Retirement Readiness and Plan Reports
Providers and retirement industry insiders frequently use the term “retirement readiness,” but what does that expression actually mean? It generally indicates that a person has the financial resources to sustain them for the rest of their life without needing to work. So the question for an organization is, how does it know that the design of its program will lead to the retirement readiness of its staff?
That readiness result can be defined in several different ways. The goal of most retirement plans is to enable plan participants to maintain in retirement their pre-retirement standard of living. In a defined contribution style plan, the employer offers a retirement savings vehicle that allows employees to make pre and/or post tax contributions, and to select from an array of investment options. The employer may also contribute to that account, either through a matching contribution that requires the employee to contribute as well, or through a discretionary contribution, which does not necessitate employee contributions. The objective is to amass a sufficient level of annual income derived from a combination of all of these contributions, as well as the growth of the underlying investments and any amounts from Social Security. That level of income should allow the recipient to continue to live their lifestyle as desired, rather than being constrained by a scarcity of resources.
The projected annual amount is frequently referred to as “replacement income,” which is the amount of income replaced in retirement by the accumulated savings. That figure can be divided by the projected final working year’s salary to produce the “replacement ratio.” The retirement plan seeks to replace the final working year’s salary, because that projected salary is probably more representative of future lifestyle spending than the salary the person might be earning today.
Various methodologies address what level replacement ratio will enable participants to maintain an ongoing standard of living in retirement. Most of these approaches target around 80% of the final year’s salary. Note that the replacement ratio does not need to be 100% in order to maintain the same standard. The retiree may require less money for various reasons: the person is no longer saving for retirement, there is a reduction in transportation costs without the daily commute and people generally have lower housing costs, having paid off their mortgage by the time they reach retirement. Yet individual employee needs for retirement will vary dramatically, depending on personal circumstances and retirement goals. For example, someone who intends to travel in retirement will likely require significantly greater annual income than someone who will be staying close to home.
When organizations seek reports from their providers about the retirement readiness of their employees and the percentage that are on track to meet their replacement ratio target, they must still put the results in perspective. Just because the provider defines retirement readiness as an 80% replacement ratio does not mean that figure will be suitable for all employees. For instance, some people with projected replacement ratios of less than 80% may still easily meet their retirement needs. Furthermore, the information on which the projection is based is likely limited to the current plan, plus Social Security; in reality, the future income of the participants may also draw upon additional savings and accumulated assets, such as retirement plans from previous employers, outside IRAs or housing assets.
Of the three inputs above, the participation rate is the most important. The additional time for the compounding of investment gains and additional contributions outweighs the benefits of similar percentage increases in contribution rates and investment returns. Therefore, it is important to maintain careful scrutiny of the investment options, as well as a communication program to alert people to the program and get them enrolled (or an automatic enrollment process). Having the best investment options in the marketplace is obviously a plus for any retirement plan. Nevertheless, if the participants are not in the plan for a long enough period of time, additional returns from the investments will still not enable them to meet their goals.
Even the overall number of employees who are on track to meet their retirement needs is only a starting point. While it is an important gauge and a useful tool to plan evaluation, it must be carefully reviewed before taking action. Diving into the assumptions and recognizing what these analyses can and cannot measure is critical if an organization wishes to learn from the report and to consider any plan design or procedural adjustments to help the plan meet the employer and the employee goals.
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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