Why America Must Understand Real Retirement Risks

Here’s why the nation faces a growing retirement crisis but many individuals may not.

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More than half of all American households are at risk of not being able to maintain their current standard of living in retirement, according to the Center for Retirement Research at Boston College's National Retirement Risk Index (NRRI). The percentage of at-risk households rose from 44 percent in 2007 to 53 percent in 2010.

A road sign warning of risk.
A road sign warning of risk.

The primary causes for the deterioration are not surprising: falling investment and housing values since the recession, very low interest rates, and the planned transition in the age of eligibility for full Social Security benefits, from 65 to 67. (Raising the retirement age effectively reduces retirement incomes for people who retire at age 65 and claim Social Security.)

This is sobering stuff in a nation where 10,000 baby boomers are turning 65 every day, traditional pensions are disappearing, and 401(k) balances are disappointing. Oh, did I forget to mention the imminent fiscal cliff, which will put even more financial pressure on Social Security, Medicare, and other senior safety-net programs? No wonder virtually every retirement expert has been urging people to set aside more money for their later years.

Before declaring retirement defeat and retreating to our respective caves, however, it's important to understand exactly what this national retirement risk measure means and whether it actually applies to your situation. When the Center says 53 percent of American households face retirement risk, what it means is probably much different than what you think.

[See 10 Places Where Retiree Income Has Declined the Most.]

The Center calculates a household's preretirement earnings, then estimates its retirement income. It looks at the percentage of income that will be replaced in retirement and compares this with a target replacement rate that the Center has determined would be sufficient to maintain the same standard of living in retirement. People generally don't need to earn as much money in retirement as during their working years, so the target replacement rate for all households is roughly three-fourths of their preretirement earnings.

The index measures the percentage of American households whose projected income-replacement rates fall more than 10 percentage points below their target rates. It's the center's professional opinion that this large of a gap places the household at risk of not being able to maintain its preretirement standard of living.

Figuring out preretirement household earnings is fairly straightforward. The Center relies on the Federal Reserve's extensive Survey of Consumer Finances, which is done every three years. The 2010 survey was released earlier this year, so it's the most recent set of authoritative numbers.

[Read: 12 Ways to Increase Your Social Security Payments.]

Projecting household incomes in retirement involves some assumptions that are not so obvious. The Center looks at household financial assets and assumes they are all converted into an annuity as soon as the people in the household turn 65 years of age. If the household owns a home, it's assumed this asset is turned into retirement income by taking out a reverse mortgage. The amount of income generated by these assets is then added to any pension and Social Security payments to produce an overall figure for household income at age 65.

What the Center is really measuring is potential retirement income, assuming everyone retires at 65 and, in effect, annuitizes all their assets. Real people don't do this, which the experts at the Center know. But for research purposes, researchers need to make certain assumptions to develop a useful snapshot of the nation's retirement situation.

Real people retire both earlier and later than their 65th birthdays. They invest in all sorts of things, some of which return more profits than an annuity, and some of which don't. People also continue working during their retirement years, yet such earnings are not counted in the Center's measure of retirement income. Surely, this single factor might substantially lower that 53 percent NRRI reading.

[Read: 20 Practical Ways Seniors Can Cut Expenses.]

Most of all, people look for different ways to spend money and live their lives to adjust to their realistic levels of retirement income. The Center's target income-replacement levels were developed more than six years ago and haven't been changed since then. We've seen enormous shifts in spending patterns since the recession. Some of these shifts may well have resulted in declines in living standards, but there are clearly spending cuts that don't harm living standards.

The Center assumed in a 2006 report that single-person households in the top third of income groups needed to replace 65 percent of their preretirement incomes to maintain their living standards in retirement. The other 35 percent of their preretirement incomes were spent on higher taxes, retirement savings, and work expenses that could be trimmed in retirement without hurting their standard of living.

Lower-income households needed to replace higher percentages of their preretirement incomes to maintain their living standards in retirement. That's because they have fewer reduced spending needs in retirement. They didn't earn enough while working to save much money for retirement, and did not pay higher tax rates that would be reduced once they stopped working. Couples with a single earner in the bottom third of all income groups, for example, needed the largest amount of preretirement earnings to maintain their living standards in retirement: 85 percent.