I’m not a big fan of rules of thumb when it comes to retirement income planning. The wage replacement ratio is no exception.
Rationale for Wage Replacement Ratio
What is the wage replacement ratio? It is the percentage of pre-retirement income needed in retirement. 70% to 80% is the general rule of thumb. As an example, assuming your gross income before retirement is $100,000 and your goal is a 75% wage replacement ratio, then you would need $75,000 in retirement.
A 75% ratio is justified on the basis that you won’t need as much to live on during retirement. Six reasons often cited for a 25% income reduction are:
- Social Security and Medicare taxes end.
- Income taxes usually decrease after retirement.
- Saving for retirement is no longer necessary.
- Social Security benefits are partially or fully tax free.
- Pensions and other forms of retirement income are often exempt from state taxation.
- Mortgages may be paid off in retirement.
Wage Replacement Ratio Holes
While it’s true that Social Security and Medicare taxes end and you no longer need to save for retirement, the other four reasons vary from situation to situation. Income taxes don’t necessarily decrease after retirement. It depends upon the types and amounts of retirement income, itemized deductions, and changes in income tax laws.
Although it’s possible that Social Security benefits may be fully tax-free, this is determined by the amount of your other income and the state where you live. 85% of benefits are taxable for federal purposes if you have at least $18,000 – $38,000 of other adjusted gross income, with the amount depending on your Social Security benefits and your tax filing status.
It isn’t necessarily true that pensions and other forms of retirement income are exempt from state taxation. While there are only 13 states that tax Social Security benefits, there are only ten states that exclude all federal, state, and local pension income from taxation. Furthermore, pensions have been on the decline for several years as a source of retirement income for most retirees.
The potential payoff of mortgages in retirement is too much of a wild card to use as support for a wage replacement ratio. For starters, not everyone owns a house. Many individuals who own houses sell them in retirement and become renters. Unlike mortgages which often have fixed monthly payments, rent is subject to periodic increases. Mortgage payoffs, if they do occur, may not happen until well into retirement.
Income Needed in Retirement Depends on Type of Income
An important variable that’s often ignored with the wage replacement ratio approach to retirement planning is the type of income that will be received in retirement. The security and taxation of each type of income must be analyzed in order to determine the amount of net income that’s likely to be available to cover expenses.
The importance of receiving predictable lifetime income streams when you’re no longer working is often downplayed when planning for retirement. Lifetime sustainable income paid by the U.S. government, i.e., Social Security, and by highly-rated life insurance companies, i.e., fixed income annuities, is more reliable than distributions from sales of an equity-based portfolio that fluctuates in value.
The amount of income that you need in retirement is also dependent upon the income source. Different types of income have different income tax consequences. Certain types of income are more tax favorable than others. These include Roth IRAs, nonqualified long-term capital gains, nonqualified fixed income annuities, and Social Security.
Expenses Often Increase in Retirement
70% – 80% of income received in the year before retirement may coincide with the amount that’s required to cover expenses in the first several years of retirement. While some retirees experience decreases in their expenses, a 75% wage replacement ratio won’t necessarily be adequate as you progress further into retirement.
With modest inflation, total expenses will often approach and will begin to exceed pre-retirement income approximately ten years into retirement. Unless you have other sources of income that kick in during retirement, e.g., deferred income annuities, you may begin to experience sizable decreases in your portfolio assets. This can be especially problematic if you incur uninsured or underinsured medical or extended care expenses.
Wage Replacement Ratio Ignores Extraordinary Expenses
Extraordinary expenses are problematic when it comes to the wage replacement ratio. There are sizable cash outlays that retirees incur from time to time. Some are predictable while many are not. Examples include vehicle purchases, home improvements, weddings, gifts to children, and uninsured or underinsured medical and extended care expenses. These items can significantly increase expenses and the wage replacement ratio in the year(s) in which they occur.
Retirement Income Planning Needs to be Customized
Retirement income planning needs to be customized to each individual’s situation to increase the likelihood of success. This includes ongoing monitoring of one’s plan beginning many years before, and continuing throughout, retirement.
A one-and-done calculation of a single wage replacement ratio for the duration of retirement doesn’t work in most cases. It is too simplistic. There are too many variables, many of which are unpredictable or uncontrollable.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.