As fewer retirees receive retirement income from traditional pension plans, the role of 401(k) plans is becoming more important. Assets in defined contribution plans comprise 25 percent of the total retirement market in the United States and between 72 and 92 percent of employers offer some form of a defined contribution plan, depending on company size. But, current market volatility and pessimistic predictions that the Social Security program will go broke continue to cause understandable concern among clients who wonder if they’ll have enough saved to last them through retirement.
Clients can enjoy a secure, fulfilling retirement when they augment Social Security benefits with appropriate savings behavior. 401(k)s and similar types of plans are the most likely vehicle to foster good savings behavior in clients, particularly when the plans have automatic features to help the individual make the right savings decisions. The Pension Protection Act of 2006 (PPA) significantly improved the effectiveness of 401(k) plans by facilitating the adoption of features like automatic enrollment and automatic contribution escalation, which help to increase participation and improve savings adequacy.
With fewer future retirees receiving retirement income from traditional pension plans, the role of 401(k) plans is becoming increasingly important. Social Security will continue to play a critical role, providing approximately 34 to 40 percent of the average retiree’s income, according to the Social Security Administration. Social Security represents a higher percentage of income for lower-income retirees and a lower percentage for higher-income retirees. An important follow-up question thus becomes, “What percentage of retirement income should 401(k) plans provide?” Research by the Center for Retirement Research at Boston College (CRR) addressed this question.
The CRR produces the National Retirement Risk Index (NRRI), which measures the share of American households at risk of being unable to maintain their preretirement standard of living in retirement. The NRRI calculates statistics for the average household across all income groups, as well as for three categories of household income groups (based on households headed by 33- to 35-year olds; thresholds vary by age bracket).
- Low income (under $41,500)
- Middle income ($41,501-$76,500)
- High income (over $76,500)
In the NRRI model, retirement income can be provided by Social Security, defined benefit plans, defined contribution plans, personal savings, and home equity. In the CRR’s research, defined benefit, defined contribution and other personal savings, including IRAs, were considered “401(k) wealth,” as future retirees are unlikely to have defined benefit income, little personal savings occurs outside of 401(k) plans and most IRA assets originated from defined contribution plan rollovers.
Using Household Income to Determine the Right Percent
The CRR research found that, on average, 35 percent of retirement income must come from 401(k) plans for households to maintain their preretirement standard of living. For low-income homes, the number translates to 25 percent, for middle-income homes it's 32 percent, and for high-income homes it's 47 percent.
The research also established required 401(k) savings rates to achieve the targeted income amounts. Assuming retirement savings begins at age 35 and that retirement occurs at age 65, the average required savings rate to achieve the targeted income from a 401(k) plan is 14 percent of pre-tax household income per year. For low-income households the savings rate is 11 percent, for middle-income households, it is 15 percent, and for high-income households, it is 16 percent.
In a simple exercise, the CRR researchers modeled an average wage earner in a single-person household retiring in 2040 at age 65 (based on 2014 Social Security Administration data). They found that the required savings rate drops from 15 percent to 10 percent if the individual starts saving at age 25, instead of age 35. When the retirement age increases two years to age 67 — the full retirement age for Social Security for those born after 1959 — the required savings rate (starting at age 35) is lowered from 15 percent to 12 percent. When retirement is further delayed to age 70, the required savings rate drops to 6 percent. If a combined approach is taken, with savings starting at age 25 and retirement occurring at age 70, the required savings rate drops to 4 percent.
An Advisor’s Perspective
The findings of this NRRI research are encouraging. If clients start saving for retirement earlier and delay retirement by a few years, the required savings rate becomes even more attainable. Furthermore, many employers will match their employees’ 401(k) contributions.
Savings rate targets are within reach for many Americans, especially when savings start early and when considering 401(k) matching contributions. The key is to get clients started along a proper savings path and to improve their savings behavior along the way. This is why access to 401(k) plans is so important, particularly plans with automatic features. As workers age, they need to shift from focusing on accumulation to focusing on retirement income. With the appropriate tools, 401(k) participants can see if they are behind in their retirement income objectives and make adjustments accordingly. Nearly 20 percent of participants who completed Prudential’s Retirement Income Calculator modeling tool immediately increased their 401(k) contribution rate by an average of 4.5 percent of pay.
In-plan guaranteed retirement income options can also improve savings behavior by helping participants focus on retirement income as an end goal. Prudential found that participants who were investing at least a portion of their 401(k) savings in an in-plan guaranteed income option contributed 38 percent more than the average 401(k) participant.
The key takeaway is that a secure retirement is entirely possible — 401(k)s have greatly improved since they were launched in 1978 as supplemental savings vehicles. With Social Security benefits serving as a base, 401(k)s can be an effective means to help clients achieve a secure retirement. They provide tax-deferred savings and the convenience of saving through payroll deduction. Access to a 401(k) plan also brings investment education, advice, institutionally-priced products and employer-matching contributions to many American workers.
Tips for Advisors in Light of This Data
- Assist clients in determining an appropriate target retirement age, retirement income needs, and an adequate savings rate.
- Educate clients about their options for converting savings into streams of guaranteed lifetime income for retirement.
- Work with clients to add automatic enrollment features and guaranteed lifetime income options to their employer-sponsored 401(k) plans.
- Encourage clients to commit to automatic contribution escalations or, at a minimum, to contribute at a rate that maximizes the company’s match.
An important issue in retirement income planning is choosing and adjusting the retirement portfolio’s asset allocation over time. With retirement income planning, the goal is not just to...