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Ratios in Setting Retirement Income Objectives

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Ratios in Setting Retirement Income Objectives DOCUMENT RESUME ED 370 462 HE 027 167 AUTHOR Palmer, Bruce A. TITLE Planning For Retirement: Using Income Replacement Ratios in Setting Retirement Income Objectives. INSTITUTION Teachers Insurance and Annuity Association, New York, NY. College Retirement Equities Fund. PUB DATE Jul 93 NOTE 8p. PUB TYPE Collected Works Serials (022) JOURNAL CIT Research Dialogues; n37 Jul 1993 EDRS PRICE MF01/PC01 Plus Postage. DESCRIPTORS College Faculty; Family Financial Resources; Financial Needs; Fringe Benefits; Higher Education; *Income; *Mathematical Formulas; Money Management; Ratios (Mathematics); Retirement Benefits; *Teacher Retirement IDENTIFIERS Consumer Expenditure Survey; Retired Persons; *Retirement Planning; Savings ABSTRACT This paper presents a method for higher education faculty and staff to assess pension plan objectives by determining a retirement income replacement ratio to maintain the salary-based preretirement standard of living. The paper describes the RETIRE Project which researches income replacement using the federal government's annual "Consumer Expenditure Survey" to estimate individual savings and other expenditure variables incorporated into the Project's income replacement formulas. The income replacement ratio formula's components include preretirement gross pay, preretirement taxes, preretirement savings, postretirement taxes, work-related expenses, and net change in age-related expenditures. A central section looks in detail at how the ratio formula works with a single individual and a married couple under various conditions. Two detailed tables and two figures illustrate the analysis. Further sections discuss savings rates and their effect on income replacement ratios and the effects of taxing 85 percent of social security benefits (currently proposed by the Clinton Administration). A conclusion notes that research findings indicate that those retiring in 1993 need about 69 to 82 percent of final-year salary to sustain their preretirement standard of living. (Contains 13 references.) (JB) *********************************************************************** Reproductions supplied by EDRS are the best that can be made from the original document. *********************************************************************** Research Dialogues Issue Number 37 July 1993 A publication of External Affairs Policyholder and Institutional Research Planning for Retirement: Using Income Replacement Ratios in Setting Retirement Income Objectives BEST COPY AVAILABLE U S DEPARTMENT OF EDUCATION oeice if Mew On. HPSCait,^ an, ."DrOvIY"e^1 "PERMISSION TO REPRODUCC THIS EDUCATIONAL RESOURCES INFORMATION BY CENTER tERIC) MATERIAL HAS BEEN GRAN 0 This document has been reproducedas received from the person or organization yiqinatinq it WMinor changes have been made to TIAACREF improve reproduction quality Pools of view or opinions stated in this document do not necessarily represent TO THE EDUCATIONAL RESOURCES official OERI position or policy. INFORMATION CENTER (ERIC).- Research Dialogues Issue Number 37 July 1993 A publication of External Affairs Policyholder and Institutional Research Planning for Retirement: Using Income Replacement Ratios in Setting Retirement Income Objectives In this issue ofResearch Dialogues, '86), which incorporated several impor- to achievePH incomereplacement through la present an article on the subject of re- tant changes in the federal income tax allowing individuals and their families tirement income replacement ratios b.) laws affecting individuals. The most no- to continue their preretirement stan- Bruce A. Palmer. Ph.D.. professor of table changes, in terms of their effects on dard of living into their retirement risk management and insurance, Geor- income replacement ratios, were reduc- years. Its retirement income objectives ,,:ia State: nin-rsitl. Based on Profissor tions both in the number of income tax reflect the belief that most individuals Palmer:c extensive a fifk in this area, the brackets and in the overall marginal tax wish to avoid having to adjust to a lower article describes a method of daernannig rates. standard of living even when a lower standard may permit them to maintain a retirement income replacement ratio The enactment of TRA '86 and subse- a ((JO/rt./NG. life-style. designee' to maintatn the salary-based quent legislation created a need for new preretirement standard of lii ing. The and continuing research on income re- The RETIRE Project uses the fol- replacement ratio analysis can be used placement ratios and related retirement lowing definition of income replace- ky college and unhersity jachlty. income issues. To fill this gap, the ment in calculating replacement ratios': and administrators in assessing pendion Alexander and Alexander Consulting Preretirement gross salary plan objectites. and &v indiz.iduals in Group and the Center for Risk Manage- their financial planning jOr retirement. .Ilinus Prerecirement income taxes ment and Insurance Research, Georgia and FICA taxes State University, teamed together to ini- Introduction Preretirement savings tiate ongoing research, now known as the ,Ilinus 1. Work-related expenses duca-.ors, like most other American RETIRE Project.= The latest report of the workers, want to achieve a finan- Plus Aim Changes in age- E RETIRE Project was relmsed recently.' related expenditures cially secure retirement. The first step Earlier reports were released in 1988 and Plus p Postrenrement in attaining this goal is to establish 1991.1 income taxes appropriate retirement income objec- The cornerstone of the RETIRE Proj- Equals Replacement income tives. Today, income replacement ratios needed to maintain same are the most common approach to set- ect's research on income replacement is standard of living ting realistic retirement income targets. the U.S. government's annualConsumer Expenditure Surto.5These data are used Mathematically, the income replace- The relatively recent focus on in- to estimate individual savings and cer- ment ratio formula can be written as fol- come replacement (and income tain other expenditure variables that are lows: replacement ratios) began with the incorporated into the RETIRE Project's Replacement ratio = 1981 release of a report by the Presi- income replacement formulas. Federal PrRGP - PrRT - PrRS - WRE +/- NCASE + PoRT dent's Commission on Pension Policy and state income taxes, together with PrRGP IP(PP).1 The PCPP, formed during Social Security (FI(:A) taxes, are also in- President Jimmy Carter's administra- cluded in the formulas for determining where tioniddressed several public policy income replacement ratios. PrRGP Preretirement gross pay matters pertaining to retirement-relat- ed issues, including the determination A Definition of Income Replacement PrRT Preretirement taxes PrRS Preretirement sayings of appropriate income replacement Potentially, income replacement and ratios. income replacement ratios can be de- PoRT Postretirement taxes Heightened interest in the income re- fined in one of several ways. The mea- WRE Work-related expenses placement issue occurred in 1986 with sure that has received the most NCASE Net change in age- the passage of the Tax Reform Act (TRA widespread acceptance today is designed related expenditures 1001 Teachers Insurance and Annuo Associailon 3 Preretirement gross pay (PrRGP) retiring at age 65 in 1993. Income re- salaries. As described more fully in a represents the individual's earnings in placement ratios are computed for ten later section, the savings variable (Line the year immediately preceding the separate levels of preretirement salary 6Table 1) plays a major role in both date of retirement. Prereurement taxes (i.e., final-year salary), ranging from the absolute size of income replacement (PrRT) include both federal and stare 515,0(K) to 590.000.' ratios and the shape of the replacement income taxes and Social Security The following discussion focuses ratio curve. (FICA) taxes. PoRT include federal and on Lines 12, 13, and 14 of Table 1. state income taxes but exclude FICA The decreasing pattern of Social Se- These lines display the gross income taxes, since it is assumed that the per- curity replacement ratios (Line 13-- replacement ratios, Social Security Table 1, and Figure I) is simply a re- son is fully retired. PrRS represent sav- replacement ratios, and net income ings amounts that are not replaced at flection of the underlying nature of the replacement ratios, respectiv:lv. Gross retirement.Work-related expenses Social Security program. As is widely income replacement ratios represent the (WRE) include items such as commut- recognized, Social Security's benefit for- aggregate percentage of preretirement ing costs, special clothing, union and mula is designed to favor lower-income salary needed at the moment of retire- professional dues, and other expenses individuals by providing them with mentCOmaintain the individual's cur- that arc higher for working individuals. higher income replacement ratios. This rent standard of living into the retire- Changes in age-related expenditures pattern of Social Security replacement ment period. Social Security replacement (NCASE) include changes in health ratios also explains the pattern of in- ratios are determined by dividing the care costs, housing costs, education creasing net income replacement ratios retiree's estimated annual Social Security costsind other expenditure categories as preretirement salaries increase (Line benefits by his or her preretirement where the consumption patterns may 1.iTable
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