Retirement Age and the Need for Saving

American workers typically accumulate a significant amount of savings during their working years to support their standard of living in retirement. In addition, a substantial portion of their working-age income is replaced by defined-benefit private pensions and Social Security benefits, and a large share of their medical expenses is covered by Medicare and Medicaid. Nevertheless, the extent of workers' savings has become an increasing concern to policymakers during the past decade as members of the generation born from 1946 to 1964--known as the baby boomers--approach the end of their careers and prepare to leave the workforce. That coming wave of retirees will cause spending for federal entitlement programs to swell, which will in turn increase pressure on the federal budget.⁽¹⁾ That pressure could be even greater if, as some researchers have claimed, baby boomers are not accumulating enough private savings to maintain their working-age standard of living in retirement. Low saving could restrain the growth of investment and output and thus the tax base from which entitlements must be financed.

In response to policymakers' concerns, the Congressional Budget Office (CBO) recently reviewed the past decade's research on the retirement prospects of aging Americans.⁽²⁾ Most of the studies that CBO reviewed conclude that many baby boomers are preparing adequately for retirement; at the same time, a substantial portion of boomers may not be able to maintain their current consumption levels in retirement if they retire when they now plan to.
 

The Importance of Retirement Age

An important point that is not fully appreciated is that the retirement ages assumed in studies of retirement preparedness strongly affect their estimates of preparedness. Most studies estimate how financially well prepared households will be for retirement when their primary workers retire at a fixed age--typically 62 or 65. However, barring disabling injury or illness, workers can choose when to retire, just as they choose how much to save. The longer they work, all else being equal, the more prepared for retirement they are likely to be. Because most studies of retirement preparedness do not treat retirement age as a matter of choice, they tend to overstate the gravity of potential shortfalls in retirement assets.

Working just a few years longer and saving somewhat more of their income can greatly improve older workers' financial status even if they have not saved much until they near retirement. Americans in their early 60s can typically expect to live another 20 years or so. By extending their working lives, they shorten the period of retirement that they need to finance while giving themselves more time to save and to earn returns on any assets they have already accumulated. Every year they continue to work reduces their likely period of retirement by several percent and increases the value of their assets by the annual rate of return, plus any additional saving.

Moreover, by waiting to apply for Social Security benefits, workers can substantially increase their annual benefits, thus cutting the share of their retirement needs that they must finance from their own assets. For instance, although the oldest boomers will be eligible to receive 75 percent of their normal retirement benefit if they apply at age 62, they will qualify for 100 percent if they apply when they turn 66 and 132 percent if they wait until age 70. Those additional years of earnings could raise benefits even further if they replaced lower annual earnings from previous years in the calculation of Social Security benefits. (That calculation is based on a worker's highest 35 years of wage-adjusted taxable earnings.) For boomers born after 1954, Social Security benefits are somewhat lower as a percentage of preretirement income because the retirement age is rising, but the advantages of retiring later are similar.⁽³⁾

For many workers, delaying retirement may also result in tax advantages because Social Security benefits are largely exempt from income taxation. Workers who apply for Social Security benefits at age 70 will receive nearly double the annual benefits they would have received at age 62. With a larger amount of income likely to be untaxed, a worker who delays retirement will not need as much total income to have the same after-tax income as one who retires earlier.

Delaying retirement thus leaves a worker with fewer years of retirement to finance, more time to save and earn returns, and--if the worker delays applying--higher Social Security benefits, which are largely tax-exempt. Taken together, those factors can substantially reduce the private retirement assets required by the typical household. That observation applies to many types of households--for example, both married couples and single people--across a wide range of incomes (see Table 1).⁽⁴⁾

Table 1.

An Example of How Delaying Retirement Affects a Household's Finances

As an illustration, consider a married couple in their early 60s earning $77,000 per year--roughly the median pretax income of married households ages 55 to 64 in 2002. (This couple's finances are shown in the middle of the upper panel of Table 1 and in Figure 1.) After paying federal and state income taxes and Social Security taxes, the couple typically takes home about $58,600 in annual income. Thus, in retirement, they will need about $46,900 per year in order to replace 80 percent of their preretirement after-tax income--a percentage that financial planners often recommend to allow most people to maintain a roughly constant standard of living.⁽⁵⁾

Figure 1.

Source: Congressional Budget Office.

Note: The values shown here replicate those in the middle panel of the top half of Table 1.

If both spouses retire at age 62, the couple will receive about $20,100 in Social Security benefits annually. To achieve an 80 percent replacement rate, they will need another $26,800 of after-tax income per year--for about 20 years, if they reach the average U.S. life expectancy for people their age, but possibly more or less, depending on how long they live. Assuming that they will not receive any income from a pension plan and must finance the entire sum themselves, they can guarantee that income by purchasing a "joint and 50 percent survivors" annuity--a contract that would provide them with annual payments sufficient to yield $26,800 per year after taxes while they are both alive and $13,400 per year after taxes to the survivor when one of them dies. To purchase such an annuity, with substantial (but not necessarily complete) adjustment for inflation, they will need to accumulate about $510,800 before retirement.⁽⁶⁾

If the couple retires one year later, at age 63, their annual Social Security benefits will increase to about $21,600, so they will need to finance $25,200 per year after taxes themselves--and, in all probability, for a shorter period of time.⁽⁷⁾ Thus, to purchase the same type of annuity, they will have to accumulate only about $465,000 in assets before retiring--nearly $45,800 (or 9 percent) less than they will need to accumulate to retire at age 62. The price of the annuity--and thus the amount the couple needs to accumulate--continues to decline for each year that they delay retirement, to about $298,400 if they retire at age 66 and to about $117,700 if they retire at age 70.

Each additional year of work not only increases annual Social Security benefits and reduces the amount of wealth needed at retirement, but it also extends the amount of time during which working households can earn returns on their savings. As a result, if the couple reaches age 62 with only $243,300 in savings--less than half the assets they will need to retire immediately--they can still retire with sufficient assets at age 66 by saving 10 percent of their after-tax income and earning a 3 percent real (inflation-adjusted) rate of return. Likewise, by continuing to work and saving 10 percent of their income, the couple can still retire comfortably at age 70 even if they reach age 62 with only $51,800 in savings.⁽⁸⁾

The effect of retirement age on required saving rates applies to workers long before retirement. For example, if the couple had accumulated only $161,400 in retirement assets by age 55, they would need to save nearly 70 percent of their after-tax income to accumulate the $510,800 in assets necessary to retire with 80 percent of their preretirement income by age 62 (assuming a 3 percent real rate of return). But they would need to save only 10 percent to retire at age 66.

The calculations described above are all based on the assumption that baby boomers retiring in years to come will receive entitlements as scheduled under current law. However, the growing population of retirees, increasing life spans, and rising health care costs will likely contribute to severe and mounting pressures on the federal budget. To the extent that such pressures are addressed by reducing the future growth of entitlement benefits, affected boomer households will have to work even longer, increase their saving by even more, or reduce their consumption in retirement.
 

Trends in Labor Force Participation

Labor force data suggest that some workers are indeed working longer and that the long-term trend toward earlier retirement may have ceased or even reversed. Participation in the labor force by people ages 65 and over--both men and women--declined for many years until the mid-1980s, but it has risen modestly since then. For people ages 55 to 64, the patterns are slightly different: labor force participation by men declined until the mid-1990s and has since turned upward; participation by women has been climbing more or less continuously for half a century, though with a relatively stable period in the 1970s and 1980s (see Figure 2).⁽⁹⁾ With rising life expectancy, improvements in health, and the fact that many types of work are less physically demanding than in the past, at least some people may be deciding to provide for a longer retirement by working somewhat longer, too.⁽¹⁰⁾

Figure 2.

Source: Department of Labor, Bureau of Labor Statistics.