Sweet Spot: Encourage Deferring Adequate Pay to 401(k)s

Savings rates are too low; education and automation can turn things around

By Joanne Sammer and Stephen Miller, CEBS May 25, 2012

When defined contribution plan sponsors and financial advisers start talking about saving for retirement, they often throw out numbers like 15 percent to 20 percent of pay as a way of measuring an appropriate level of annual contributions. However, such numbers might not tell the whole story.

It is an unfortunate fact that many are not saving enough, or anything, for their retirement. An April 2012 study by LIMRA, a research and consulting firm in the financial services industry, found that 49 percent of U.S. adults are not contributing to any retirement plan and that individuals ages 18 to 34 are most likely (56 percent) to be among those not saving.

In addition, an October 2012 study by LIMRA found 65 percent of workers earning between $40,000 and $99,999 annually are saving less than 5 percent of their income for retirement.

However, many individuals are saving what they can. They just might not know whether their efforts will be enough to secure their retirement.

Dallas Salisbury, president of the not-for-profit Employee Benefit Research Institute (EBRI), argues that current savings rates are far too low to ensure adequate retirement income for most employees. Recently, he highlighted the importance of employers “providing automatic payroll deduction at an average of 15 percent of pay into a savings program for every worker, from day one of employment. Workers must then add more with every increase in income. Those who start at age 35 instead of 20 will have to defer more like 25 percent on average for the rest of their working years,” Salisbury contended.

As is readily apparent to HR benefits managers, these amounts are far higher than the typical employee savings deferral rate. According to EBRI, the average employee contribution to a 401(k)-type plan is 7.5 percent of annual earnings for workers who report making a contribution. A 2012 survey by Fidelity Investments put the average deferral rate only slightly higher, at 8 percent.

Salisbury isn't alone in sounding an alarm over low deferral rates. “We have unwittingly contributed to this problem by creating unrealistically low expectations for employees when it comes to helping them set their savings goals,” wrote Michael J. Malone, managing principal at investment advisory firm MJM401k.

“We have created unrealistically low expectations
for employees when it comes to helping them
set their savings goals.”

In an April 2012 policy brief, “The Language of Employee Savings: Encouraging Employees to Capture the 402(g) Limit,” Malone noted that the maximum allowed employee contribution to a 401(k) plan was $17,000 in 2012 [rising to $17,500 in 2013] with an additional $5,500 “catch up” contribution for those age 50 and older. “These are the amounts that all employees should be encouraged to capture each year,” Malone wrote. “While there is no question that an annual deferral of $17,000 (or $22,500) is a high bar for some and may be unrealistic for others, it is a lofty goal that all employees should aspire to even if it may take a few years to get there,” he added. “It doesn't seem like such a long trip to increase your contribution to $12,000, for example, when the goal figure you have in mind is $17,000.”

Beware Unrealistic Work Expectations

Many Americans say they plan to grow their nest egg by working past age 65, and going beyond age 66 to 67 when most will become eligible for full Social Security benefits. However, according to an EBRI fact sheet, each year a sizable proportion retire sooner than they had planned (50 percent in 2012). Those who retire early often do so for reasons such as health problems or disability—their own or caregiving for a spouse/partner—or loss of their job.

Moreover, while 70 percent of workers say they plan to work for pay after they retire, a much smaller proportion of retirees report having done so (27 percent). Aside from health and caregiving issues, finding full- or part-time work during retirement may be more difficult than expected.

Savings Goals Vary

“For many, target income replacement ratios should be higher than the 70-75 percent ratio conventionally accepted as a rule of thumb,” stated a May 2012 position paper from the Retirement Advisor Council, a trade group.

“When actuaries look at a defined contribution plan, they consider individual needs and come up with a replacement income of about 80 percent, and some even go as high as 100 percent because of the unpredictability with rising medical costs,” said Sandy Pappa, a principal with Buck Consultants in Pittsburgh. “Some employers are starting to segment their populations to help different groups with different characteristics to save for retirement.”

Many retirement experts, however, point to a number of variables involved in calculating necessary retirement savings. “There is no one-size-fits-all approach,” said Bill McClain, a principal with Mercer in Seattle. The “right” amount of savings depends on age, how early employees start saving for retirement, how much income in retirement is necessary and what other sources of retirement funds someone has available.

An adequate retirement income is very much about personal choice, others contend. “Adequacy is difficult to define because it varies so much by individual. Marital status, health, age, dependents, location, pre-retirement spending patterns—all affect the need,” said David Wray, president of the Plan Sponsor Council of America in Chicago. “I know someone who is driving around the country in an old school bus because he wants to. His income needs are far less than someone living in a gated community with a swimming pool and lots of other amenities.”

Just how that replacement income translates into annual savings as a percentage of salary varies. For example, a low-income worker is likely to find that Social Security replaces a larger percentage of pre-retirement income than it does for a higher-income worker. Therefore, the lower-income worker might need to save only enough to replace 40 percent or 50 percent of his income. Very high-income workers often have more potential sources of income than others, such as deferred compensation and nonqualified retirement arrangements, to supplement broad-based retirement plans.

How Much Is Enough?

An Aon/Georgia State University Replacement Ratio study suggests that, along with Social Security, a worker earning $50,000 at retirement will need to replace 81 percent of that amount annually to continue the same standard of living, while a worker earning $150,000 at retirement will need to replace 84 percent of that salary to continue the same pre-retirement standard of living.

The common denominator for these calculations is that the earlier and more consistently younger workers save for retirement, the lower the percentage of income they need to save over time. For example, Pappa noted that workers who start saving for retirement at age 25 might be able to secure their retirement with total (employer and employee) contributions to a 401(k) plan equal to 12 percent to 15 percent of their income over the course of their career. If this individual works for a company that sponsors a 401(k) plan with a generous match of 6 percent of salary, the employee could reach the 12 percent level relatively easily by contributing 6 percent to gain access to the company’s match of 6 percent.

Wray cited a company with a large group of long-term employees with total contribution levels equal to about 15 percent of pay (employer and employee contributions). “This plan delivers a lump sum of about 20 times final pay to their median wage workers at retirement,” said Wray. “I believe that such an amount is much more than the normal retiree will need and provides a significant cushion for the unexpected.”

Although he noted that saving 15 percent of pay over a working career is an optimal target, Wray conceded that saving even 10 percent of pay is likely to be adequate for many employees, assuming the continuation of Social Security at around current levels.

Deferral Rates Have Greater Impact than Fund Performance

Putting fund performance front and center in terms of the plan sponsor’s priorities is an error with far-reaching implications, according to a July 2012 Putnam Institute research report, Defined Contribution Plans: Missing the Forest for the Trees?

That isn't to say that fund performance doesn't matter, but over a long time frame, the analysis suggests, it's a much less powerful driver of retirement wealth than asset allocation and, most of all, higher deferral rates.

"For many years, fund performance has taken center stage in the discussion of [defined contribution] plan effectiveness and how to improve it," the report concludes. "With the present study, we hope to shift the emphasis of that discussion to deferral rates—and the ways in which plan design and employee education can be leveraged to raise deferral rates for eligible participations."

Automated Savings

Automatic 401(k) plan features can help employees to achieve these savings levels. According to a 2011 benchmarking report by 401khelpcenter.com, the most common default deferral is 3 percent of pay, present in 58 percent of plans, and 53.1 percent of plans increase the default deferral percentage automatically over time.

It's common, however, for employers to enroll employees into the plan automatically with a default contribution rate of 6 percent of pay or some other level of savings that allows employees to earn a full employer matching contribution.

An automatic escalation feature that increases employee contributions by, say, an additional 1 percent per year is the second part of this approach. Employers that want to be aggressive when increasing employee savings can increase the automatic escalation amount to 2 percent annually. And, many experts advise, don't stop auto escalation at too low a level; let it build up to at least 15 percent.

Of course, employees have the ability to stop that escalation. There is plenty of flexibility to this approach while “auto enrollment and escalation set a standard level for plan participation,” said McClain.

Even a company that is not comfortable having a default contribution rate as high as 6 percent on enrollment can use automatic escalation as a way to increase employee deferrals gradually over time. In an industry like manufacturing with a lot of low-wage earners, companies might shift their matching contributions to reward a low rate of savings because these employees require less money at retirement to replace their income, given that Social Security will replace a higher percentage of their income.

“The key is to match the plan characteristics with the employee demographics and other benefit programs,” says Pappa. For example, a manufacturer might offer a traditional defined benefit pension plan that provides retirees with an annuity. In that case, 401(k) plan contributions take on much less weight.

Finally, once employers get employees into the plan and increasing their contributions, employers need to make sure that the plan is functioning at top efficiency, said McClain. That means that employees need to have the right investment allocation, which changes over time, whether that is through the use of a target-date fund, managed account or some other means. In addition, it means preventing the leakage of plan assets through hardship withdrawals, plan loans and failure to roll over account balances when employees switch jobs.

Estimating Expected Retirement Income

Knowing the amount of expected retirement income can help employers to determine whether they are saving enough through employer-provided retirement plans and individual retirement accounts to provide an adequate replacement income in retirement.

The U.S. Social Security Administration (SSA) has launched a portal that enables workers who have paid into the Social Security system to view their personalized earnings and benefits information, at www.socialsecurity.gov/mystatement.

Retirement income from Social Security plus accumulated retirement plan and other savings can be estimated using free online tools such as AARP's Retirement Income Calculator and the SSA's Retirement Estimator.

Joanne Sammer is a New Jersey-based business and financial writer. Stephen Miller, CEBS, is an online editor/manager for SHRM.

Related SHRM Articles:

Generation X Most Concerned About Financing Retirement, SHRM Online Benefits, October 2012

Age-Based Savings Benchmarks Chart the Course, SHRM Online Benefits, September 2012

401(k) Match: Higher 'Thresholds' Drive Participation, SHRM Online Benefits Discipline, July 2012



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