Retirement Income - Replacement
Ratios
Many financial advisors suggest that you need at least
70% of your pre-retirement income in retirement. This is based
on Aon and Georgia State analysis of retiree spending habits. The
1997 survey had an average replacement ratio of 70%. Since 1997
there has been a shift in tax policies and spending habits (e.g., medical
expenses) in addition to other issues that have shifted the replacement
higher than 70% (closer to 80% for the average American). Based
on their 2004 study, they calculated the following replacement ratios:
Pre-Retirement Income |
Replacement Ratio |
$20,000 |
89% |
$40,000 |
80% |
$60,000 |
75% |
$80,000 |
77% |
$150,000 |
85% |
$200,000 |
88% |
There
studies have shown that you need less than 100% of your pre-retirement
income for many reasons including:
- FICA (Social Security and Medicare) taxes do not apply to retirement
income
- Savings for retirement has stopped
- Certain work expenses have decreased (some transportation,
food and clothing costs) while other expenses have increased such as
vacation and entertainment (e.g., golf costs)
- Federal & State taxes are typically less
- Additional deduction for being age 65 or older
- Post-tax savings has already been taxed
(other than capital gains and interest income)
- Social Security income is not taxable if your income is below
a specified limit
- Some states like Florida do not have
income taxes
However, because your specific situation may be different (e.g., have
a higher pre-retirement savings rate or more income coming from a 401(k)
accounts which are taxable), one should calculate the exact amount
that they will need as they get closer to retirement. One person
may need less than 70%, if they were saving 20% before retirement and
move to a state with low state taxes, while someone else may
need (want) 90% or more, if they want to take extra vacations and want
to help their grandchildren's college fund.
So how does one know how much they need to save for retirement?
The first step is to know how much you are going to get from Social
Security and your company's pension plan (if your company has one). With
Congress discussing changes to Social Security, this is not an
exact science. Below is an estimate of the current benefit
(for someone currently retiring at their Social Security retirement
age) for a single retiree assuming a full working lifetime with stable
earnings. If
you take the benefit earlier (or later), the replacement ratio will be
less (or more). If married, the spouse would get the larger of his/her
Social Security benefit (based on his/her earnings or 50% of the retiree's
benefit)
at
his/her Social Security retirement age.
Pre-Retirement Income |
Social Security Replacement %
|
Aon's Study |
Difference for Single Retiree |
Difference for Married Retiree
(spouse gets 50% of retiree's Social Security) |
$20,000 |
52%
|
89%
|
37%
|
11% |
$40,000 |
41%
|
80%
|
39%
|
19% |
$60,000 |
34%
|
75%
|
41%
|
24% |
$80,000 |
28%
|
77%
|
49%
|
35% |
$150,000 |
16%
|
85%
|
69%
|
61% |
$200,000 |
12%
|
88%
|
76%
|
70% |
The more that you earn, the more you will need
to save because the smaller benefit you will get
from Social
Security. In
addition, due to changes coming from Congress, the benefits
from Social Security will probably be reduced especially for younger
workers. The
reductions will probably have a smaller (if any) effect on older
and lower
income Americans while have a larger effect on younger and higher
income Americans.
In the last two columns of the table above, is
the difference between the replacement ratio based
on the Aon and
Georgia
State
study and the Social Security benefit (as shown in the last
two columns in table above). This is one measure of what
the retirees should be saving towards. For example, a retiree
and spouse (who did not work) who
make $60,000
a year would
need to
save enough to replace 24% of their income ( 75% - 34% - 34% * 50%
= 24%). While a retiree and spouse (who did not work) who made
$150,000 a year would need to save enough to replace 61% of their
income (85% - 16% - 16% * 50% = 61%).
Some of this money can may come from your company's pension plan,
if your company has one. You can request an estimate of
this benefit from your employer or it is sometimes provided in
an annual benefit
summary statement.
The rest of the money will need to come from your savings (including
401(k) accounts). Most
financial advisors suggest saving at least 10%. Yet, as you can
see from the information above, each situation will be different (e.g.,
based
on how much you
make, if
you are married or single, etc.). It
is also dependent on when you start saving for retirement and when you
retire. For
example, based on the following assumptions:
you can replace x% of your income by saving 1% of your
income each year .
| |
Start Contribution At |
| Retire at: |
Age 25 |
Age 35 |
Age 45 |
| Age 55 |
2.3% |
1.2% |
0.5% |
| Age 60 |
3.0% |
1.7% |
0.8% |
| Age 65 |
3.8% |
2.3% |
1.2% |
| Age 70 |
4.8% |
3.0% |
1.7% |
For example, someone saving 1% from age 35 to age 65 would replace
2.3% of their income in retirement. So for the married couple
making $60,000 who needed to replace approximately 24%
of their
income
at
retirement
(from
the
example
above), they would need to save approximately
10.4% of their income each year from age 35 to
retirement at age 65 (24% / 2.3% = 10.4%). While
the other couple who are making $150,000 and needed to replace
61% of their income
at retirement need to save approximately 26.5% of their income
from age 35 to retirement at age 65 (61% / 2.3% = 26.5%) assuming
that they do not have a company pension plan.
So, the 10% saving rule of thumb for retirement is a myth. For
the average American couple making $60,000 who starts saving at age
35, the
10% may
be reasonable. However, for those who start saving later in life
or have higher incomes, a larger savings rate may be required. For
younger workers, they may need to save more than 10% if Social Security
benefits are reduced.
Note, you should be counting your employer's contribution
in your 401(k) plan towards your savings rate. If a company
has a 401(k) match, the company contribution gets counted
towards savings goal. For the 10.4% savings target shown
above, a 7.4% employee contribution with a 3% company match (e.g.,
50% match of the first 6% of contributions) would get
a 10.4% savings target as well. Thus, you can see that each
situation will be different, and this is why it is important to avoid
using generic
advise
such
as saving 10% for retirement.
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