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Secret to a 401(k) Plan’s Success: The Income Replacement Ratio
Determine whether employees are on target to meet their retirement needs

By Earle Allen, Cammack LaRhette Consulting  4/9/2012
 

Sponsors of defined contribution retirement plans often encounter the problem of how to measure the success of their plan in meeting the future needs of their employees. As part of offering a retirement plan, they need a gauge of results.

Many measurements can be used to give a plan sponsor some guidance:

The most popular of these is probably participation rate, calculated by dividing the number of employees making payroll deduction contributions to the plan by the number of employees eligible to contribute. For example, if an employer has 100 eligible employees and 70 of them are making contributions to the plan from their paychecks, the plan’s participation rate is 70 percent.

Another popular metric is average deferral rate. Based on participants who are making deferrals to the plan from their paychecks, this metric quantifies the average percentage of compensation that each person contributes.

Yet another measure is designed to gauge participants' diversification among investment asset classes such as stocks, bonds and cash equivalents. By tracking the percentage of participants that are using more than three investment funds focused on distinct asset classes, or a balanced allocation fund (such as a lifestyle or target-date fund), the metric measures how well diversified the plan participants are as a group.

All these measurements provide some indication of how the plan is performing. In each case, the higher the percentage, the more advantageous it is for the plan and the participants. A greater percentage of employees contributing at higher deferral rates, and being well diversified among the investment offerings over the long term, should yield higher account balances at lower risk levels. In general, this should lead to better retirement outcomes.

However, none of these metrics captures what most plan sponsors are trying to determine—what percentage of the employee population is on target to meet their retirement needs. This is a much more difficult number to assess, which is probably why many plans focus on the above statistics, which are relatively easily attained.

Income Replacement Ratio

There are a number of challenges in determining the percentage of participants who are on track for meeting their retirement savings goals. For instance, the savings goal for one person can be differ greatly from the goal of another. Clearly, the savings needed for a person who intends to retire early and travel the world are very different from those of a person who does not intend to ever fully retire.

Nevertheless, an important metric used to help determine if a person is on track for adequate retirement savings is the income replacement ratio.

Most retirement experts counsel their clients that a person needs to have income in retirement that replaces between 70 percent and 80 percent of their final year’s salary. This amount represents the income necessary to maintain the standard of living in retirement that they enjoyed while they were working. While it might not be true for all employees, it is assumed that a person will require less income in retirement than during employment. Daily commuting costs and other work-related expenses might be reduced, as might taxes and housing expenses.

Replacement income comes from many sources, including Social Security, the current retirement plan, retirement plans from previous employers and other savings. For the purpose of determining the percentage of employees who are on track with their retirement savings, targeting 75 percent of the person’s projected final year’s compensation as the replacement ratio is reasonable.

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Targeting 75% of an employee's projected
final year’s pay as the replacement ratio
is reasonable.
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No plan sponsor, however, is able to capture all of the potential replacement income sources for all of its employee participants in the plan. For the purpose of measuring plan success in meeting participants’ targeted replacement ratio, the calculations focus on the accumulations from employer and employee contributions to the retirement plans offered by the plan sponsor as well as assumed Social Security payments.

How Are Calculations Performed?

The calculation of a participant’s replacement ratio requires some indicative census data (date of birth, annual compensation), some current plan data (account balance, deferral percentage, asset allocation) and some assumptions for the future (age at retirement, future increases to compensation, inflation rates, future returns on investments).

In most cases, these calculations can be provided by the plan recordkeeper. Many recordkeepers have systems to perform this computation and hold the current plan data. In addition, depending on the agreement with the plan sponsor, the recordkeeper might be receiving the necessary census information with each plan remittance. If not, the plan sponsor must produce a file with the census information in order for the recordkeeper to provide the projections. Using this data, along with an agreement on the assumptions to be used, the recordkeeper should be able to project a future account balance based on historic rates of return for the investments being used by each participant.

Because of the unpredictability of financial markets, a recordkeeper with a robust system will run multiple iterations of these projections. Different investment return scenarios (i.e., so-called "Monte Carlo simulations") provide a range of potential outcomes for each participant. Having performed these simulations, the recordkeeper will compute the percentage likelihood for each participant to meet his or her replacement ratio.

Translating that into a rate of participants on target for meeting their retirement savings needs, the recordkeeper typically will indicate what portion of the population has a 100 percent chance of reaching the 75 percent replacement income target. Although it is not used as standard industry term, this can be called the plan’s “success ratio.”

With this information as a baseline, the plan sponsor can set in motion steps to improve this metric. The plan sponsor might undertake an initiative to increase the participation rate or the average deferral percentage. Working with the recordkeeper, the plan advisor or both to design a campaign targeting specific groups of individuals who might not be participating or who might be contributing very small amounts, the plan sponsor might be able to enhance these statistics. An improvement in these numbers is likely to improve the plan’s success ratio.

In addition, plan sponsors who are considering an analysis of their plan’s success ratio must take into account which members of the employee population have the most critical need to meet the retirement targets. While ideally all employees will accomplish their retirement savings goals, plan sponsors might choose to focus more attention on the longest-tenured employees or the ones who will be longest-standing, assuming that they remain with the employer until retirement age. These will likely be the most loyal to the organization and those most likely to achieve their savings needs.

It is more challenging to design a retirement program to meet savings goals for an employee who will be employed by the organization for fewer than 10 years. These employees are likely to have savings in retirement plans from previous employers, which will add to their overall replacement income. As you review your plan success statistics, it is important to keep this in mind.

Next Steps

Plan sponsors should ask whether their plan recordkeeper can provide them with these plan statistics, particularly a calculation of the percentage of participants who are on track to meet their replacement ratio. While most have the capability to project an individual participant’s replacement ratio, they might not have the capability to aggregate the numbers on a planwide basis. But it is still worth asking.

Armed with this information, plan sponsors can be more aware of how well their plan will meet the needs of participants. They will have concrete information that can drive communication initiatives to improve the plan’s numbers and will be much better informed about the plan's overall success.

Earle Allen is vice president, retirement, at Cammack LaRhette Consulting.

© 2012, Cammack LaRhette Consulting.

Related Articles: 

‘Safe’ Withdrawal Rate from Retirement Plan Deemed Critical, SHRM Online Benefits Discipline, April 2012

Use of Target-Date Funds Continues to Surge, SHRM Online Benefits Discipline, March 2012

Give Your 401(k) Plan an Annual Checkup, SHRM Online Benefits Discipline, March 2012

Tiers Recommended for 401(k) Investment Menus, SHRM Online Benefits Discipline, October 2010

401(k) Distributions: Easing Into Annuities, SHRM Online Benefits, June 2008

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