What Is the Wage Replacement Ratio?

How to Calculate the Wage Replacement Ratio

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The wage replacement ratio is an annual estimate of how much money you'll need during your retirement years and how much you'll need to save to reach that goal. Each individual's circumstances are unique, but this method can help determine if you're far off course.

Learn how the wage replacement ratio works and why it pays to start saving early.

What Is the Wage Replacement Ratio?

The wage replacement ratio generally refers to the percentage of pre-retirement income needed in retirement. 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 your goal is to retire in 20 years, you need to make some realistic assumptions and do a bit of math before deciding on savings rates, asset allocation, and an investment plan.

The annual income is usually increased every year by the rate of inflation. This knowledge will also help determine an appropriate asset allocation and the types of mutual funds that can help you reach the goals before and during retirement.

  • Alternate name: Income replacement ratio

How Do You Calculate the Wage Replacement Ratio?

If an investor's pre-retirement income is $100,000 and the investor assumes the standard 80% wage replacement ratio, the investor must plan to need $80,000 income in year one of retirement.

Wage Replacement Ratio Equation

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.

How the Wage Replacement Ratio Works

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 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 the retirement income you'll need.

Keeping things simple, let's assume a 3.5% inflation rate, which is a bit higher than the historical 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.

If you have not saved anything at all and 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% 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 with the same assumption of an 8% average rate of return.

Limitations of the Wage Replacement Ratio

The further from your retirement date, the less accurate your wage replacement estimate is likely to be. Still, the earlier you start calculating it and investing, the lower the interest rate you may need to achieve your wage replacement goal.

Key Takeaways

  • The wage replacement ratio is a retirement planning tool that calculates how much money you will need each year once you stop working.
  • Start planning early enough and you will have the best chance of choosing the asset allocations that allow you to reach your target goal.
  • The ratio is not a guarantee because the economy can take many different turns and requirements can change.