3433-vol. 6 issue 2-3.pmd - iarfc

Volume 6, Issue 2 & 3 77
Income Replacement Ratios
This paper does not attempt to estimate income replacement rate
targets or assess the adequacy of the current situation. It may be reasonable
to assume that income replacement ratios less than 100% are sufficient during
retirement because most individuals will experience lower tax rates, no Social
Security taxes, less spending on food, commuting and clothing expenses, and
smaller mortgage expenses. However, higher medical goods and services raise
the income replacement rates. Schieber (2004) estimates the income replacement
rate at around 70% for a wide range of income classes. Alford, Farnen,
and Schachet (2004) report replacement ratios of 89% for the low income level
of $20,000 and 78% for the high income level of $90,000. Of course, Social
Security represents a larger percentage of income for low income earners
(65%) and a smaller percentage of income for high income earners (33%). In
an earlier study, Palmer (1994) reports replacement ratios of 76% and 78% for a
married couple with income levels of $20,000 and $90,000, respectively.
Obviously, higher income earners have to save a larger percentage of their
income to maintain their pre-retirement standard of living. Replacement ratios
are based on the situation of an average worker and need to be carefully
estimated for each individual particular situation. Simple rules of thumb may
be misleading in estimating target savings and replacement rates.
Devaney and Su (1997) report that, in 1995, Social Security income
constituted 42.8% of a retiree’s income while pensions, annuities, and assets
comprised 37.2% of its retirement income. The retiree’s current earnings were
17.8%. Therefore, if assets comprise 40% of accumulated wealth at retirement,
an income replacement ratio of 80% implies that 32% of a retiree’s income
comes from his accumulated wealth at retirement. If the withdrawals from
pensions and assets range from 30% (low income groups) to 90% (high
income groups) during retirement, an 80% income replacement ratio indicates
that the low income and the high income groups would need income replacement
ratios of 24% and 72% of their accumulated wealth at retirement,
respectively.
Research & Theory
The Model for Calculating Income Replacement Ratio
In addition to the savings rate, the income replacement ratio depends
on the following factors, with the base case values used in the examples
shown in parentheses:
I 1
: the income at end of the first year
n: the length of the savings period (35 years)
i: the rate of inflation (2.5%) and income keeps up with inflation
g e
: the real rate of growth of income (1%)