Income replacement ratio refers to the percentage of a person’s pre-retirement income that is paid out by a pension program upon retirement. Its formula is as shown below:
Income Replacement Ratio = (Post Retirement Income)/(Pre Retirement Income) x 100
For example, if you earned 100,000 shillings before retiring and after retirement you earn 75,000 shillings as a pension then your income replacement ratio is 75% that is;
(75,000/100,000) as a percentage =75%
While income replacement ratio is a simple and easy to understand metric, it is more complicated when it comes to its construction and workings. For instance, it can be subjective in that a person earning a high income in their working years needs a higher income replacement ratio than one who earns a lower income during his or her working years. This is because higher-earning individuals tend to spend more money on recreational activities. In order to maintain this living standard, they end up requiring a relatively high income replacement ratio. This means that a one-off rate cannot be applied to every member of the society.
Another conundrum is whether to use the pre-tax or after tax income when calculating the ratio. Most economists argue that after tax income is more accurate as it represents the amount available for use by the individual or household.
One thing, however, that remains constant is that you will need less income in your retirement than in your working years. The reduction could be attributed to many factors such as the absence of work related expenses including transport to and from work. You will no longer be saving for your retirement or even your children’s education as they will be grown, assuming you have children. Income taxes are lower on your pension than the usual 30% you pay as PAYE.
Despite the differences in approach, the income replacement ratio is used as a measure of pension adequacy, which raises the question: is the pension you get after retiring sufficient for you to maintain your desired standard of living?
Income replacement ratio has many possible effects, the main one being that the higher the expected income replacement ratio the more motivated you are to save for your retirement. Unfortunately, in Kenya this ratio does not meet the desired target. According to the Retirement Benefits Authority (RBA), the ratio for retirees in the country stands at 34%. This low ratio could be attributed to a lack of discipline among Kenyans when it comes to retirement savings. For instance, 95% of Kenyans withdraw the maximum allowable amount when changing employers. Often, they do not transfer any amount to the scheme of their new employer but divert the money to other needs.
Another reason is lack of adequate regulations. The above example of Kenyans withdrawing money before retirement takes place because the law (or lack of it) allows it. It is therefore imperative that the RBA comes up with checks and balances that would enhance benefits preservation and reduce old age poverty.
However, regulations aside, one key way of improving the income replacement ratio of Kenya and consequently the lives of Kenyans in retirement is to encourage a savings culture in the country. Education is key here. Focus should be on training and informing the public of the importance of savings for retirement and solutions that are offered by a healthy savings plan.
Ultimately, for you to retire on your own terms, you need to consider just how much of the income you earn you will need in your sunset years.