Replacement Ratio Method

Before a retirement corpus can be calculated, someone has to say how much income retirement will need. The workbook gives two methods: the Replacement Ratio Method and the Expense Protection Method.

The replacement ratio method assumes the standard of living stays the same as just before entering retirement. The target is then simply a percentage of the income being earned at that point. If income is Rs 2,00,000 a month and a standard 80% replacement ratio is assumed, the plan must deliver Rs 1,60,000 of income in the first year of retirement, increased by the inflation rate every year to maintain purchasing power.

Why less than 100%? Many expenses fall at retirement — the housing loan, children's education, work-related costs — and some long-term savings requirements cease. Income often drops into a lower tax bracket. Some expenses, such as medical and travel, do rise.

Two steps.

1. Project income to the date of retirement and apply the ratio: first-year replacement income = pre-retirement income × replacement ratio.
2. Grow that figure by inflation each subsequent year.

The workbook example. Mr Rajeev, 50, earns Rs 1,00,000 a month and wants to retire at 60 with 50% of his income. His income grows at 10% a year and inflation is assumed at 7%.

• Income at retirement = 1,00,000 × (1.1)^10 = Rs 2,59,374
• First-year replacement income = 2,59,374 × 50% = Rs 1,29,687
• Second year = 1,29,687 × 1.07 = Rs 1,38,765, and so on.

Its limitation. The more years to retirement, the less accurate the estimate is likely to be — though the earlier one starts calculating and investing, the lower the rate of return needed to reach the goal.

The alternative — Expense Protection Method. Build retirement income from a budget of expected retirement expenses, adjusting for costs that rise (medical, travel, gifting, house maintenance) and fall (loan repayment, education, income tax). The workbook's Mr Ashish: household expenses of Rs 30,000 plus Rs 15,000 of additional retirement expenses, inflated at 6% for 20 years, gives Rs 1,44,321 a month. It too becomes speculative the further away retirement is, and needs periodic review.

Income at retirement            = Current income × (1 + income growth)^years to retirement
Replacement income, year 1       = Income at retirement × Replacement ratio
Replacement income, year t       = Year-1 replacement income × (1 + inflation)^(t − 1)

The workbook writes the subsequent-year formula as "Pre-retirement Income × Annual rate of Inflation (added per year) × 0.80"; its own worked example applies it as compounding at the inflation rate, as above.

Rajeev's figures are the workbook's; the annual totals and the comparison are computed here.

Taking Rajeev's income as monthly throughout:

Those annual numbers are what the retirement corpus has to fund, rising every year.

Now set the two methods side by side for a planner. Suppose Rajeev's current household budget is Rs 45,000 a month. The expense protection method, inflating Rs 45,000 at 7% for ten years, gives about Rs 88,522 a month at 60 — well below the Rs 1,29,687 the replacement ratio produces. Neither is wrong. The replacement ratio preserves the lifestyle his income could support; the expense method funds the lifestyle he actually lives. A client who saves a large part of income will show a big gap between the two, and the adviser has to decide which one the plan is protecting.

The choice of ratio moves the answer hard: at 80% instead of 50%, Rajeev's first-year need becomes Rs 2,07,499 a month.

Chapter 4 (Retirement Planning Basics), section 4.4 — Estimating Retirement Corpus — with the replacement ratio method at 4.4.1 and the expense protection method at 4.4.2; inflation and expected return in 4.3 feed the corpus calculation. Expect the Rajeev-style two-step computation and a question on the limitations of each method.

• Apply the ratio to income at retirement, not today's income. Rajeev's 50% is applied to Rs 2,59,374, not Rs 1,00,000.
• Inflate from year 2 onward — the ratio sets year 1.
• Income growth and inflation are different rates in the workbook example: 10% to project salary, 7% to inflate retirement income.
• Unit slip in the workbook. Rajeev earns Rs 1,00,000 a month, but the text calls Rs 2,59,374 his income "per annum". Rs 1,00,000 × (1.1)^10 is a monthly figure; treat all his figures as monthly.
• Replacement ratio is income-based; expense protection is budget-based. Both lose accuracy the further away retirement is.