Wage Replacement Ratio

Defining and Planning for Income Replacement in Retirement

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Learn how to use wage replacement ratio for retirement planning. Getty Images

If you want to know how much money you'll need to save for retirement, you'll need to start with a general estimate of the annual income you can live on in your retirement years.

Wage Replacement Ratio Definition

The wage replacement ratio, also known as income replacement ratio, generally refers to the percentage of pre-retirement income needed in retirement. For example, if an investor's pre-retirement income is $100,000 and the investor assumes an 80% wage replacement ratio will be sufficient for retirement income, the investor will need to plan for $80,000 income need in year one of retirement.

This knowledge can then also help with determining an appropriate asset allocation and the types of mutual funds to buy to reach the goals.

Getting Started With Income Replacement Planning

Although it has its flaws, the wage replacement ratio can be a good planning tool for estimating retirement income needs. General "rules of thumb" don't work for everyone but if you are planning and your goal is to retire 20 years from now, you need to make some realistic assumptions and do just a bit of math before deciding on savings rates, asset allocation, and investment selection.

Another general guideline for retirement income is the 4% rule, which suggests a good beginning withdrawal rate for the first year of retirement is 4% of total retirement assets.

Now you're ready for some math. To make things simple, let's assume you are 20 years from retirement now and you can live on a current gross income of $50,000.

Using the rule of 72, which says that you can divide 72 by an expected rate of return and arrive at the number of years to double your savings, you can also figure a retirement income need this way.

Keeping things simple, let's assume a 3.5% inflation rate, which is a bit higher than average. If you divide 72 by 3.5, you get approximately 20.

This tells you that your $50,000 income need in today's dollars will double to $100,000 in 20 years. Now, assuming a 20-year time frame to retirement, factor in the 80% wage replacement ratio and you arrive at a first-year retirement income need of $80,000.

Using the 4% rule, you can divide your income need (80,000) by .04 and you arrive at $2 million. Now all you need to do is figure out how to get to $2 million from where you are today! That math is a bit more complicated. I can tell you now that if you have not saved anything at all and you need $2 million in 20 years, you would need to save around $3,400 per month and your investments would need to average an 8.00% rate of return to get there. But if you have $200,000 saved to date, you would only need to save around $1,100 per month under the same assumptions.

Keep in mind that the wage replacement ratio and the 4% rule are simple but useful estimates. Therefore, in general, the further from your retirement date, the less accurate your estimate is like to be. This is why financial planning is an ongoing process. You can make adjustments as you get closer to your retirement date.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.