Stock Market Returns Help Replace Income
December 10, 2001
How wise would it be to make stock market investments by workers part of Social Security reform?
The 10.1 percent inflation-adjusted rate of return on stock market investments over the last 75 years clearly suggests it would be. But what impact might such stock market returns have on a worker's retirement standard of living, especially compared with Social Security?
The rule of thumb is that one can maintain one's standard of living if retirement income equals 70 percent of one's last year's wage, a ratio called the replacement rate.
As a multiple of one's last year's wage, the wealth necessary at retirement to provide a 70 percent replacement rate is about 10.5 times, assuming a 3 percent real rate of return earned on an annuity certain for 20 years during retirement. That is, if one's last year's wage were $30,000, one would need about $315,000 to provide the 70 percent replacement rate for the next 20 years.
Starting in 1926 there are 30 possible 45-year investment periods, the last one ending in 2000. Assuming a constant 6.0 percent saving rate, all but four of the 30 periods achieved the 70 percent goal.
- The worst last year's wage multiple was 9.7 for the worker entering the labor force in 1937, earning a replacement rate of 65 percent (see figure).
- The highest multiple was 22.4 for the 1955-to-1999 cohort, earning a 149 percent replacement rate.
- In contrast, at age 65 average income workers' replacement rate from Social Security is scheduled to be only 37 percent from a payroll tax rate of 10.6 percent.
Thus at their worst, market-based retirement benefits are about 76 percent greater than projected pay-as-you-go benefits and cost 43 percent less.
Source: William G. Shipman, "Is The Stock Market Too Risky For Retirement?" Brief Analysis No. 382, December 10, 2001, NCPA.
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