Income Replacement Ratio

Nobody needs their entire salary in retirement.

Some costs stop the day the job stops. Commuting. Work clothes. Children's education, by then usually finished. And the biggest of all: the part of the salary that was being saved for retirement is no longer needed, because retirement has arrived.

Other costs rise. Health, in particular. Recreation, often.

The income replacement ratio is the net answer to all of that in one number. The workbook defines it as gross income after retirement divided by gross income before retirement, and describes it as the percentage of income just before retirement that will be required to maintain the desired standard of living.

The usual range is 70 percent to 90 percent. But the number is not a constant — it depends on how much of the pre-retirement income was going into savings and tax.

Which costs move, and which way. Section 3.2.2 lists them:

The categories of expense mostly stay the same. What changes is the contribution of each to the total.

Why the ratio can fall well below 70 percent. The workbook gives the case explicitly. Many people hit a phase of high income in their early 50s, with the large-ticket expenses already behind them, so a large portion of income goes into savings. For such a person the saving and tax components account for a large part of pre-retirement income, and the replacement ratio is likely to be much lower.

When to stop using a thumb rule. In the early planning years there is less clarity on future income, so a thumb rule is convenient. But especially in the last 5 to 10 years before retirement, the workbook says it is best to consider the particular situation of each individual while determining the income replacement ratio.

Where it is used. The ratio is step 5 of the Income Replacement Method: grow today's income to the retirement date, then apply the ratio. Chapter 7 refers back to the same figure when it describes the thumb rules used in the initial earning years as 70 percent of pre-retirement income, and warns that they may not truly reflect actual needs.

Income replacement ratio = Gross income after retirement / Gross income before retirement

Both figures are gross — before tax, not after it.

A ratio of 0.75, or 75 percent, means the retiree needs three-quarters of the income they were earning immediately before retiring.

Two colleagues retire on the same day from the same grade, both on a final salary of Rs 20,00,000 a year. Their replacement ratios are nowhere near the same.

Mr Salvi has been spending most of what he earns. His savings rate in his final years is about 8 percent of income, and he has a home loan EMI running until two years after retirement.

Mrs Salvi hit a high-income phase in her early 50s with the house paid off and both children graduated. In her last five working years she was saving roughly 35 percent of her income and paying tax on the rest.

The gap of Rs 5,00,000 a year has nothing to do with lifestyle. It comes almost entirely from the fact that Mrs Salvi's final salary was funding a large savings programme that retirement brings to an end.

Now the planning consequence. Applied over a 20-year retirement, sizing Mrs Salvi's plan at a blanket 85 percent rather than her actual 60 percent would have her chasing roughly Rs 5,00,000 a year of income she does not need — and in corpus terms, at the kind of real rate the workbook uses, tens of lakhs of extra saving. The workbook's instruction to set the ratio individually in the last 5 to 10 years is what stops that.

And for Pradeep in the same chapter, the ratio was set at 75 percent on a projected retirement income of Rs 1,08,34,706, giving Rs 81,26,029 a year — the middle of the range, chosen because retirement was still 25 years away.

Chapter 3, section 3.2.2, opens with the definition — gross income after retirement over gross income before retirement — and the 70 percent to 90 percent range. Chapter 7, section 7.1, cites the same 70 percent figure as the kind of thumb rule the Prevention Strategy exists to correct.

Expect a direct recall question on the range and on the formula, and a reasoning question on why a high saver's ratio is lower than average. The distinguishing question is when should the thumb rule be replaced by an individual assessment — in the last 5 to 10 years before retirement, when income and expenses are clearer.

• 70 to 90 percent is the range, not a fixed 70 percent. And the workbook says the number may be lower than 70 for a person who was saving heavily before retirement.
• It is gross income over gross income. Not post-tax income, and not expenses over expenses — that would be the Expense Protection Method's territory.
• The denominator is income just before retirement, not income today. Today's income has to be grown to the retirement date first.
• A high savings rate lowers the ratio; it does not raise it. The saved portion of income disappears as a requirement once retirement starts.
• Health expenses are higher in the later years of retirement, not uniformly through it — the workbook distinguishes the early retirement years from the later ones.
• A thumb rule is for the early years only. Using it inside the last decade before retirement is the error the paper tests.
• Do not confuse the ratio with the Income Replacement Method, which is the five-step procedure that applies it.