Retirement Ratios: How They Work

Understanding how much money you will need to live on after you have retired is an important part of any retirement savings plan – so why do so many people find it hard to come up with an accurate idea of how much they will need? 

Retirement Ratios: How They Work

As a retired person, your budget will be different to when you were working. One of the ways that you can work out how much money you will need is by calculating your retirement replacement ratio, also called your work-to-retirement ratio.

But what is a retirement ratio? How do you work it out? And what role does it play in your retirement plan (Find out What Is A NonQualified Retirement Plan?)? If you want to know more about retirement ratios then you have come to the right place.

We have put together this guide to tell you everything you need to know about retirement ratios. Keep reading to find out more, 

How Is A Retirement Budget Different From A Working Budget?  

When you retire, your monthly budget will change. This means that you will not need the same amount of money to live on as you did when you were working. 

Once you have retired you will not be paying national insurance and you will pay less tax. This means that any money that comes your way from a pension plan or from personal investments will go further than your wage did. 

You will not have the costs associated with working – commuting, buying work clothes, the coffee and lunches that you might buy whilst at work. You will also be living a more relaxed lifestyle, which means you will probably spend less money trying to de-stress yourself. 

Another aspect of a retirement budget is that you won’t be ‘saving for the future’, as you are living out the end of your life. You still need to be sensible with your money, but you no longer need to portion off a significant chunk of your money in order to prepare for retirement. 

When coming up with a retirement budget, most people work on the basis that by the time they reach retirement they will be debt free. They will also have no dependents relying on them financially, as their children should be fully grown and independent. 

So, how do you know how much money you will need for retirement? 

The Retirement Replacement Ratio

The retirement replacement ratio is a good way to figure out how much money you will need during retirement. It can be defined as the percentage of your pre-retirement earnings that you will need in order to maintain a similar standard of living during retirement. 

As an example, if you earn $50,000 a year before retirement but you have calculated that you will only need $35,000 a year to maintain a similar standard of living during retirement, your retirement replacement ratio is 70% ($35,000 is 70% of $50,000).

The percentage will vary based on your lifestyle, your earnings, and your spending habits. Most people have a retirement ratio of between 70% and 80%.

If your retirement replacement ratio is 70% but you  know that your pension plan only covers 50% of your pre-retirement salary, you will need to make up the rest with savings or returns on investments (or reduce your standard of living during retirement). 

Once you have your retirement replacement ratio, you can start to plan your retirement fund to ensure that you will have enough money.

Think about what social securities you will be entitled to, how much you will be able to put aside between now and your retirement, and how much you will be able to build up in a pension plan. You can then assess whether your retirement replacement ratio is achievable. 

If you work out your retirement replacement age with plenty of time to spare, you can track your progress as you work towards your goal. This will help to keep you motivated and will ensure that you are prepared for retirement. 

What Are The Advantages And Disadvantages Of Using The Retirement Replacement Ratio? 

The retirement replacement ratio has been around for a long time, but what are the pros and cons of using it to help you plan for retirement? 

Pros

  • Simplicity – The retirement replacement ratio is easy to understand and to calculate.
  • Flexible – As your income increases over time, your retirement replacement ratio will adapt. This means that you can use it to plan for retirement from a young age to an older age. 
  • Motivation – The retirement replacement ratio helps you to set a clear goal early on. This allows you to plan your strategy for achieving this goal. You are able to track your progress and stay motivated as you save for retirement.  (Find out the Average Retirement Savings here)

Cons

  • Generic – It is a generic approach which does not always account for individual financial circumstances. 
  • Unpredictable – There is an element of unpredictability when it comes to retirement planning that the retirement replacement ratio does not account for. It is impossible to know what the tax policies will be like in the future and how inflation rates will change. Social security policies could change, healthcare costs could rise – it is impossible to plan for this. 
  • Assumptions – The retirement replacement ratio works off several assumptions that may not be true – that you will be debt free and that you will have no dependents etc. 
  • Timescale – The retirement replacement plan is not a great tool to use if you are already close to retirement as it is too general. You will need a more accurate and detailed plan to ensure that you will have enough money to live on. 

Should You Use The Retirement Ratio? 

If your retirement is still quite far away then using the retirement ratio could be a good way to help you set a target and stay on track, assisting you with planning your retirement. If your retirement is imminent, you will need a more detailed plan based on your current finances and savings. 

Summary 

Retirement ratios are a useful tool for helping to plan your retirement fund, but they are not suitable for everyone and every situation.

Andre Flowers
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