Retirement Implications of a Low Wage Growth, Low Real Interest Rate Economy

Abstract

Using a life-cycle model, the authors examine the implications of persistent low real interest rates and low wage growth for individuals nearing retirement. Low returns and low wage growth are found to affect welfare substantially, often producing large compensating variations. Low economy-wide wage growth has a much larger welfare effect than low individual wage growth, largely because the Social Security benefit formula is progressive and incorporates wage indexing. Low economy-wide wage growth undercuts the effects of wage indexation as average wages fall along with individual wages. Low returns raise the optimal Social Security claiming age and the marginal benefit of working longer, while low wage growth decreases the marginal benefit of working longer. Low returns also increase the relative price of consumption during retirement, suggesting that individuals may wish to reduce future consumption relative to current consumption. The authors then compare these findings with standard financial planning advice.

Keywords: Life-Cycle Model, Wages, Interest Rates, Compensating Variation, Retirement Saving, Financial Planning

JEL Classification: D15, E43, G51, J30