A: The short answer: a replacement rate is the ratio of net social insurance benefit in the corresponding social security scheme (sickness, unemployment, pensions and family/parental leave) to the net wage before the loss of income.
The more technical answer: a replacement rate is basically estimated in four steps. Step (1) is to determine the gross benefit. Benefits are usually defined in relation to former earnings or are paid at uniform rates (flat-rate benefits). In case of an earnings related benefit, the amount paid is a function of former wages and is in most cases defined as a certain percentage (nominal replacement rate prescribed by law) of some reference income. In contrast to this, flat-rate benefits are not tied to former earnings and thus do not vary with former income. (2) Thereafter the tax liability (if benefits are subject to personal income taxes) and payments of social security contributions are determined. Tax payments and social contributions are then subtracted from the gross benefit. In a third (3) step cash benefits for families are added to the amount. (4) The replacement rate is then calculated by dividing the net benefit by the net wage. The replacement rate thus reflects the relation of the income drawn from social security benefits to the income drawn from earnings when in work. It is the result of social rights (the amount of benefit defined by law), taxation and contribution rules and the relation of income and benefit growth (depending among other things on the indexation of benefits and the growth of wages).
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