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Income replacement ratios: a shortcut in retirement planning?

For financial professionals only

At retirement you’ll no longer commute, buy expensive sandwiches at lunch, or go for after work drinks on a Friday. You might have paid off the mortgage, and the kids may have even left home. All in all, you’ll likely need to spend less money. But after 40 years of adult life, spending habits are hard to change. In fact, the ratio of your retirement income to working income may remain the same. I’ve seen this with friends retiring too early, hoping that a little economy might allow them to make ends meet. But it hasn’t worked – reducing luxuries is challenging.

What is the required pre/post retirement income ratio?

The chart below shows the median retirement income as a percentage of median incomes of the pre-retired, over the last few decades.

Source: ONS, Table 9a329b2f

Older people have seen their relative wealth rise materially since the 1970s. On the face of it, planning for a retirement income that is 75% of your career income seems reasonable.

But the extent to which those with above median household incomes, those who are more likely to be able to afford advice, will have the same income replacement ratio in retirement is an interesting question. Generally, the lower your work income in employment, the higher your replacement income ratio will be, because more income is spent on basics. So you might expect wealthier households to buck the rising trend and have lower replacement income ratios, but that has not been the case.

Source: ONS, Mean and median household income of individuals in retired and non-retired households from 1977 to 2018 in current prices by decile, Oct 2019

This data shows that for high earners, like the median group, retirement income is closely linked to career income. So, could retirement income planning be simplified to calculating the cost of delivering 75% of recent career income?

What’s your minimum certainty requirement?

This sum is slightly more complicated because of the question around how much guaranteed income you want. You can easily access secure income, via annuity, but at first sight it seems expensive, particularly if you have defined contribution pension savings. And if you die before age 75, your beneficiaries lose a tax break on the income they would inherit if you’ve not bought an annuity.

This drives thinking towards riskier income, but many households take comfort from State Pensions, some DB pension and housing equity – which all provide an underpin.

What’s the relevant discount factor to price up retirement?

Your annuity rate can be a very helpful discount factor in retirement planning. Say your household income has been £60,000, and you estimate you need 75% (45,000) for retirement income. Assume that State Pension and Defined Benefits contribute £30,000. For an escalating annuity of £15,000 to make up the shortfall with 50% spouses benefit at age 65, the annuity factor is around 3%. So the headline cost of this retirement, with complete certainty in its income cash flows, is £500k.

For many, whatever their income expectation, this ruthless equation means accepting a measure of uncertainty about later life income. The discount factor in a drawdown plan will be higher than the annuity rate, but the two are best thought of being closely linked. The key reason is that the annuity factor has accounted for the likely longevity of the client, and the drawdown discount factor cannot ignore that reality. But by staying invested we can hope to push the rate of drawing higher, with the inclusion of some riskier equity returns in our portfolio – returns which are unavailable to annuity providers given the solvency requirements they must satisfy.

Using our Income Management Tool (IMT) to price up retirement

You can easily explore relevant discount factors using Parmenion’s IMT, the retirement income management tool integrated into our platform. To use it, just speak to your Regional Sales Manager or regular contact.

For example, in a Risk Grade 5 portfolio for a man aged 65 who’s satisfied with a 75% chance of success (there’s never total certainty with drawdown) the rate is 3.75% including CPI escalation.

This would reduce the cost of retirement income in our example by 20% to £400,000. The total can probably be further reduced by 5% and keep the same chance of success, as from age 80* lifestyle spending reduces by around 15% across the entire demographic. Finally, a slightly more adventurous investor, taking their portfolio risk up to Risk Grade 6, would have the offer of another 5% cost reduction. This makes retiring on £360,000 a possibility, if they had the capacity to ride out tougher times in markets.

Don’t forget the big spend

Of course, many of us would like to kick off our retirement with some big spends, like conservatories, holidays or camper vans. These extras will need to be added to the overall financial plan. Who doesn’t want to keep buying their favourite luxuries?

*Note: ONS Tables 15 and 16

Male, DOB: 1/9/1961. Portfolio invested in PIM Passive RG 5/RG 6. Including standard platform charges. No adviser charge. Figures are expressed in constant £ terms.