More on Retirement Replacement Ratios

We wrote a post awhile back saying that, to keep retirement planning simple, you should set as a minimum retirement goal a replacement ratio of 75% of pre-retirement income. When all is said and done, effective 401k planning boils down to figuring out how to attain an acceptable retirement replacement ratio (RRR).

A visitor was kind enough to point us to this excellent 2008 retirement income replacement ratio study done by Aon Consulting. The Aon study goes into far greater detail showing how replacement ratios need to be adjusted for factors such as income levels and family situations. Here’s an exhibit from the report showing how they arrived at replacement ratios for a “baseline” couple (ages 65, 62) at various pre-retirement income levels:

Line 10 of the above exhibit shows the overall replacement ratio. Significantly, lower income households will need a substantially higher replacement of pre-retirement income to maintain their standard of living in retirement. As the report explains, there are two primary reasons for this:

First, before they retire, lower paid employees save the least and pay the least in taxes as a percentage of their income. Thus, they spend a higher percentage of their income and need higher Replacement Ratios to maintain that level of expenditures. Second, age- and work-related expenditures do not decrease by as much, as a percentage of income, for the lower paid employees. This also means they need more income after retirement (as a percent of their pre-retirement income) than the higher paid employees.

Line 13 highlights the share of the replacement ratio that needs to from sources other than Social Security. For some this may include defined benefit pension benefits, but for most U.S. workers, this number represents the amount that will need to come from your 401k, IRA, and other retirement savings vehicles.

A second exhibit from the Aon expands on this by showing the lump sum balances that need to be accumulated at retirement to fund a the non-social security portion of the replacement ratio:

Thus, according to Aon, a baseline male with pre-retirement gross income of $80,000 would need a lump sum retirement account balances of $488,000 (6.1 x 80,000) at retirement to fund the non-social security share (38%) of his replacement ratio.

Of course, you can dispute assumptions underlying the Aon study. But, on the whole, it is a very useful and well-done report that could greatly benefit 401k participants who are serious about attaining their retirement goal. The report is free and can be downloaded here.