The standard measure of how well-prepared people are for retirement is very close to useless.
This gauge is called the replacement ratio. You're supposed to save enough money to generate annual income of about 70 per cent of what you grossed in your peak working years. Some experts say 50 per cent will do, while others think 80 per cent to 100 per cent is a better target.
We can now stop arguing about what percentage is right and focus on a new way to judge retirement readiness. It's called the living-standard replacement ratio, or LSRR. Think of it as a personalized way to measure how your lifestyle in retirement will differ from your working years.
The LSRR was developed by actuary Bonnie-Jeanne MacDonald, an academic researcher at Dalhousie University in Halifax. Her starting point was a recognition of the flaws in the widely used replacement ratio. She found that while some people in the financial industry were aware of this to varying extents, they felt trapped into using the ratio by virtue of its universal acceptance and a lack of alternatives. "There has never been a single study that actually shows the replacement rate does what it's supposed to show," she said.
Dr. MacDonald and colleagues Lars Osberg and Kevin Moore tested the replacement ratio by using a population simulation model from Statistics Canada called LifePaths. They looked at whether people born between 1951 and 1958 would attain the standard 70-per-cent replacement ratio and keep the same standard of living after retirement.
What they found was next to no connection between the replacement rate achieved by a retiree and their standard of living. "The living standards of people who retired at 70 per cent could go way up, they could go way down," Dr. MacDonald said. "We saw nothing systematic."
The LSRR attempts to do much the same thing as the replacement ratio, which is provide a guideline on how much you need to save to live in comfort. But it's more accurate and personalized because it looks not just at your income, but also your savings, home ownership and the number of people you support (kids, parents).
Here's how to do your own much-simplified LSRR calculation if you're a married homeowner who intends to stay in your house after retirement. Dr. MacDonald said the calculation should be done at a family level (combine incomes) and should be averaged over a few years if possible.
Start by calculating how much money you have left over in your working years after paying major costs. Take your monthly or yearly employment income plus your spouse's, if applicable, and subtract taxes and payroll deductions, the amount you save for retirement, the amount of your mortgage payments and money spent to support your children and aging parents.
What's left over is money you have to spend on you and your spouse. Will you have more, less or the same amount in retirement? This is where the second step in calculating the LSRR comes in. Take your expected retirement income (your spouse's, too) and subtract expected taxes. Then, where applicable, subtract mortgage payments and money spent on your adult kids or aged parents.
What's left over is money – in retirement – you have to spend on you and your spouse.
Need help estimating your retirement income? The federal government's Canadian Retirement Income Calculator is a great resource. For estimating your tax rate, try the Ernst & Young personal tax calculator.
Technically speaking, the LSRR is the ratio of leftover money to spend on you and your spouse in retirement divided by leftover money to spend on you and your spouse while working. You're in good shape if the LSRR is 100 or more. That is, your money available for spending after retirement is 100 per cent or more of what it was before retirement. If your LSRR is below 100, you need to either increase your savings to generate more retirement income, or reduce your expenses in retirement. Keep checking your LSRR to see how you're doing.
Remember that your consumption will change a lot in retirement. You may spend a lot on travel at first and more on health care as you age. The LSRR simply measures the amount of money you'll have for all this type of spending.
Financial professionals have already started to use the LSRR. For everyone else, one of the LSRR's biggest contributions may be in documenting how your standard of living in retirement will be connected to your family's financial situation. Consider your savings and your debts when planning your retirement, and then check into how your adult kids and parents are doing. Their financial independence adds to yours.