Key Takeaways
- The retirement income replacement ratio is the percentage of your current income you’ll need in retirement.
- Tailor your ideal replacement ratio to fit your unique situation.
- Combined with other income sources and your planned withdrawal strategy, this ratio helps you determine your retirement savings target.
As you develop your retirement plan you may come across a term called the retirement income replacement ratio. This can be a helpful concept to understand. Knowing your own retirement income replacement ratio can help you visualize what you will need to cover your planned expenses and live comfortably.
What Is a Retirement Income Replacement Ratio?
What is the retirement income replacement ratio, and how does knowing it help you plan for retirement? Simply put, this ratio represents the percentage of your pre-retirement income you’ll need to replace during retirement. Understanding this ratio helps you determine the amount of money you’ll need each year in retirement.
For example, if you earn $100,000 per year, you might only need to replace 80% of that, or $80,000, in retirement. Although it’s a simple concept, understanding this information enables you to set a realistic savings target, ensuring a comfortable retirement.
What Factors Affect Your Retirement Income Replacement Ratio?
Like most aspects of financial planning, there are common rules of thumb that can help you identify the ideal income replacement rate. You might read that 80%, or a range such as 70%-90%, are good targets. If you are young and have many years until retirement, these can serve as useful guideposts to help you start putting a plan together. However, you should tailor these estimates to your specific situation as you get closer to retirement.
So, how do you do that? Start by examining your current income. Then, adjust based on factors that may change within your budget. Common items to consider include:
- Retirement Savings
- You won’t need to save for retirement once you reach it, so you can exclude that from your calculations. For instance, if you’re currently saving 10% of your income toward retirement, that’s 10% you won’t need to replace.
- Taxes
- Consider how your taxes might change in retirement. A common rule of thumb is that taxes often decrease in retirement, but this isn’t universally true, so be sure to analyze your specific situation. For example, FICA or payroll taxes: most self-employed workers pay 15.3% of their income, while most employees pay 7.6%.
- Work-Related Expenses
- For likely obvious reasons, expenses in this category generally decrease in retirement. Commuting costs, professional association dues and work-specific clothing are examples of expenses you may no longer have.
- Travel and Leisure Expenses
- Do you plan to travel or pursue hobbies more actively in retirement? You might find that you spend more in these areas once you have the time and freedom to enjoy them.
- Health Care
- In general, you’ll likely spend more on healthcare in retirement. However, these expenses may not be evenly spread throughout your retirement. For example, if you retire early, your health insurance premiums may increase until you qualify for Medicare, after which they might decrease. Additionally, healthcare costs often rise over time due to the natural aging process.
What About Other Sources of Income?
Even if you are no longer earning a paycheck in retirement, you may still have other sources of income. These can help cover a portion of your expenses and provide additional security.
Social Security
Most working Americans are covered by Social Security. Those who qualify for benefits can start drawing them as early as 62 years of age for a reduced monthly payment, but you can delay benefits until you turn 70 to receive a larger monthly amount. Because Social Security is a guaranteed, inflation-adjusted, tax-advantaged benefit, it is very important to optimize your claiming decision.
Pensions
Although they are less common today, some employers still offer pensions. These typically provide several payout options at retirement, including lifetime payments.
Annuities
If Social Security and pension benefits don’t provide you with the level of guaranteed income you want or need, annuities can make up the difference. These are insurance products that also offer payments guaranteed to last for your lifetime and can cover a portion of your income needs.
Rental Income or Royalties
If you own rental properties or collect royalties and expect these payments to continue in retirement, include them as part of your income planning.
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How To Incorporate Your Income Replacement Ratio Into Your Retirement Plan
Once you determine the retirement income replacement ratio that fits your intended retirement goals and budget, you can identify an appropriate savings amount to support it. From there, you’ll be better able to assess your retirement readiness.
For example, assume you make $90,000 and determine that you’ll need 75% of your current income, or $67,500, in retirement. Suppose you expect to collect $2,000 per month from Social Security and $1,000 per month from an annuity. That totals $36,000, so you’ll need to cover the remaining $31,500 with savings.
This helps you identify the amount you need based on your chosen withdrawal strategy. For simplicity, let’s assume you plan to use a 4% withdrawal rate. Since $31,500 is 4% of $787,500, that’s your approximate savings target.
What Are the Risk Factors?
Don’t forget that you’ll encounter unplanned expenses in retirement, just as you do during your working life. Since these expenses are irregular, they won’t be reflected in your replacement ratio. Consider setting aside specific savings or obtaining insurance to protect yourself from these unexpected costs.
Even in retirement, it’s important to maintain an emergency savings fund. An adequate emergency fund can protect you from the need to withdraw from your investments due to unexpected expenses. Having this financial cushion ensures that you won’t disrupt your retirement savings or investment strategy to cover unforeseen costs.
Long-term care is another critical consideration, as about 69% of retirees will need such care at some point in their lives, typically later in life. To help cover these costs and safeguard the savings you rely on for monthly withdrawals, consider long-term care insurance and Health Savings Accounts (HSAs). These resources can provide important support and help protect your financial stability.
Longevity also poses a risk to your retirement savings, even though it doesn’t directly impact your replacement ratio. Living longer than anticipated can strain your retirement funds. To mitigate this risk, ensure you have a well-planned withdrawal strategy and take advantage of Social Security and annuity income, which can offer additional protection against longevity risk.
Knowing your income replacement ratio is key for creating a solid retirement plan. If you’re not comfortable calculating it yourself or need assistance, a financial planner can help. They can work with you to determine your ideal replacement ratio and develop a comprehensive retirement strategy tailored to your needs.
