he said. He was talking about MINT (Modeling Income in the Near Term). MINT is a complex income model developed over the last 20 years by the Social Security Administration.
His second point is that surveys of actual experience show that most retirees are happy. They believe they are OK. Indeed, some surveys have found retirees who were shocked by the amount of income they have to spend.
You can understand how some people may save more than necessary by considering the case of an average worker. The conventional wisdom is that workers need to replace at least 70 percent of their pre-retirement income. Some in the financial services industry suggest more. Social Security benefits replace about 40 percent of the average worker’s earnings. Simple subtraction tells us the worker will need to have save enough to replace the remaining 30 percent.
But Social Security, Mr. Biggs points out, measures replacement income in a different way than financial planners do. Social Security uses a complex formula to create a “wage-index average of lifetime earnings.” This measure suggests a 40 percent replacement rate for the wage-index average workers wages. But if you convert the Social Security measure into the percentage of final income that financial planners use, the average replacement rate is 60 percent. Not 40 percent.
The need to replace 30 percent of income from savings for the average worker drops to only 10 percent. That’s a two-thirds reduction in needed savings. (Don’t expect a memo on this from the financial services industry.)
But wait, the errors or misstatements don’t end there. Social Security also understates the assets that retirees use as sources of income. Biggs and Schieber note that the Social Security Administration uses data from the Current Population Survey. This survey ignores most income from IRA and 401(k) accounts. As a result, Social Security reports that retirees collected $5.6 billion of IRA income in 2008. They collected $200 billion more in employer pensions.
But few people overstate their income to the IRS. And the IRS reported $111 billion in IRA withdrawals and $457 billion in pension income in the same period. These two income sources total $568 billion. That's double the figures used by Social Security. It’s also more than the $509 billion Social Security paid out in old age benefits in the same year.
Biggs and Schieber also discuss another factor— something I’ve been harping on for 30 years. The 70 to 85 percent replacement rate figure used in most financial planning discussions is wrong. Most people have never had 70 to 85 percent of their income to spend on themselves.
Easy. During most of our adult lives we spend much of our income on things like mortgages, student loans and car loans. Did I forget children and their education? Consider the amount of our income that we get to spend on ourselves and the amount of income we need to replace drops like the proverbial stone.