While Income Replacement Ratio may sound technical and complicated finance jargon, it’s really quite simple. The end goal of any retirement plan is to accumulate enough money to replace the income from a job at retirement. The amount needed is calculated using an income replacement ratio. An income replacement ratio is a projection of the annual income a retiree will need in retirement; and so it should be a leading benchmark for plan sponsors to measure participant savings progress.
An Income Replacement Ratio is a calculation of a person’s (after retirement) gross income divided by his or her gross income before retirement. For example, assume someone earns $60,000 per year before retirement. Then, assume he or she retires and receives $45,000 of Social Security and other retirement income. This person’s replacement ratio is 75 percent ($45,000/$60,000). Put another way, this person should plan to have 75% of their working salary available annually at retirement.
The income replacement ratio varies from person-to-person, however 75%-80% is quite reasonable to assume.
Typically, a person needs less gross income after retiring, primarily due to several factors:
- Income taxes go down after retirement. This is because extra deductions are available for those over age 65, and taxable income usually decreases at retirement.
- Social Security taxes (FICA deductions from wages) end completely at retirement.
- Social Security benefits are partially or fully tax free. This reduces taxable income and, therefore, the amount of income needed to pay taxes.
- Other forms of retirement income, like pensions, are often are exempt from taxation by states
- Saving for retirement is no longer needed.
The calculation above is quite simplistic. For more advanced calculations, plan sponsors may wish to consult with their advisors to see if their record keepers can provide advanced intelligence for benchmarking a participant’s progress towards the optimal ratio. The record keeper should be able to provide projections on future account balances based on historical performance for the participant’s investment profile.
Once a benchmark has been established, sponsors can then assist participants in understanding ratios, staying on track with savings goals and achieving optimal balances.
