When you retire, you will still need an income. That much is clear. But the big question on people’s minds is how much will be needed to fund retirement years? What will your income have to be to maintain your desired standard of living? In order to think through this question clearly, financial planners and economists use something called an “income replacement ratio.”
The concept of income replacement ratios is simple, and may already be familiar to you if you have a retirement plan or are participating in a 401(k). An income replacement ratio is a retiree’s income viewed as a percentage of his or her income before retirement.
Income replacement ratios are widely used as a planning rule of thumb because they provide a comprehensive “top-down” perspective on cost-of-living expenses, many of which will continue into retirement. In fact, as more and more Americans enter retirement with mortgages or other household debt, the reality is that retirement expenses will increasingly look like those when working.
Today, most financial advisors, as well plan advisor or plan sponsor retirement planning calculators, use these ratios to provide clients and plan participants with an idea of how much they will need to save to generate the income they will need in retirement.
There has been a significant amount of research into income replacement ratios with the goal of understanding what percentage of pre-retirement income will be needed to fund retirement. Based on this research, the consensus is that replacement ratios should be in the range of 75% to 85% of pre-retirement income.
The way pre-retirement income replacement ratios are determined is to inflate income by 2.5% to 3% (to account for underlying inflation) annually up to retirement age, and then use this figure to calculate anywhere between 75% and 85% of the final pre-retirement income level.
These ratios may sound high, but it is important to understand that they include expected taxes in retirement and are designed to account for inflation over the period of retirement, along with average returns on the diminishing asset portfolio used to generate income. When accounting for both factors, 75% to 85% of pre-retirement income starts to make a lot of sense.
Income replacement ratios do include a good portion of future health care costs. Why? Because pre-retirees typically pay 25% to 30% of group health insurance premiums and 100% of other out-of-pocket expenses, all of which are included within the pre-retirement income calculation.
But here’s the problem. Income replacement ratios generally do not take into account that health care inflation is rising at more than double the underlying inflation rate, as well as the fact that retirees will have to cover more out-of-pocket expenses in retirement and additional costs as life expectancy increases. And for wealthy individuals, the assumptions underpinning income replacement ratios do not include the impact of Medicare surcharges.
Driven by inflation and increased cost sharing, health care costs – once a manageable line item – are on track to take up an increasing portion of retirement budgets. So using an income ratio that does not include actual projected health care costs means that many retirees will face additional expenses they had not planned for.
This is not simply an academic point. Millions of Americans are currently using tools based on assumptions that are underestimating the cost-of-living in retirement, but not including actual expected health care costs.
The key question is “what is the likely shortfall when actual retirement health care costs are built into planning?” Based on our preliminary data, while in total dollar terms the gap is significant, the additional contributions to make up this difference are quite manageable – particularly for plan participants who benefit from company matches.
So what are the takeaways? The first is that although millions of Americans and plan sponsors are relying on them to help plan participants achieve retirement security, income replacement ratios (IRRs) only cover a portion of one of the most significant costs in retirement: health care. The second is that individuals will have to save more to cover these costs if they want to maintain their desired standard of living. Based on our data, the good news is that plan participants or advisor clients using IRRs don’t have to save much more. In some cases, only $100 a month in pre-retirement savings may be enough to close this gap.
The questions surrounding income replacement ratios are so important that we are working on a detailed analysis – based on our data – to provide estimates of the size of this savings gap and what will be needed to close it. The results will be presented in an upcoming HealthView Insights paper, so keep your eyes peeled.