Income Adequacy in Retirement: Accounting for the Annuitized Value of Wealth in Canada

Abstract

Discussions of pension adequacy for elderly Canadians have used the rate at which income falls with age — the income replacement rate or the ratio of post-retirement income to pre-retirement income. Use of income streams to assess post-retirement welfare requires a standard against which adequacy of the replacement rates can be judged. Because some expenditures (for example, work-related expenses) can be expected to fall after retirement, a declining income stream does not necessarily signal financial problems for seniors. More importantly, income as normally measured captures only part of what is available to seniors if households possess assets, which in retirement are not being used to generate measured income.

This paper uses a different metric, referred to as "potential" income. Potential income is the sum of realized income and the income that could be realized from owned assets such as mutual funds and housing. Households prepare for retirement by saving and borrowing and investing the proceeds. The assets accumulated over a lifetime may or may not be drawn down in later years. If they are not, income streams underestimate the “potential” income available to support retirement. This paper takes this potential into account when comparing the pre- and post-retirement financial status of Canadian households.

Based on data from the 1999 Survey of Financial Security, this analysis shows that when “potential income” is considered, households headed by seniors (aged 65 or older) compare much more favorably with younger households than when normally measured income is utilized. Indeed, when after-tax estimates are used, the potential income per adult-equivalent in senior households exceeds the income of households headed by younger adults.

Keywords: assets, household income, income, retirement, seniors, sources of income, wealth

JEL Classification: D31, J26