Although the term retirement income replacement ratio sounds formidable, its actually a simple, understandable concept that doesnt require any fancy math. The ratio helps you zero in on your retirement savings goal and periodically measure your progress as you move toward your target.
Will you need 60 percent, 75 percent, 90 percent or even 100 percent of the income you have in your last year of work to maintain a desirable standard of living after you retire? The answer to this question is your income replacement ratio - the percentage of your pre-retirement earnings that will provide you with the same standard of living in retirement. For example, if your pre-retirement income is $50,000 but your income after retirement is $35,000, you have a replacement ratio of 70 percent ($35,000 divided by $50,000).
Setting the foundation of your plan
With the ratio, you can estimate how much income you may need for a comfortable retirement and how much money you need to save to supplement your expected sources of income - which may be some combination of Social Security, pension benefits, personal investments and post-retirement employment. If these income sources fall short of your goal, you can increase your rate of saving or take other actions to close the projected deficit, such as planning to reduce living expenses or moving to a lower-cost locale in retirement.
What research tells us
One recent study from the Employee Benefit Research Institutefound that many people may need between 60 percent and 80 percent of their final working years income to maintain their lifestyle after retiring - and long-term commitment to an employer-sponsored retirement plan is key to meeting that goal.
Why dont retirees need 100 percent of their working income? Lower taxes may be one reason. When a person is no longer employed, there are no Social Security payroll taxes to pay. Federal income taxes are usually lower because Social Security benefits are either partially or fully tax free for many retirees, and extra deductions are available for people over age 65. In addition, many people no longer need to save for retirement, and those who have paid off debts before retiring or eliminated work-related expenses, such as commuting costs, also have a greater share of their income available for spending.
However, one increasingly important unknown is the rising cost of medical care. Already, medical care has been taking a bigger bite out of retiree budgets as health care expenses have risen; some employers have reduced or eliminated medical coverage for retired employees; and life expectancy has lengthened. In addition, retirees have faced higher contributions for Medicare benefits and increased premiums for Medicare supplemental insurance policies.
The outlook for future retirees
While recent retirees and those nearing retirement may have adequate replacement income, the situation may not be so favorable in the future. For instance, the increasing financial strains on Social Security caused by the nations aging population may lead Congress to alter the system at some point in the future, perhaps reducing Social Security benefits or increasing the age of eligibility. As a result of these trends, future retirees may have to rely more on income from personal savings and investments than todays retirees.