Factors That Impact Optimal Retirement Replacement Ratios

A new study from the Michigan Retirement Research Center (MRRC) sheds more light on the topic of retirement replacement ratios – i.e., the percentage of pre-retirement income that needs to be targeted to maintain living standards in retirement. This is key component of effective retirement budget planning.

Typical advice suggests that replacement rates should be 70 to 85 percent of pre-retirement income. Target replacement rates are thought to be less than 100 percent for three main reasons. First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement.

Interestingly, the MRRC study finds that 75% is the median optimal replacement rate for married couples – seemingly confirming the standard rules of thumb often used in retrement budget planning. However, the study cautions that, as is often the case, the median misrepresents the wide variation in optimal replacement ratios for households in differing situations. For instance:

1. Replacement rates for a married couple need to be higher than for an otherwise identical single person, both because of couples’ greater expected medical expenses in retirement and because of longer expected longevity for at least one partner. While the study found the median optimal rate for married couples to be 75%, the median optimal rate for singles was 55%.
2. Replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families, because the reduction (relative to their levels during the working year) in saving and taxes in retirement would be smaller for low income individuals and families.
3. High-income households need lower replacement rates than low-income households, because of their substantial reduction in average effective tax rates. Of course, the opposite point applies going forward: if one expects future taxes to rise, optimal target replacement rates for highincome households should reflect those expectations.
4. Other things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working.



5. Other factors (including medical costs, educational attainment, and taxes) affect optimal retirment replacement rates.

The study concludes that no single target replacement rate is appropriate for all households and that financial planning tools (like online calculators) relying on simplified, rule-of-thumb replacecement ratios need to be used with caution. This research includes findings that will be incorporated into the next generation of 401k planning and online tools.

Still, there is something to be said for retaining the understandable and teachable concept of a 75% retirement replacement ratio. The number of people who do even basic retirement planning (such as using an online retirement calculator)is far too small. Overcomplicating the retirement planning discussion runs the risk of keeping even more people away from serious planning efforts.