Income replacement rate

Income replacement rates provide a simplified method to estimate income needs in retirement. The gross (pre-tax) income needed in retirement is calculated as:

Gross Income (retired)   =  Gross Income (pre-retirement)  ×  Replacement Rate

Pre-retirement gross income is often the value received just before retirement. This might be for the year immediately preceding retirement, or for an average of a limited number of years prior to retirement (e.g. 5 years).

In such models, calculations relate to gross income, not actual consumption: it is assumed that if a certain percentage of pre-retirement gross income can be replaced, then the retiree will be able to maintain his/her standard of living.

The targeted replacement rate is typically less than 100% because many expenses can disappear after retirement (mortgage payments, children-related expenses, work-related expenses, payroll deductions, etc.). The tricky part is deciding on a proper replacement rate.

The 70% rule of thumb

A 70% total replacement rate (from all sources of retirement income, including government transfers (CPP/QPP and OAS/GIS) is the typical value used by financial planners, actuaries and pension funds to approximately maintain the standard of living of the retiree. It is seen as a rule of thumb.

The 70% replacement rate approach is not without its critics. MacDonald et al. (2016) writes that “the conventional final earnings replacement rate measure has little predictive value for living standards continuity between working-life and retirement”. There are many factors at play (household size, home ownership status, income level), meaning that a single replacement rate cannot apply to everyone. For many Canadians with middle to high incomes, the 70% rate will often be too high, as shown in the next section. For low income people, replacing 70% could be too low to maintain their standard of living during retirement.

Middle to high incomes

Actuary Malcolm Hamilton writes that "most Canadians retire with closer to 50% replacement. Most say that their quality of life is as good or better after retirement". He thinks that an income replacement rate of 50% "would preserve the standard of living of the average family of 4 because a large percentage of their pre retirement income (often 40% to 50%) is consumed by kids, mortgages and taxes". Hamilton also mentions targets of 50-60% in a MoneySense interview. In a 2015 C.D. Howe report, he writes that if "the post-retirement standard of living to which Canadians aspire need not be the peak standard of living momentarily enjoyed at the end of their working lives, the replacement and savings targets become much smaller".

Replacing only 50% might seem very low, but Vettese (2016) provides detailed explanations of why this is correct for homeowners with children, and middle to high incomes. Basically, such households do not spend that much on personal consumption during their working lives, because of significant other expenses like:

• Children-related expenditures
• Saving, especially for retirement
• Mortgage payments
• Employment expenses
• Income tax

He shows the case of a hypothetical couple, Steve and Ashley 2.0 (2.0 because there is an earlier version of the same example in the chapter), with a combined gross income of $90k, and two children born during their early- to mid-thirties. They eliminate their mortgage at age 57 and want to retire at 65. Until that mortgage is extinguished, mortgage payments will be more than 20% of gross income in the example. Child-related costs might be over 20% in some years too. When retirement saving, income taxes and employment costs are also taken into account, there remains well under 40% of their gross income for personal consumption until their early 50s. Only during the last few years before retirement does personal consumption reach 48% of gross income. Steve and Ashley would therefore have a retirement income target of about 52% for gross final pay, where the extra 4% is added to cover income taxes after retirement.

Vettese then goes on to suggest the following rule of thumb-type replacement rates for couples with middle to high incomes:

• At least one child, paying a mortgage: 50%
• At least one child, but renting: 60%
• No children, paying a mortgage: 60%
• No children, renting: 70%

The Horner (2009) study, discussed in detail in Savings rate, has a similar take on replacement rates being often lower than 70% to maintain consumption after retirement.

Low incomes

People in the lower 20-30% of the population in terms of income would have income replacement targets over 70%.

However, much -- if not all -- of their retirement income will likely be supplied by government programs (OAS, CPP/QPP and GIS).

Replacement rates and savings rates

Your savings rate is the proportion of your gross employment income you put away every year to prepare for retirement. There are two ways to conceptualize the relationship between income replacement rates and savings rates.

A commonly employed method (e.g., ) is to assume, without testing it, that a certain income replacement rate, often 70%, is the one that will allow preservation of living standards during retirement. A savings rate is then calculated that will allow this replacement rate to be attained. The higher the desired replacement rate, the higher the required savings rate. Critics see this approach as flawed.

Other authors (e.g., ) recognize that high savings rates have the effect of depressing consumption during work years. If you are saving so much, your living standard is lower during your working years, which lowers the required replacement rate. The idea is to adjust consumption and saving in such a way that the living standard of the retiree is maintained. The income replacement rate is then an output of the calculations, not an input.

Alternative methods

A much more personalized estimate of how much income you will need after retirement can be obtained by preparing a detailed retirement budget. This will be easier to do closer to retirement than several decades ahead.

See also

• Retirement budget models
• Introduction to retirement spending models (Bogleheads wiki)

Further reading

• *Financial Wisdom Forum topic: "Income replacement ratio"