Calculating a Retirement Income Replacement Ratio

If you are like many not-yet-retired baby boomers, you want to know what percentage of your pre-retirement income you will need when you are retired. Some financial writers call this the “retirement income replacement ratio.” My advice? Do not use a percentage or ratio for this calculation. Let me explain.

There are many “rules of thumb” in personal finance. Lots of them are actually rules of “dumb.” The retirement income replacement rate or ratio is one of them.

In this article from CNN/Money, a reader asks what percentage of his income he should be saving for retirement. The writer – a well known personal finance pundit – refers the reader to this “What You Need to Save” calculator. This simple retirement planning tool contains only three inputs: your age, current income, and existing retirement savings. How can this tool accurately tell you how much you need to save, you ask? It can’t.

If you look in the calculator footnotes when the result is displayed, you read that the calculation assumes that Social Security and income from your savings will replace 80% of your pre-retirement salary. This 80% number is seen often in discussions of retirement income replacement ratios. Another “rule of thumb” that is frequently cited is that to maintain your current lifestyle in retirement, your income replacement rate should be 70%. Other writers go higher, even to 100%.

In my view, the concept of using an income replacement ratio for retirement planning  is flawed. Other experts (not that I’m claiming to be an expert) agree with me.

In a recent paper published by the University of Michigan Retirement Research Center, the authors addressed the question of “What Replacement Rates Should Households Use?”  According to their research:

The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed.  In fact, no more than 15% of the population needed to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.

Replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families.

That data is quite a departure from a fixed percentage replacement ratio “rule of thumb.”

In this MarketWatch article on retirement plan building, Robert Powell discusses the study and quotes another well-known finance professor:

“The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard,” said Larry Kotlikoff, a Boston University professor.

“Rules of thumb are, quite simply, rules of dumb,” he said. “Their use violates the financial planner’s Hippocratic oath: First do no harm.”

Kotlikoff is well-known for economics-based financial planning based on consumption smoothing.

So what should we do to determine how much of our pre-retirement income we will need in retirement? My recommendation is to prepare a real world retirement spending plan. Base it on what you spend now and on what you anticipate your expenditures will be when you retire. That number is what your estimated income needs will be. A little time on a spreadsheet goes a long way and gives you much more accurate data than using an income replacement rate.

That’s exactly what I did to generate my retirement income plan using the Failsafe Retirement System.

So skip the rules of thumb. Go right to the data, your data. Otherwise, you could end up over-saving or under-saving for your retirement.


  1. says

    Absolutely! Thumbrules are for thumbs. The only way you’ll have any true knowledge of your retirement income needs is by creating a retirement budget. Of course, it’s like pulling teeth to get people to work on a current budget, let alone a budget projection, but it does need to be done.

  2. Randy says

    My quick and dirty method: if you are a fortunate boomer currently in your peak earning years, with little or no debt (home is paid for or nearly so), and a good rate of saving, you would not need nearly as high an income during retirement as many so-called experts claim. First, deduct all of the income (and associated income taxes being paid on it) required to make the house payment and fund your saving rate. Next, deduct the income to be replaced by social security. Then be sure to add in more money for health care insurance premiums and additional vacations, and don’t forget the impact of inflation.

  3. Kevin says

    Duh! If I would have any reasonable estimate of my retirement needs, it is pretty easy to figure out how much in need in retirement. If I would have only know 15 years in advance of the Tech bubble bursting and the Real Estate bubble bursting, I could have planned ahead. If I would have only known 10 – 15 years before my wife would need a major surgery that wasn’t completely covered by insurance, I would have saved more money. Stupid article in my opinion. I am so glad the author has a crystal ball and can tell what is going to happen in the future. Maybe they could share it so everyone will know?

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