The Replacement Ratio Vs. Final Average Earnings

by Vicki A. Benge

Planning for retirement involves accumulating enough wealth to pay expenses when no longer earning a regular salary. Financial planners, pension fund managers and workers nearing retirement may refer to the replacement ratio in retirement and final average earnings. The replacement ratio is used to determine how much income a retiree may need to live without undergoing major lifestyle changes.

Defining the Terms

Basically, the replacement ratio equals annual retirement income divided by final average earnings. Annual retirement income includes all gross income, Social Security benefits and all other forms of income. Final average earnings is the current gross annual income at the time of retirement. When computing the ratio, gross income is used in both the numerator and denominator, thus income from investments, annuities, IRA distributions and other forms of income are included.

Varying Denominators

According to the Government Accountability Office, the final average earnings used to calculate the replacement ratio is generally the income earned in the last year before retirement. The Social Security Administration (SSA) warns that what salary or salary average is used as the qualifying denominator affects the replacement ratio result. For example, the SSA lists real average earnings as one possible denominator. This number is an inflation-adjusted average of all a worker's earnings and if compared with the earnings from the previous year before retirement, a significant gap may be evident, depending on the worker's annual salaries decades earlier.

How It Works

The replacement ratio shows what percentage of income a retiree will maintain. For example, an individual retires making $50,000 annually. Private retirement plus Social Security benefits received equals $42,000 annually. The replacement ratio for this example is 84 percent, because 42,000 divided by 50,000 equals 0.84 or 84 percent. Individuals without a private pension plan or some form of IRA cannot expect to earn nearly as much in retirement as when employed. Consider an employee who earns $50,000 and depends solely on Social Security benefits. With a replacement ratio of 41 percent, the individual would receive $20,500 in retirement based on a $50,000 salary.

Individual Ratios

Finding what you need for retirement, in other words calculating your own replacement ratio, involves figuring post-retirement income, adjusting for inflation and estimating living expenses. Is the mortgage paid? Are the children independent? What costs were associated with work that will no longer be applicable? How much did was regularly contribute to a retirement account from gross income? Will taxes be less after retirement? How much income can be generated from an IRA and other investments? These are just a few sample questions to answer objectively to determine what replacement ratio of final average earnings works for an individual situation.

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