ABSTRACT
We review three main approaches to assessing economic preparation for retirement: the income replacement rate, a life-cycle model optimization approach, and a consumption-based approach. The income replacement rate is widely used by financial advisors and in research on economic preparation for retirement. However, it is ill-equipped to capture some key features of the financial planning for retirement problem. The other two approaches address the main shortcomings of the income replacement rate. The low correlation between the income replacement rate and the preparation measures from the other two approaches suggests that the income replacement rate can be misleading for many households and that it is unsuitable as a rule of thumb to guide household planning for retirement. The consumption-based approach, informed by life-cycle model considerations, is simple enough that it can be adapted for individuals to use if those individuals are provided with information on some inputs such as survival risk and spending trajectories for persons with similar demographics. According to the consumption-based approach, 51 percent of single persons near retirement in the United States and 81 percent of married persons are adequately prepared, that is, they have a small probability (5 percent or less) to run out of wealth at advanced age, accounting for differential survival and out-of-pocket medical expenditure risk. Unlike the income replacement method, the consumption-based measure conveys the expected financial advantage of retirement-age couples over single people. We highlight several promising avenues for future research.
