Adequacy of Economic Resources in Retirement and Returns-to-scale in Consumption

Most assessments of the adequacy of retirement resources are expressed as a comparison of preretirement income to immediate post-retirement income. Yet, among couples a substantial fraction of retirement years is eventually spent by the surviving spouse living alone. To the extent that singles need less than couples to maintain the same standard of living, assessments of the adequacy of economic resources that make no adjustment for widowing will systematically misstate economic preparation. We estimate returns-to-scale parameters in spending by older households, using data from the Consumption and Activities Mail Survey and apply these to assessments of adequacy of retirement resources. Authors’ Acknowledgements We are grateful for financial support from the Social Security Administration via a grant from the Michigan Retirement Research Center (UM07-07). We thank the National Institute on Aging for additional financial support for data development (1P01AG08291). The opinions and conclusions expressed are solely those of the author(s) and do not represent the opinions or policy of SSA or any agency of the Federal Government. Introduction In considering whether prospective retirees will have the resources they need for retirement, a commonly used indicator is post-retirement income expressed as a proportion of pre-retirement income, that is, the replacement rate. Complete replacement of income or of some fixed fraction such as 80 percent are often put forward as a yard stick to ensuring a comfortable retirement. This kind of thinking is simplistic in that it makes no systematic accounting of a number of things: the differing role of taxes for households at different points in the income distribution; work-related expenses; financing consumption out of savings; the time horizon or survival curve of the household; returns-to-scale in consumption: couples’ need to assess the risk of increased per capita spending once one of the partners dies; the changing consumption profile with age; a household’s use of its increased leisure in retirement in ways that may either increase or decrease spending. For example some households may want to use their increased leisure-time to engage in activities that are associated with elevated expenses such as travel, while some may engage in home production or more efficient shopping to reduce spending. The overall goal of this paper is to define replacement rates that take into account many of these aspects. In prior work we defined an alternative concept, the wealth replacement rate. We asked whether observed bequeathable wealth, pension income, Social Security benefits and other income sources would be able to support the observed life-cycle path of consumption from the beginning of retirement to the end of life (Hurd and Rohwedder, 2006). While we believe that paper made a useful contribution by moving away from income replacement rate toward a more accurate and comprehensive measure, it was incomplete along a number of dimensions. First, its measure of adequacy was in terms of actual bequeathable wealth holdings compared with “necessary” wealth, where necessary wealth was defined to be the minimum level of wealth necessary to carry out a life-cycle consumption plan. For example, lack of financial preparation for retirement would occur if the household’s actual wealth holdings fell short of the “necessary” wealth holdings. We believe a more informative measure of adequacy would be based on the necessary adjustment to consumption because it reflects directly the required adjustment to a