Reinventing Retirement Income in America

Studies | Retirement

No. 248
Monday, December 31, 2001
by Brooks Hamilton and Scott Burns


Determinants of Retirement Income

Figure I - Annual Retirement Income Under Different Assumptions

Three major elements determine the amount of one's retirement income: the ratio of years worked to years of retirement, the average amount saved during the working years and the average real rate of return on the savings.

"The ratio of years worked to years of retirement has shrunk from 15:1 to less than 2:1."

Working Years vs. Retirement Years. A few generations ago, the males in a typical family started working in their teens. They remained on the job into their 50s, when a final illness often contributed to what we now would call their retirement - which only spanned a few years. After 35 or more years of work, they would have perhaps three years of retirement before death, making the ratio of years worked to years of retirement 12:1.

The case today is quite different for many people. Those who pursue a college education do not begin full-time work until about age 22. Given current trends, the retirement target for many is age 62. As with previous generations, working years number about 40. But now the retirement years approach 25. In fact, in the case of a healthy employee and spouse both reaching age 65 and retiring in good health, the odds are 50-50 that one will live to age 90. Thus the ratio of years worked to years of retirement has shrunk from 12:1 to less than 2:1.

Average Amount Saved. According to a survey by the Profit Sharing Council of America, in 1999 non-highly compensated employees contributed an average of 5.4 percent of pay to their 401(k)s and the average company contribution was 4.7 percent. Between one-fifth and one-quarter of eligible workers do not participate, and participants who make only minimum contributions fail to take full advantage of the employer match.7

"Sufficient retirement income depends on a wise combination of years worked vs. years of retirement, the savings rate and the rate of return."

Average Real Rate of Return. This is an average of the annual rate of return on savings minus the annual rate of inflation. The figure most often used as the annual rate of inflation is the change in the Consumer Price Index, which measures the changes in prices of a fixed amount of selected goods and services. Thus if a person receives a pay increase of 4.25 percent and inflation is 3.25 percent, the real pay increase, in terms of added purchasing power, is 1 percent. After years of high inflation during the late 1970s and early 1980s, the U.S. annual inflation rate has varied from as much as 5.4 percent in 1990 to as little as 1.9 percent in 1986 and 1.6 percent in 1998.

Prospective Retirement Income: An Example. What kind of retirement income will a 401(k), combined with Social Security and private savings, provide?8 A successful replacement income model will have a wise combination of the three major elements - the ratio of years worked to years of retirement, the savings rate and the rate of return over inflation.

Let us look at a 25-year-old worker earning $25,000 a year.9 Assuming annual pay increases of 4.25 percent (and annual inflation of 3.25 percent), by age 65 he will be earning $126,744 per year. Figure I shows the difference the three major elements make.

  • If the worker retires at age 65, he can expect to live 23 years in retirement, and thus will have 1.7 years of future work for each expected retirement year.
  • With an average investment return of 5 percent (1.75 after inflation), if he contributes 5 percent to his 401(k) plan, he can expect a pension of $19,136 per year, or 15.1 percent of preretirement income.10
  • If the worker doubles his contribution to 10 percent, it will double his pension to $38,271 per year, or 30.2 percent of preretirement income.
  • If the rate of return also doubles to 10 percent (6.75 after inflation), the worker can expect a pension of $165,176 per year, or 30 percent more than his preretirement income.
  • If the worker stays on the job until age 70, when his income will be $156,066, he will have 2.5 years of future work for each expected retirement year, and his pension will be $291,640 per year, more than four-fifths greater than his preretirement income.

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