Income Replacement Ratios
An income replacement ratio (IRR) is the percentage of estimated pre-retirement income that you will need to maintain your desired lifestyle after you stop working. This projection must cover various household expenses, such as food, shelter, and transportation, as well other variables, including health care costs and discretionary income.
The most widely used estimate of income replacement ratios is between 75-85% of pre-retirement income, but 80% has pretty much emerged as the accepted norm. This means that if you were earning $100,000 before you stopped working (and were living comfortably), you would need $80,000 per year after retirement to maintain that standard of living. This calculation provides retirement planning professionals with a baseline that helps create the foundation for an investment portfolio to supplement your annual earnings.
A standard 80% IRR assumes that pre-retirement income and expenses can be used to predict what you will need during retirement. The theory is that while income may change, your basic living expenses – such as housing, transportation, food, clothing, taxes, and health care – don’t go away, so the methodology does seem logical.
Unfortunately, all expense projections are not that simple. As the data will show, health care expenditures before and during retirement are, in fact, very different.
According to HealthView data, employees pay between 25% and 30% of group insurance premiums, while employers subsidize the rest.
In order to maintain a similar level of coverage that you enjoyed while working, you must sign up for Medicare Parts A, B and D, and purchase a supplemental policy, most of which have premiums and copays.
Here’s the problem:
Standard IRRs use that same employee-contribution percentage in their calculations, but after retirement, you are likely responsible for almost 100% of your health care costs. Since IRRs only include a portion of this expense, you could face a substantial shortfall because your medical-related expenditures will outpace what you have factored into your retirement budget.
Another reason current IRRs may be inefficient is that the calculation relies on the general inflation rate (usually between 2.5 and 3%). HealthView projects retirement health care inflation to grow at an average of around 5.5% for the near future.
Ultimately, the disparity between the health care inflation rate in current IRRs and the actual projected Medicare Part B and D inflation rates could, over time, create a significant shortfall in your retirement savings.
EXAMPLE OF INFLATION DIFFERENTIAL IN IRRs OVER TIME
You are probably aware of the benefits of compounding interest. Unfortunately, this concept can work the same in reverse. If health care inflation rates are underestimated by around 3% annually – as the majority of IRRs do – future premiums will compound like a high-interest-rate credit card and expand medical costs beyond what you may have allocated in your budget.
INCOME REPLACEMENT RATIOS AND LIFE EXPECTANCY
IRRs also do not account for longevity. Simply put: living longer will result in higher health care costs, and consequently, more savings needed to fund them. This discrepancy has not been factored into IRRS and may contribute to higher long-term health care costs.
To illustrate, a 55-year-old male with an average life expectancy of 86 who lives to age 88 will be responsible for an additional $69,627 in health care costs that are not included in current IRR-based calculations.
SOLUTIONS TO THE INCOME REPLACEMENT RATIO DEFICIT
The good news is that if you have invested in an IRR-based plan, you will be better positioned to address retirement health care expenses than someone who has not saved at all.
In fact, the additional savings needed to close the health care savings gap can be quite modest (depending on age and current income). Boosting 401(k)/Roth 401(k) contributions and benefiting from company matching; investing in a health savings account (HSA); annuities; life insurance; IRAs, and a Roth are the best strategies to supplement your retirement income and reduce the impact of unplanned medical expenses.