How to Determine the Right "Replacement Ratio"
A key component of any retirement plan is the replacement ratio, which is the percent of your pre-retirement income that will need to be replaced in retirement. While there are general rules that can help you determine the right replacement ratio, additional factors that are specific to your individual retirement plan will better determine the replacement ratio that is right for you. Thus, you should spend some time planning out your desired retirement lifestyle early to make sure you have enough money to do it. The sooner you start preparing for retirement, the more time you’ll have to reach your goals.
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Determine Your Pre-Retirement Income
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The replacement ratio is typically based off your earnings immediately preceding retirement. This works because most people on a career track can calculate what their final earnings will be early on. Additionally, using your pre-retirement income from the year before retirement also helps account for lifestyle changes associated with increased earnings. However, if you anticipate that your income will be more variable as you approach retirement, you may choose to calculate your average income for the five years preceding retirement.
Apply the 70 Percent Rule
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Although there is no single rule that can accurately measure the right replacement ratio for everyone, the 70 percent rule is nonetheless used as a good rule of thumb for approximating your replacement ratio. The 70 percent rule holds that you should replace roughly 70 percent of your income immediately preceding retirement. Thus, if you were making $50,000 the year you retire, you should look to provide yourself with at least $35,000 per year in retirement. Since no single rule works for everyone, you need to consider your individual circumstances.
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Account For Changes In Your Expenses
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When you retire, your expenses will change and you need to account for these changes when calculating your replacement ratio. Some common variables you need to take into account when determining your replacement ratio are: tax expenses (decrease), savings expenses (decrease), housing costs (decrease), education expenses (decrease), clothing expenses (decrease), transportation expenses (decrease), health care costs (increase), utilities (increase), entertainment (increase).
Mathematical Approach
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After you have an idea of what expenses you will need to cover when you retire, you can use math to determine what replacement ratio is right for you. A basic formula to calculate your replacement ratio:
Replacement Ratio = Gross pre-retirement income (less) pre-retirement taxes (plus/minus) any change in expenses (plus) post-retirement taxes (divided by) gross pre-retirement income.
Use a Range of Estimates
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Don’t worry if you cannot precisely quantify all of your expenses; you can calculate your replacement ratio using a range of variables to give you an idea of your minimum and maximum replacement ratio. It is always better to err to the more conservative number; you don’t get penalized for saving too much for retirement. If you are uncertain about what replacement ratio is right for you, schedule an appointment with a qualified financial advisor who can better assess your overall situation and work with you to reach your retirement goals.
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