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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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