3 Approaches to Income-Replacement Ratios in Retirement

A Clear Target
Yesterday's column suggested--courtesy of a paper entitled "American Workers' Retirement Income Security Prospects: A Critique of Recent Assessments (AWR)"--that retirees need less income than is generally believed. Typical advice is to plan for replacing 80% to 85% of preretirement income during the retirement period. That may be too much. In saving for such an amount, investors may be accepting an unnecessarily low lifestyle during their working years.

The key word being "unnecessarily." There's nothing wrong with living better during retirement than while working. That is a personal choice; there's no preferred path for consumption spending. However, the decision should be consciously made, rather than accidentally and, later, with regret.

Morningstar's Jason Stipp writes, "Just do a quick back-of-the-envelope calculation. Imagine you are saving 15% for retirement, another 15% goes to the mortgage, 5% to a 529 plan, and then another 10% for child care. Those are all expenses you can aim to not have by retirement. You're living on 55% of income--not even in the ballpark of the 80% to 85% income-replacement estimates, or worse, the 100% rates that some retirement tools use as their default."

That's the spirit, Jason. Our hypothetical investor probably isn't socking away 15% for retirement while saving for college expenses and funding child care, but then again, some of those other expenses could be higher.

Jason continues, "Now if you want to have a lavish retirement, that's a different story. But I also think people should consider if they want to be 85 and sitting on a giant cash pile, having sacrificed unnecessarily their whole lives. It's a balance. Dying with too much is not an optimal outcome, either--except for the financial-services industry."

Another reader writes, "The right income-replacement ratio is highly dependent on a lot of factors, in particular one's income level. If anywhere the 'one-size-fits-all' label doesn't apply, it's surely here. I know that in my case as a fairly affluent retiree, I am able to live on a higher standard of living on less than a 50% replacement ratio, due to the absence of the cost of funding retirement savings, the elimination of children's expenses (although not quite as much as planned!), and tax reductions (elimination of Social Security/Medicare tax, dividends/capital gains taxed less than ordinary income, etc.)."

It's fruitless to seek the correct income-replacement ratio, as individual circumstances vary broadly. However, one can seek a reasonable starting point. The AWR paper offers three such attempts. While each is calculated and displayed differently, the upshot is broadly similar. Low earners tend to have income-replacement ratios from 70% to 80%, while high earners are mostly from 60% to 70% (with a few lower estimates). 

The first study, by John Karl Scholz and Ananth Seshadri, removes the estimated costs associated with raising children and work-related expenses from the retiree's ledger and credits the retiree's lower tax burden. It calculates income-replacement ratios as a percentage of average lifetime wages and as a percentage of the five to nine years before retirement (which are presumed to be the highest-earning years, although that is not always so). Results are given over various income levels.

Setting aside the lowest-earning 30% of workers, the picture is consistent: The income-replacement ratio rises with income when averaged over the lifetime working years, and it declines with income when averaged over the later period. That occurs because higher-income workers substantially grow their wages over time, while lower- and middle-income workers do not. The pattern is a clear warning about creating a single income-replacement rule across a broad salary spectrum.

The Center for Retirement Research shows higher required income-replacement ratios because the Center credits workers for unearned income, such as 401(k) or other investment profits, and for "imputed rent from housing (net of interest paid on mortgage debt)." As these are not consumable items, it's not clear to me (or to AWR's authors) why they should count as preretirement income that needs to be replaced.

Even with that conservative feature, though, the Center's estimates are moderately lower than the rule of thumb, landing mostly at 70% to 75%. Again, wealthier workers have the lowest income-replacement ratios.

Finally, AWR's authors offer their own estimates. I've included only their results for retirement at age 65, but they also give targeted replacement-income ratios for those who wish to retire at ages 55 and 60. The good news is that the ratios are quite modest. The bad news is that to retire at such a young age while maintaining the same lifestyle, one must save a great deal while working--which means that consumable income is also modest. In short, the income-replacement target is low because the standard of living was sacrificed during the working years. 

Some read yesterday's column as being advice. It was not. I do not recommend an income-replacement ratio of less than 85%. Nor do I recommend 85% itself, or any figure about 85%. My goal is accomplished if people think twice when hearing the term "retirement crisis" and three times (at least) when thinking about their own financial futures.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.