Since the 2006 passage of the Pension Protection Act, employer adoption of auto enrollment, annual increase programs, managed accounts and target-date default funds has resulted in dramatic improvements in participation rates, savings levels and age-appropriate asset allocation. This is extremely significant, as adoption of these plan design elements can help drive better retirement security for participants with access to these features. But these measures alone do not provide visibility into whether or not employees are on track to achieve desired outcomes. In fact, many employers and employees don’t even understand what a “desired outcome” looks like. We need to think differently about how to drive even better retirement outcomes for American workers.
Defined benefit (DB) plans were designed with an income goal in mind. Plan sponsors contributed and invested assets in DB plans at levels designed to achieve a pre-determined income replacement rate for their participants in retirement. And that is exactly how DC plans need to be designed—with a targeted income replacement goal. Simply put, DC plans need more focus on the desired outcomes for retirement income levels.
A Fidelity Investments survey of more than 500 employers, conducted in March 2013, found the vast majority of employers do not have clear visibility into the income level their DC plans might generate for employees. Given the current state of retirement readiness, this information is critical to managing a benefits strategy and adequately preparing employees for retirement.
The fundamental objective of a DC plan is to ultimately generate retirement income. Therefore, DC plans should be designed to target a percentage of an average earner’s final income as an income replacement rate goal. For example, a reasonable starting point for a typical DC plan could be to target a 50% income replacement rate and that, combined with Social Security for their average earner, could potentially replace 85% of the typical employee’s final pay. The DC plan income target would vary based on an employer’s goals, other benefits offered and plan demographics. To achieve a potential 50% target, Fidelity recommends utilization of auto enrollment with an initial deferral of at least 6% of income, with total employee and employer contributions reaching 15% or more as early in an employee’s career as possible. ([i]) For higher income earners, whose Social Security will represent a smaller portion of retirement income, additional savings vehicles such as non-qualified plans, equity compensation plans, health savings accounts (HSAs), and individual retirement accounts (IRAs) can supplement the DC plan.
Often when an employer makes a plan design change, it is not always understood or considered how the change may impact the potential retirement income for the employee. It’s like putting gas in a car, but not knowing how far you can drive. The conversation and the analysis must shift from simply evaluating defined contribution plan inputs to designing outcomes-based plans.
Today, many plan sponsors don’t have an easy way to determine the outcome their plan is designed to yield, though this is changing. We are starting to work with sponsors to create visibility on the connection between plan design and possible participant outcomes. This is critical because, without an outcomes-based focus, employers could face a growing pool of individuals who will want to stay in the workforce longer because they are not confident they have saved enough for living and health care expenses once they leave full-time employment. The percentage of workers 60 and older contributing to DC plans has nearly doubled over the past 10 years. As a result, many employers may be facing a generation of “never ready” employees who will stay in the workforce well beyond the age of 65 because of inadequate savings, rising health care costs and longer life expectancy.
Translating plan design into a targeted level of income replacement will create visibility—for both employers and their employees—into what age employees may be able to retire. Some DC plans could be designed to enable workers to retire at age 60 while others may be designed for a retirement age of 70.
[i] The 50% DC plan income replacement target is based on an average earner with a starting age of 26 and a retirement age of 67; starting salary: $40,000; ending salary: $73,649; salary growth rate: 1.5% annually; starting deferral rate: 6% with an annual 1% increase up to 15%; employer contribution of 3% per year and assumed annual rate of return: 5.7% (3.2% net of inflation).
Plan design changes that potentially increase the targeted income replacement rate can be implemented without incremental cost to a plan sponsor. For example, our data reveals that many employees lack the will, skill and time to properly manage their asset allocations. Plan adoption of target-date funds and managed accounts can help solve for this, and can potentially increase an individual’s income replacement rate without increasing plan expenses.
Employees must also understand the potential income their plan can provide, and must be shown a clear path toward realizing that potential. This is reliant on simple and engaging web and mobile capabilities and the ability to speak or interact with highly trained representatives for guidance.
Understanding the potential yield of a given plan design will help employers optimize workforce planning, provide critical insight into the potential outcomes they are getting for their benefits spend, and ultimately help their employees enjoy a retirement they have prepared for and deserve.
By Jim MacDonald, president, Workplace Investing, Fidelity Investments
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.
Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.
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