Magazine

Feature | Published in June 2017

The Flaws in a New Standard

Retirement readiness cannot be expressed as a simple score or a single metric

By John Manganaro | June 2017
Art by Paige Mehrer

By taking a close and critical—even contrarian—look at the subject of “using retirement readiness as a plan performance benchmark,” one may conclude that the bulk of retirement readiness metrics employed today by defined contribution (DC) retirement plan sponsors have limitations.

It is true that DC plan sponsors with the right mindset can greatly benefit from leveraging the income calculators, prediction tools and analytical models created in recent years by plan providers, investment managers, consultants, third-party administrators (TPAs) and the like. These solutions can help put a quantitative framework around the nebulous topic of “retirement readiness,” at both the plan and individual participant levels, particularly by helping individuals translate lump-sum savings into monthly or annualized lifetime income.

But there are strong arguments to be made that any readiness metrics reducing a participant’s financial future to a single score or income replacement percentage will necessarily offer little insight into his or the whole population of his plan’s true outlook for retirement. Chief among these stands the fact that there will always be uncertainty baked into any and all efforts to save for the long-term future, just given the inherently unpredictable nature of human life. Not to mention the fact that most plan sponsors view only a small portion their employees’ financial lives, that being what they hold in the plan.

One improvement to the system would be if financial services providers agreed to share, in real time, all the information they have on individuals, giving plan officials a collective and total insight into participants’ household wealth holdings. However, even if such information-sharing came to be, any conversation dealing with retirement readiness would still need to embrace and account for a real measure of uncertainty and avoid definitive statements of readiness.

Sources of Complexity
According to Laraine McKinnon, founder of LMC17, a strategic consulting firm that uses “behavioral science, big data and practical implementation techniques to influence change,” in Silicon Valley, California, the first step in establishing a meaningful retirement readiness benchmarking system must be setting goals. Formerly, McKinnon was a retirement readiness strategist and managing director with BlackRock in San Francisco, where she focused on developing thought leadership and tools to help clients quantify the implications of participants’ savings and investment decisions.

“It sounds simple, but to define retirement readiness you have to first work with all stakeholders to determine the real objective of what the retirement program is, of what effectively using the plan would look like in the ideal scenario,” McKinnon says. “More often than not, we find there are fundamental questions that are left wide open in the management of DC plans.”

Many employers simply have not stopped and assessed why they offer retirement benefits or what such benefits should accomplish, either in terms of helping employees or promoting business goals. Examples of questions that are often left unasked—making it difficult to start approaching “retirement readiness” as a serious metric—include the following: Just how much income replacement is needed by participants to be “ready,” anyway? Will participants who are “ready” be encouraged to leave the plan or to stay invested once they actually retire? Is readiness calculated from a lump sum or by projecting a lifetime income stream? Should the plan on its own make people retirement ready, or should it expressly consider other sources such as anticipated Social Security income and housing equity?

“You can imagine how older workers grandfathered into defined benefit [DB] plans at an employer would have an entirely different readiness definition than the younger workers, and Gen X will have its own outlook,” McKinnon observes. Therefore, thinking about defining retirement readiness must be flexible enough to consider the differences between demographic groups in a plan—indeed within demographic groups, as well.

“Once you set objectives in this manner, it actually becomes possible to quantify the readiness of individuals and plan populations, but it is still not easy,” she warns.

Is It Easy to Underestimate Readiness?
Many suggest that DC plan sponsors are prone to underestimate the financial health of their plan populations, given that they typically still view their workers’ retirement readiness only in terms of current account balance in the workplace program. Measuring readiness in this way overlooks other key wealth sources such as Social Security, home equity and individual retirement account (IRA) holdings, along with other DC plans and pensions at previous employers.

“We all know that older people joining your plan will very likely have external dollars saved for retirement, potentially across a number of places and split between DB and DC assets. How will your readiness metrics account for this type of complexity?” McKinnon says.

A survey conducted by Gallup, April 5 through 9, among a random sample of 1,019 adults ages 18 and older, offers some context here. The research shows that Social Security in particular forms the backbone of many peoples’ anticipated retirement income plan, in many cases far outstripping what people expect or hope to save for themselves in the workplace. In fact, the percentage of non-retirees counting on Social Security as a major source of future retirement income is near its peak—34%—when viewing Gallup’s 17 years of trend data. Prior to the 2008 through 2009 recession, between 25% and 29% thought they would rely heavily on Social Security, but this increased to 31% during the recession and has since ranged from 29% to 36% (see Figure 1).

After these sources of retirement security, regular cash savings accounts or certificates of deposit, as well as work-sponsored pension plans, figure as major future income sources for 25% of non-retirees. More than half of this group is counting on each to supply at least a minor source of income, Gallup reports. At the same time, roughly one in five non-retirees predict that home equity, part-time work and individual stock or stock mutual fund investments will be a major income source for them, and majorities of 55% to 71% identify each as at least a minor source.

These numbers present important food for thought for plan sponsors and show that many individuals simply do not expect to become “retirement ready” through a workplace defined contribution retirement plan or IRA. Indeed, according to the 2016 PLANSPONSOR Participant Survey—our latest—seven in 10 respondents with under $50,000 in total income had less than $50,000 in retirement savings. Only 23.0% of these individuals in households with total income of under $50,000 report actively deferring more than 6% of their salary to a retirement plan on a regular basis.

Higher up the income scale, where the Participant Survey shows greater levels of workplace DC plan savings—which, theoretically, should denote greater retirement readiness, from the plan sponsor perspective—different challenges present themselves.

Besides uncertainty about the income replacement that will be available from Social Security, especially if the system is reformed, this higher-compensation group also faces rising health care costs expected to be covered less generously by Medicaid. Not to mention the fact that wealthier people will need more money saved—potentially a lot more—than their less-well-off counterparts to maintain their present lifestyle after work ends.

Beyond the Basic Metrics
McKinnon says plan sponsors looking to determine an individual’s or a plan population’s readiness should, additionally, consider factors beyond hard-number metrics, “such as the level of individual engagement with the retirement plan, the confidence level of employees about financial topics that could challenge them in the future, the occurrence of constructive retirement planning actions in the web portal, and whether or not there is appreciation of the quality and features of the retirement plan.” All of these are components of retirement readiness that one cannot really put hard numbers to, but which nonetheless are crucial to think about.

James Nichols, head of advice and strategy services for Voya Financial in Windsor, Connecticut, echoes many of the points raised by McKinnon. He says he generally tries to think and talk about the topic of retirement readiness metrics in terms of “measuring the output of a retirement-planning experience, as opposed to just tracking the inputs.”

Participation rates, diversification rates and savings rates are the inputs to a retirement planning program, Nichols says. “They are important to think about, but we also know, at the end of the day, if we’re not speaking in terms of the broad output, and if we’re not speaking clearly in those terms, it’s very hard to influence behavior and to do our best work as providers and as plan sponsors.” Plan sponsors will have to decide exactly what outputs are most important for their purposes in offering the plan, he says, and different plans will reach different conclusions.

Nichols agrees that it is hard to talk compellingly about plan outputs in terms of a single readiness score or percentage, and adds that he is “thrilled to see that this broader conversation about defining readiness is happening.” Like McKinnon, he feels output “certainly ought to be defined at least partially in terms of anticipated lifetime income replacement.”

“Being on track for retirement means having both the confidence and the resources to cover your lifestyle throughout retirement,” he notes. “It’s a simple definition, on its face, but very complicated to put into practice and track. Retirement readiness is about more than just having a large enough balance in the DC plan.”

Nichols stresses that the inherent complexity and the lack of simple metrics do not give employers an excuse to ignore the idea of retirement readiness. Quite the contrary: “We have seen so much research come out that shows finding a reliable way to measure retirement readiness within your work force and organization delivers real value. It drives better predictability [concerning] work force management, especially. If you have older people who aren’t prepared for retirement, or maybe people who are prepared but don’t know it or don’t feel confident, this can have a major impact on the makeup of your work force. There are real costs and productivity considerations here.”

The natural conclusion from all of this, once again, is that the defined contribution plan savings picture is seldom the whole story for plan participants, complicating plan sponsors’ efforts to determine who is and who is not retirement ready.

TAKING A DIFFERENT PERSPECTIVE

If plan sponsors cannot with great confidence rely on straightforward attempts to measure retirement readiness, what should they do instead to ensure they offer the best retirement package they can for the money put in?
ForUsAll Head of Marketing Healy Jones, based in San Francisco, urges plan sponsors to focus on the following broad themes, similar to suggestions from James Nichols of Voya and Laraine McKinnon of LMC17:

  • Benchmark where you stand with core pieces of the plan; make sure investments are performing well and the fund lineup is appropriate for participants; and make sure the fees you pay to investment funds and providers are in line with averages.
  • Make sure compliance and administration is done correctly, satisfying the requirements of the Internal Revenue Service (IRS), Department of Labor (DOL) and Securities and Exchange Commission (SEC).
  • Make sure the plan is so designed that all employeesand the employer can take advantage of any applicable tax savings; this will likely require progressive design features such as automatic enrollment, automatic salary deferral increases and use of diversified default investments, etc.
  • Meeting these requirements will at the very least mean that plan participants are presented with powerful opportunities to pursue retirement readiness on their own terms. —JM

Figure 1. Income Replacement From Social Security

1940s
1960s
1980s
2000s
96%
82%
86%
89%
63%
49%
44%
41%
33%
23%
20%
18%
Lower Quintile
Middle Quintile
Highest Quintile
Source: Congressional Budget Office, “2016 Long-Term Projections for Social Security”

Figure 2. 401(k) Plans Looking Better

Private, non-pension savings (examples include 401(k)s and IRAs)

Social Security
47%
29%
54%
25%
47%
25%
55%
34%
42%
33%
46%
30%
49%
36%
50%
34%
2003
2005
2007
2009
2011
2013
2015
2017
Source: Gallup, “401(k) Regaining Importance as Future Income Source”

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