What is income replacement ratio and how useful is it for retirement planning?
Income replacement ratio is a thumb rule to help you estimate this income. Simply, it is the percentage of the pre-retirement income that you are likely to need to maintain a similar standard of life in retirement.
The key element in retirement planning is to determine the income required to meet expenses later. Once this is known, then you can estimate the corpus you need to build. Income replacement ratio is a thumb rule to help you estimate this income. Simply, it is the percentage of the pre-retirement income that you are likely to need to maintain a similar standard of life in retirement.
By this rule of thumb you will need 70% to 80% of pre-retirement income to meet your expenses. But like all thumb rules, this too needs to be used judiciously.
The reason why only a portion of your pre-retirement income is adequate in retirement is because some of the expenses that were incurred during the course of employment or earning an income, such as commuting costs and work-related expenses, will no longer be relevant. Also, many of the goals for which savings were made, including retirement, will not be a charge on the income anymore. Similarly, some of the loans that you were servicing may now be closed and taxes will be lower too as income levels will be lower. All this translates into lower income required to meet expenses.
But there are other expenses you may incur in retirement that may not have formed a significant portion of your pre-retirement years. For example, health costs are likely to be higher in retirement. Also, in early retirement years, the expenses on travel and leisure are likely to be higher than it was when you were employed. Consider your specific preferences and situation while deciding on an appropriate income replacement ratio.
Refine the estimate
Income replacement ratio is a good starting point to plan when you are young and retirement is decades away. You are unlikely to have a very clear idea of the expenses in retirement, but this is no reason to not save and build the corpus from the beginning to benefit from compounding returns. Estimate what your pre-retirement income based on your current income, a realistic annual increment rate and the years to retirement. About 70-80% of this income is what you will target as the income you need from your retirement corpus. Now you have a goal to work towards.
Stay with this till you have greater clarity on how you would like to lead your retirement. Say, if you see yourself travelling extensively or giving generously to charity or you anticipate health complications or other family commitments, then you may find that 70-80% may not be adequate and you should revise the percentage accordingly. Or, if you find yourself leaning towards a low-key retirement then you can stay with a low percentage. Do this every time there is an event that is likely to have a significant impact on your expenses in retirement.
Revising the ratio and your savings target will ensure that you are on track to meet your retirement goals.
As your retirement comes closer you need to get more specific about the retirement expenses. You will now be able to build a budget that will accurately reflect your needs in retirement. The corpus has to be adjusted accordingly. Do this at least 10-15 years before retirement so that you have adequate time to recalibrate the corpus.
Income replacement ratio is a useful tool to get you started on retirement planning. It is simple to understand and execute. But remember to refine the ratio as you have greater clarity and to move to the more robust method of listing all your expenses to estimate the required retirement income to make the transition into retirement smooth.
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