Magazine

Published in July 2012

Recipe for Success

By PLANSPONSOR staff | July 2012
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Lifetime retirement income is the key ingredient for an effective 401(k) plan

The definition of “success” is constantly changing. Plan sponsors who want to offer successful 401(k) plans need to participate in that evolution … rather than being anchored to historical measurements.

In the 1990s, 401(k) plans were largely measured by features and funds, the success of the plans often determined by whether they offered brand-name mutual funds and “extras” such as a website, investment education or advice, and/or brokerage accounts.

Beginning in the early 2000s, and continuing to date, success has been based on current results. By “current,” I refer to measurements of where a plan stands today. Perhaps the most commonly accepted current yardstick is level of participation. If a plan has high participation, it’s a successful plan. Similar thinking applied to deferral rates and participants investing in portfolios of balanced funds, target-date funds, asset allocation models or managed accounts.

We are now evolving into the next generation of success standards. The new measurement will be based on back-end results. Rather than: “What is the plan doing?” the question will be: “What is the plan producing—will it yield adequate benefits for participants to live on in retirement?” Success will be measured not by account balances but retirement income. After all, the need for benefits in retirement is month-to-month and not lump-sum.

How will plan sponsors know if they are evolving to this new standard? The first test will be whether the plan offers gap analysis to its participants. Simply stated, gap analysis tells participants whether they are on course to having adequate retirement income and, if not, what they need to do. To calculate benefit adequacy, a participant would need to perform relatively complicated actuarial calculations. And a participant would need to have information about income replacement ratios, Social Security benefits, life expectancy and probabilities of exceeding life expectancy, and so on. For example, does the typical participant know that one member of a 65-year-old couple has a 25% chance of living at least 30 more years? Probably not.

Participants also need information about sustainable withdrawal rates in retirement. For instance, based on authoritative research, many experts believe that participants should withdraw no more than 4% a year (inflation adjusted) if they want their retirement savings to have at least a 90% probability of lasting for 30 years.