How Much will you spend in retirement? Determining Your Replacement Ratio

How much of your current income will you need in retirement? The answer to this question is called the replacement ratio and is a major driver of the retirement planning piece. It will be different for everyone, so I outline how you can figure out your own replacement ratio that will ultimately determine how much you need to save for retirement.

The income replacement ratio is essentially the amount of income you’ll need in retirement as a percentage of your current income.

For example, say you are currently earning $100,000 and you estimate that you’ll need $70,000 in retirement to maintain your standard of living. This would be a replacement ratio of 70%. This is the standard rule of thumb in the industry, however often people can get away with much lower replacement ratios than this standard.

Determining Your Replacement Ratio

If you’ve already got a budget, that will help you figure out your replacement ratio quite easily. If not, you can back out some numbers relatively easily. Let’s take a couple with 2 children as an example. Say this couple makes $120,000, split equally between them, or $60,000 per year. When they subtract the taxes they pay, CPP contributions, EI premiums and their employer benefits, they each make $45,000, or $90,000 combined. They currently put a total of $10,000 towards retirement savings and have mortgage payments of $2,500 per month, or $30,000 per year. Child costs run about $10,000 per year. This means that their regular consumption is $40,000 per year.

	Pre-Retirement
Income	$120,000
Taxes, CPP & EI Premiums, etc.	-$30,000
Net Income	$90,000
Retirement Savings	-$10,000
Mortgage	-$30,000
Child Costs	-$10,000
REGULAR CONSUMPTION	$40,000

This means that in retirement, once the mortgage has been paid off and the kids are gone, they will continue to spend $40,000 per year. That’s spending though, and we need to look at income. We assume their taxes to be about $1,000.

Their taxes are much lower due to a few factors:

Their income can be much lower to support only $40,000 in retirement consumption
Their income is split equally (which can be arranged for many retirees)
They receive things like the age credit, pension credit, etc.

Keeping their standard of living the same throughout retirement would mean they need $41,000 in pre-tax income.

	Pre-Retirement	Retirement
Income	$120,000	$41,000
Taxes, CPP & EI Premiums, etc.	-$30,000	-$1,000
Net Income	$90,000	$40,000
Retirement Savings	-$10,000
Mortgage	-$30,000
Child Costs	-$10,000
Regular Consumption	$40,000	$40,000

Compare that to their $120,000 pre-retirement income and you’d get a replacement ratio of 34%.

Now you can consider adding extra onto their current regular consumption of $40,000 for additional costs like travel and leisure now that they have more time, but simply using the standard replacement ratio would almost double their consumption in retirement compared to now.

On the other side of the equation, someone who is single, renting, with no children will have a much higher replacement rate. Let’s assume that a single person is making the $120,000. After tax, CPP, EI and benefits, they net $82,500. They save 20% of their income towards retirement or $16,500 meaning their consumption is currently $66,000. Since they don’t have a mortgage that will stop once paid off and they don’t have child related costs, their total expenses won’t significantly change in retirement. Taxes for a single individual on income to support $66,000 in consumption are estimated at about $20,500.

	Pre-Retirement	Retirement
Income	$120,000	$86,500
Taxes, CPP & EI Premiums, etc.	-$37,500	-$20,500
Net Income	$82,500	$66,000
Retirement Savings	-$16,500	$0
Mortgage	$0	$0
Child Costs	$0	$0
Regular Consumption	$66,000	$66,000

In order to maintain their standard of living pre- and post-retirement, this individual’s replacement ratio will be about 72%.

In both cases, I’ve assumed the worst-case scenario, where retirement income is fully taxable. However, if you are sourcing income from TFSA’s and non-registered assets, the tax rate will be lower and therefore the replacement ratio will also be lower.

Fred Vetesse and Bill Morneau discuss this concept in their book The Real Retirement. They term this concept the Neutral Retirement Income Target, or NRIT for short.

Based on the above examples we can see that the income replacement ratio can vary wildly. A single childless individual bearing the full burden of income tax while paying rent has an income replacement ratio near the 70% rule of thumb, but most others will be lower than that. Since this rule of thumb isn’t very reliable, we can simply throw it out the window and instead focus on what your consumption is now, and what it will look like in retirement, no detailed budgeting needed! Here are the steps to figure this out yourself:

Figure out your current pre-tax income.
Deduct taxes, CPP, EI premiums, employer health benefits, etc.
Remove expenses that won’t continue in retirement, such as child related expenses and mortgage payments. If you don’t have these expenses yet, but expect to have them in the future, you can add in an estimate for them. You can even start to set these aside as savings on an ongoing basis to make sure you can handle the increased expenses. This will function like the lifecycle style of savings or barbell approach I talked about in my last video.
The remainder is your consumption level.
Add expenses to your current consumption that will start in retirement such as higher travel costs or private medical expenses. This is your total retirement consumption amount.
Estimate the amount of tax you’ll owe on income to get to your retirement consumption. To be conservative, you can assume all retirement income will be fully taxable. This is the total amount of income you will need in retirement.

Now that we know how much income you’ll need in retirement, you can tally up your current estimates for retirement income from various sources: government pensions, company pensions, personal savings to see if you’re on track. I’ll go into these in more detail in future posts, so don’t worry if you aren’t sure what income those would provide yet.