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URBAN INSTITUTE
No. 25
WHAT HAPPENS TO
REPLACEMENT RATES
OVER THE COURSE OF
RETIREMENT?
Eugene Steuerle and Christopher Spiro
REPLACEMENT RATES, WHICH COMPARE INDIVIDUALS’
initial Social Security benefits with previous wages,
are often used to determine whether or not recent
retirees can maintain their preretirement standard of
living. Replacement rates, however, can be unsteady
measures. As discussed in a previous brief, they look
different depending on the wage (for example, average, highest, or most recent) with which a new Social
Security benefit is compared.1 But such rates can also
appear different over the course of retirement.
Analysts typically rely on a replacement rate determined at the specific moment of retirement. Because
initial Social Security benefits are based on wageindexed earnings, the replacement rate relates the
retiree’s wages to those of the general population. If
society has grown richer, the benefit reflects this.
However, analysts seldom attempt to measure this
type of relative replacement rate at any point during
retirement. Relative replacement rates change during
retirement because after the Social Security benefit is
established, it grows at the slower pace of prices and
only its real, not relative, value is maintained.
Social Security benefits do not grow along with
average wages in the economy and, therefore, rela-
1. See Straight Talk No. 24, May 30, 2000.
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tive replacement rates (which compare the benefit
with this wage) during retirement appear to drop
dramatically. Figure 1 displays the earnings pattern
of an average-income worker, based on actual earnings records. This worker’s initial benefit of $9,728 at
age 65 steadily erodes relative to average wages in the
economy. By the time this worker turns 85, his benefit has fallen from 31 percent of the average wage of
all workers to 25 percent of the average wage of all
workers.2 By the time this worker turns 85, this erosion has reduced his replacement rate from 52 percent of his average wage to 43 percent.
Unfortunately, this erosion of retirees’ relative living standards occurs just as their needs are increasing. Younger retirees tend to be better off than older
retirees—they are more likely to be healthy, earning
additional income, and receiving help from a spouse.
Despite their generally stronger standing vis-à-vis
older retirees, younger retirees receive greater Social
Security benefits than their older counterparts: Each
subsequent generation tends to earn more than the
previous one and is therefore entitled to higher benefits. Thus, at any point in time, Social Security benefits are actually inversely related to the needs of the
various age groups who receive them. This contradicts Social Security’s primary goal of protecting
against the vulnerability that can accompany aging.
While price-indexed benefits allow retirees to
maintain their purchasing power over time, they do
not accommodate increased demand for goods and
services. Retirees are therefore unable to increase
their consumption as the economy grows. They may
also become less able to purchase necessary services
(such as those provided by a nurse or other caretaker) whose prices increase according to wage, not
price, growth. Because wages grow faster than prices,
the cost of these services outpaces a retiree’s ability to
pay for them.
2. This particular method of calculating the average wage includes
years in which workers receive zero earnings, but this has no effect
on the general issue that Social Security income falls over time relative to average wages.
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Private pensions can exacerbate declines in relative
replacement rates. While private pensions are an
important source of income for many retirees, they
rarely index benefits for price growth—and almost
never for wage growth. Hence, pension benefit payments decline in real value during retirement years.
Thus, combining private pension with Social Security
income further reduces replacement rates.
While Social Security tries to maintain relative standards of living at the moment of retirement, a similar
attempt is not made after retirement. The reduction
in relative replacement rates during retirement
reflects this. As retirees age, they become isolated
from the fruits of economic expansion. The paradoxical result is a Social Security (and private pension)
system that pays greater benefits to age groups who
need them less and smaller benefits to those who
need them more.
Eugene Steuerle is a senior fellow at the Urban
Institute, where his research includes work on Social
Security reform. Christopher Spiro is a research
assistant at the Urban Institute.
Note: The Straight Talk series is on vacation. The next
Straight Talk will be released July 15, 2000.
This series is made possible by an Andrew
W. Mellon Foundation grant.
For more information, call Public Affairs:
202-261-5709. For additional copies of this
publication, call 202-261-5687 or visit the
Retirement Project’s Web site:
http://www.urban.org/retirement.
Copyright ©2000. The views expressed are
those of the authors and do not necessarily
reflect those of the Urban Institute, its sponsors,
or its trustees. Permission is granted for reproduction of this document, with attribution to the
Urban Institute.
FIGURE 1. Relative Replacement Rates Fall during Retirement*
$25,000
ACTUAL LIFETIME EARNINGS PATTERN OF AVERAGE EARNER
AVERAGE EARNINGS OF AVERAGE EARNER
Wage-Indexed Dollars
$20,000
$15,000
$10,000
BENEFIT OF AVERAGE EARNER
$5,000
$0
22 25
30
40
35
50
45
55
Age
60
65
70
75
80
85
*For worker born in 1935 and retiring at age 65 in 2000.
Source: Eugene Steuerle and Christopher Spiro, The Urban Institute, 2000.
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