5 Trends in replacement rates

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As indicated in Section 3, family-income replacement rates represent the fraction of permanent family income at age 55 'replaced' by the sources of income that are available during retirement and can be used as an indicator of welfare 'loss' associated with retirement. Based on the assumption that family expenses will be somewhat lower in retirement than before retirement, it is generally agreed that 100% income replacement in retirement is not necessary. In the absence of children, expenses for goods and services are lower; work-related expenses disappear; there is no longer a need to save for retirement; and, where home-ownership rates are high (as in Canada), housing costs tend to be lower in the retirement years.

Policy-makers in the rich democracies have typically set a target replacement rate of from 65% to 75% for the average worker (Schulz 1992: 99). In Canada, Old Age Security and the Canada and Quebec Pension Plans were designed to replace about 40% of pre-retirement earnings for the average worker and it was assumed the balance would come from private pensions and personal savings. Low-income families who are already living on the margin are assumed to require higher replacement rates (close to 1.0) while high-income families are assumed to require less.

Figure 17 shows that the evolution of median replacement rates after age from 54 to 56 is remarkably similar across cohorts. Generally speaking, median replacement rates remain close to 1.0 until around age 60, then decline to about 0.8 around age 65. Furthermore, longer time series from older cohorts indicate that replacement rates remain relatively stable until late in life. The main implication of this is that the Canadian pension system appears to be doing relatively well in ensuring basic standards of well-being among seniors, at least for individuals near the median.¹³

However, there is considerable variation in replacement rates both within and between pre- retirement income levels as shown in Table 6 for the 1983 cohort.¹⁴

Almost 50% of individuals had a replacement rate above 1.0 at age from 59 to 61. This proportion fell to 35% at age from 64 to 66 and to 23% at age from 69 to 71. Conversely, the share of individuals with a replacement rate of 0.6 or less increased from 10% at age 60 to 21% by age 75.

Are these results a cause for concern? In other words, do individuals have low replacement because of limited access to retirement income, or simply because their permanent income was initially high? If low-income individuals aged from 54 to 56 consistently had replacement rates above 1.0 in the following years, this would suggest that the pensions system is relatively effective in preserving the living standards of low-income seniors. Conversely, if low-income individuals had lower and lower replacement rates as they age, this would raise serious questions about the ability of the pensions system to maintain their living standards in retirement. One way to deal with this is to control for initial income levels. We do so by dividing the population in five quintiles (for each cohort) based on their permanent adult-equivalent-adjusted income at age 55 and by examining the distribution of replacement rates in the first, third and fifth quintiles of permanent income. Results for individuals in the bottom quintile are shown in Figure 18.

For the majority of low-income families (the bottom quintile) median replacement rates were generally high,¹⁵ and remained close to, or above 1.0 most of the time. The 1989 cohort, which was undoubtedly affected by the 1990-to-1992 recession, is the exception.¹⁶ These are encouraging results but if many low-income seniors had replacement rates much below the median, there would be cause for concern. Hence, it is also important to examine the distribution of individuals across categories of replacement rates within the bottom quintile as well.¹⁷

The results are shown in the second panel of Table 6 and indicate that about half of all individuals in the bottom quintile enjoyed full replacement rates until late in retirement. Four out of five had replacement rates above 0.8 at age 75. Nevertheless, nearly 20% of the bottom- quintile seniors aged 70 had replacement rates below 0.8, which suggests that a sizeable number may be under financial duress.

Figures 19 and 20 show median replacement rates among individuals in the middle and top quintiles, respectively. Median replacement rates among individuals in the middle quintile closely resembled those of the cohort as a whole (with replacement rates above 0.7 for most cohorts after age 65), while replacement rates among individuals in the top quintile declined to approximately 0.7 after age 65. After age 70, however, about a quarter of middle-income seniors have replacement rates below 0.6 (Table 6).

Figures 21 to 24 show replacement rates separately for men and women, using data from the 1983 cohort. By and large, the trends are similar for men and women. Both had higher replacement rates if they were in the bottom quintile of the income distribution and lower replacement rates if they were in the top quintile. Similar results were also found in terms of the distribution of replacement rates (results not shown).

While replacement rates vary across the income distribution, with generally higher replacement rates among individuals with lower family incomes at age 55—variation across income quintiles—they also vary among individuals with generally the same income at age 55—variation within income quintiles. Why do two individuals who have the same income levels at age 55 end up with very different replacement rates in retirement? Is it simply the case that one has a private pension, and the other does not? Or do other sources of income significantly affect the outcome?

To address this issue we focus on individuals from the 1985 cohort (age 55 in 1985) who were in the middle family-income quintile at age 55. That is, everyone in this particular sample had roughly the same family income at age 55. We divide this group into those with high replacement rates (> 1.0), and low replacement rates (< 0.6) at various ages in retirement. We then determine the contribution of each income source to the difference in family income between the low and high replacement rate groups. The results are in Tables 7 and 8.

The average family income at age 55 of the groups with low and high replacement rates were virtually identical at around $38,000 (adult equivalent adjusted, Table 7). Hence, differences in replacement rates in the retirement years were not due to differences in income at age 55.

Table 7 shows that at age from 64 to 66, maintaining employment earnings is the major factor differentiating those with high replacement rates from those with lower ones, accounting for 57% of the $44,000 difference in income between these two groups. And as the cohort aged from 69 to 71, some maintenance of employment earnings remained the largest single factor, accounting for 40% of the still very large $42,000 difference in family income between the low and high replacement rate groups. Differences in private pension income start to become important at this age—accounting for 34% of the difference—as does investment and capital gains, together accounting for about 27% of the difference. By the age from 74 to 76, employment earnings remain significant, accounting for 29% of the difference, but the money received from private pensions (including RRSP and RIF income) becomes the major contributor (45% of the difference).

But these results are based on family income. Hence, the earnings reported under 'employment earnings' for an individual aged, say from 64 to 66, may not have been earned by that particular individual, but by someone else in the family, possibly younger. Hence, it is difficult to determine to what extent remaining in the labour market during the older years accounts for the differences in outcomes between the low- and high-replacement rate groups.

To overcome this shortcoming, we replicate the analysis based on individual, not family, income. In this case, all reported incomes are earned by the individuals themselves, not by others in the family. The results (Table 8) indicate that employment earnings is not as dominant as a source of difference, but investment and capital gains play a surprisingly large role. At age from 64 to 66, remaining active in the labour market with significant earnings accounted for 54% of the difference in income between the low- and high-replacement rate groups, and investment and capital gains about 40%. But by age from 69 to 71, investment and capital gains together accounted for the largest part of the income difference (43%), followed by private pensions (33%) and earnings (28%). When the cohort ages, reaching from 74 to 76, it is private pensions that primarily explains the difference in income (about 50%) between the low- and high- replacement rate groups, followed by investment and capital gains (39%) and employment earnings (13%).

To summarize, when replacement rates are computed at the family level, which is most appropriate from a welfare perspective, the level of employment earnings in the family is the single most important factor differentiating persons with low- from those with high-income replacement rates, at least until the cohort enters their 70s. After that age, the difference in income from private pensions is the most discriminating factor.

But to what extent is it the tendency of the individuals themselves (rather than other family members) to work into their late 60s that differentiates the low- from high-replacement rates groups? When computed at the individual level, the importance of employment earnings declines significantly, and investment and capital gains play a surprising large role, accounting for around 40% of the difference between the high- and low-replacement rate groups at all reported ages. Remaining at work is the most important factor for those aged from 64 to 66, but by their middle 70s, private pensions become the most important source.

¹³ Recall that these results are based on family income, which is more indicative of the level of financial well-being enjoyed by individuals over the course of the retirement period. The median replacement rate after age 65 is about 10 percentage points lower when individual income is used instead of family income, at approximately 0.7 (see Appendix A for more details).

¹⁴ Results for the other cohorts are not shown, but showed similar results when comparisons could be made. Readers interested in other cohorts will find a complete description of these results in Appendix B.

¹⁵ Recall that we have excluded persons earning less than $10,000 around age 55.

¹⁶ These results are consistent with Gower (1998), who also finds higher replacement rates among low-income individuals.

¹⁷ The distribution of replacement rates within quintiles are also based on our first cohort of individuals aged from 54 to 56 in 1983. Other cohorts have shown similar distributions (see Appendix B for details).