|Automatic Contribution Escalation – The Next Step Toward Retirement income adequacy
Aside from a home, for most Americans their single largest asset is their retirement account. It’s not uncommon for even a modest wage earner to accumulate a retirement account value of a few hundred thousand dollars by systematically contributing over the course of their employment. But the ultimate question when it comes time to retire is, “Have you saved enough to produce an adequate income for the rest of your life?” Tragically for many Americans, they have not. What can employers do about this?
The answer comes in two parts. First, plan sponsors can design plans with features that result in an adequate retirement income. Taking Social Security into consideration, is your plan reducing the savings gap? Though investment strategy and fees are important, the critical factor to achieve a meaningful level of accumulation is the contribution level. “Maintaining a similar standard of living during retirement requires an estimated savings rate of 11% to 15% of income over the course of a working career,” according to the Principal Financial Group’s 2011 study titled, “Our View on Retirement Readiness: How to Move from a ‘Popular’ Plan to a Successful Plan.” Successfully accumulated accounts can support systematic withdrawals of approximately 5% per year and combine with Social Security to provide a preretirement income replacement level of at least 80%.
Second, how do you encourage participants to contribute meaningful amounts for retirement? The answer is simple. Make it easier for employees to help themselves. Just as automatic enrollment solves enrollment procrastination by participants, automatic escalation addresses the tendency for employees not to increase their contribution rate after their initial enrollment. Automatic escalation is a plan design feature that systematically increases deferrals. In a typical setup, every participant is notified of the intent to increase deferrals by 2% (for example) each year until the contribution reaches a cap (e.g. 12%). In this manner, the increase is gradual and can have relatively little immediate impact on take home pay. Similar to automatic enrollment, participants must receive advanced notice and retain the ability to opt out.
What is the purpose of your retirement plan? How do you and your committee define its success? We challenge all employers to consider your retirement plan as an employee’s most important tool toward having a meaningful retirement.
Offering Socially Responsible Investments to Plan Participants
Several years ago the Department of Labor issued guidance reaffirming their position that the goal for investments in ERISA plans (such as 401(k)s and 403(b)s) must be to design investment menus to allow participants to attempt to maximize returns and not for any factor other than the economic interest of the plan. The guidance specifically addressed investments meeting environmental (green) criteria known as socially conscious or socially responsible investments. “The plan's fiduciaries may not simply consider investments solely in green companies. They must consider all investments that meet the plan's prudent financial criteria.”
This means that there should be no special consideration given to any investment due to its social agenda. The same selection and monitoring process that is utilized for the core investments in the plan’s menu must be applied to socially responsible investments. More from the DOL guidance, “…fiduciary consideration of noneconomic factors should be rare and, when considered, should be documented in a manner that demonstrates compliance with ERISA’s rigorous fiduciary standards.” Furthermore the DOL indicated that “fiduciaries who rely on factors outside the economic interests of the plan in making investment choices and subsequently find their decision challenged will rarely be able to demonstrate compliance with ERISA absent a written record demonstrating that a contemporaneous economic analysis showed that the investment alternatives were of equal value.”
Socially responsible investments are acceptable investment selections to offer in a retirement plan, but must be selected using the same quantitative and qualitative analysis used to select the rest of the investment menu.
A Key Way to Save Enough for Retirement
If I put a 4x4 piece of wood on the ground and told you I’d give you $50 dollars to walk across it you would probably do it. Why not? The worst that could happen is you fall 4 inches. If I put that same 4x4 100 feet high between two buildings and still only offered you $50 to walk across it, you’d probably say $50 isn’t worth the risk of falling 100 feet. Now, if that other building was on fire with a loved one in it, you probably wouldn’t care about the $50 to go across the board because you have a loved one to save. The difference is why you would go across a board 100 feet high. To get $50…no way. To save a loved one’s life…without hesitation.
Many participants don’t save enough for retirement simply because they don’t mentally connect with the idea. They think to themselves “Retirement? That’s many years from now. I have plenty of time.” Then they reach the age of 45 or 50. Now that it is within reach, a mental connection is made because retirement starts to seem real. However, panic often sets in because they may need to make major financial adjustments to get their saving habits on track to save enough money.
Close your eyes for 5 minutes and really try to picture yourself in retirement. What are you spending your money on? Do you have enough money, or are you barely getting by? What activities are you doing or not doing because of your financial mindset?” When we think of why we want to retire and what we want retirement to look like, we mentally connect with our retirement. However, when someone else is telling us to save for retirement, or we just think of the word “retirement”, we generally don’t connect with the concept.
If participants can take some time to really figure out why they would want to retire and get themselves emotionally connected with their "why", just like in the burning building example, then they willl find prioritizing their budget to save properly for retirement will be much easier.
Here are a few action items for participants to apply this principle:
- Take a few minutes and ask yourself, why you want to retire. Start to get a vivid picture of it by imagining your life in retirement. What don’t you want to live like in retirement? Think about people you’ve seen with the retirement lifestyle you want, and those whose lifestyle you don’t want to copy. Do you have family members such as parents, grandparents, uncle’s, or aunt’s whose lifestyle you can picture. Is that a lifestyle you can use as a model, or perhaps one you want to avoid?
- Figure out the income you desire in retirement, then how much you’ll need to save to get there. Most financial institutions have tools on their websites that can help you with this. As a good rule of thumb, in order to have a retirement income of about 80% of your worthing income you need to save 15 - 20% of your paycheck. The older you are, and the less you have already saved, the more that percentage goes up.
David M. Montgomery, AIF, CRPS
Seeds of Investing
For a copy of this month’s Seeds of Investing newsletter, formatted for distribution to retirement plan participants, contact David Montgomery at DMontgomery@m-rpa.com or 813-868-1930.
News from MRPA
Mike Montgomery has been accepted into the Retirement Partners Group, a membership organization accepting the most experienced, qualified retirement plan advisors associated with LPL Financial. Membership is based upon specific guidelines for number of plans served, years of experience, industry designations and commitment to professionalism.
This material is intended for informational purposes only and should not be construed as legal advice and is not intended to replace the advice of a qualified attorney, tax adviser, investment professional or insurance agent. Montgomery Retirement Plan Advisors does not warrant and is not responsible for errors or omissions in the content of this newsletter.