If you’re planning for retirement, you’ve probably figured out your Social Security benefits and any distributions you might receive from pension accounts, IRAs, or 401(k) investments. You might be in the process of determining how much income you’ll need once you’re no longer drawing a consistent salary or wages. This is where the retirement income replacement ratio comes in.
The income replacement ratio, sometimes called the wage replacement ratio, provides an estimate as to how much pre-retirement income you need to set aside now, to handle expenses and maintain your current quality of life by the time you walk away from your full-time job for the last time. Proper use of the retirement income replacement ratio can help provide you with sufficient cash flow to enjoy a decent lifestyle when you retire.
How It Works
The general rule of thumb when it comes to figuring out how much you might need is 75%. In other words, most people will likely need to replace 75% of their income when they retire. Other studies indicate that between 60% and 80% of their working years’ income is the sweet spot. But each individual is different. Your first step to determining your pre-retirement income is to determine what you’ll be paying after the steady paychecks end.
As an aside, the reason why you might not need your full working income when you retire is because your expenses might not be as high. If you aren’t employed, you likely aren’t paying Social Security payroll taxes. You also might not be paying into a pension fund or IRA. Perhaps you’ve paid off debts and own your home outright. And, in eliminating work-related expenses, you could have a greater share of income for spending.
In a hypothetical situation, if you’re currently earning $100,000 a year in salary and/or wages and you’re using the 75% rule of thumb as a point to determine what you’ll need for retirement, you’d likely need to come up with post-retirement income of approximately $75,000. If your Social Security benefit covers $40,000 a year, you’d need to have benefits covering an additional $35,000 a year. Those additional funds might come from your pension and/or retirement accounts.
If you want to pinpoint how much to save, you could work backward from that $35,000 and determine a comfortable initial withdrawal rate. Let’s say that rate might be 4%. Dividing $35,000 by 0.04% gives you $875,000, which is what you should aim to save by the time you retire.
While the figure might not be set in stone, it does provide a milestone that lets you know how much to start saving.
The Caveats
The retirement income replacement ratio is an estimate only; it’s not a guarantee. The following could change what’s needed for retirement.
Inflation. The above calculation doesn’t take economic inflation into account. These days, it’s at 8%, which will likely increase your post-retirement spending.
Your situation. What you need for retirement can vary, based on whether you’re a sole earner, married, or caring for young children.
Time to retirement. The retirement income replacement ratio is generally more helpful if you’re closer to retirement. It might not be as effective the further away you are from retirement.
Potential reduction in Social Security benefits. While Social Security has been in trouble for a while, a 2021 government report forecasted that the trust fund would run out of money by 2033 if nothing was done before then. Though it’s unlikely that Congress or the Treasury will let that happen, it’s something to consider when planning post-retirement income.
While the retirement income replacement ratio might not be perfect, it is a useful tool to get you started on a comprehensive savings plan to help you ensure that you have enough to pay expenses and enjoy a quality lifestyle when you stop working.
