Retirement Replacement Ratio
Ask most how much they’re going to spend in retirement, and they have no idea.
But to plan for retirement adequately, you need to have some sense of what your spending needs are going to be.
Just like everything else in finance, the answer to how much you will spend in retirement is “it depends.”
Most of us want the same standard of living in retirement that we had when we were working. But the standard of living and the cost of living aren’t necessarily the same.
You should pay less in tax, and you won’t have to pay National Insurance, once you have stopped work, so your gross income will go further. That’s not the only difference – it seems that retirement changes everything, including how you determine your budget.
A frequently used approach to work out how much income you’ll need in retirement is the “replacement ratio.”
The retirement replacement ratio is found by taking your earnings immediately before retirement and calculating what percentage of that income you think you’ll spend every year in retirement. The amount you expect to spend is the amount you’ll need to replace.
The received wisdom in the UK is that your replacement ratio will be somewhere between 50% and 66%.
This expected retirement replacement ratio is based on the design of defined benefit pension schemes which were intended to provide this amount of income, based on a 40-year working life. But these schemes were designed 50 years ago when life was very different! A more personal approach is appropriate nowadays.
Indeed, replacement ratios are inversely related to pre-retirement income.
The higher your income before retirement, the lower your replacement ratio. Essentially, that’s because higher earners tend to save more for retirement, pay more tax and have higher work-related expenses.
Most people end up needing less income in retirement than they did while working, because:
-You don’t need to save for retirement;
-You don’t have work-related expenses (commuting, clothes for work, eating out for lunch);
-You won’t pay National Insurance
-You don’t much pay as much tax – because you will draw on more tax-efficient investments like ISAs and pensions, and also your taxable income will be lower.
While a lot of expenses will go down, some, like travel and other leisure activities, will go up. Depending on what you enjoy doing, this can end up being a significant portion of your budget in retirement.
If you want to work out a realistic spending rate in retirement, look closely at your financial situation and your desired lifestyle.
If you’re going to spend a month travelling in South America every year, you’ll want to budget for a higher spending rate than if you spend a few days in a B&B on the Isle of Wight.
The retirement replacement ratio is a good starting point to help you to save for retirement and the further away you are from retirement, the more useful this is.
As retirement approaches, a more personal and scientific method becomes necessary.
A good alternative approach is to make two lists — one list of the things you want to accomplish in retirement; and another of the things you are afraid of in retirement. Those two lists will put you on the path to working out how much you will need every year in retirement, which is one of the foundations of a solid retirement plan.