Using the Income Replacement Ratio to Measure Plan Health

A common challenge for sponsors of defined contribution retirement plans is measuring the success of their plans in meeting their employees’ future needs. When offering a retirement plan of any kind, sponsors need the resources to determine the “plan health” or overall success of their defined contribution program.

Many approaches have been used historically, including:

  • Participation rate. This is one of the most popular measurements. It divides the number of employees making payroll deduction contributions to the plan by the number of employees eligible to contribute. For example, if an employer has 100 eligible employees and 70 of them are making contributions to the plan from their paychecks, the plan’s participation rate is 70 percent.
  • Average deferral rate. This is another common metric. Based on participants who are making deferrals to the plan from their paychecks, this measurement quantifies the average percentage of compensation that each person contributes.
  • Diversification. An additional important measure is to gauge diversification among investment asset classes such as stocks, bonds and cash equivalents to determine how well diversified the plan participants are as a group.

All of these measurements provide some indication of how the plan is performing, and in each case, the higher the percentage, the more advantageous it is for the plan and the participants.

However, none of these metrics capture what most plan sponsors are trying to determine – what percentage of the employee population is on target to meet their retirement needs. This is much more difficult to assess.

Income Replacement Ratio

There are a number of challenges in determining the percentage of participants who are on track to meet their retirement savings goals. After all, the savings goal for one person can differ greatly from that of another.

Nevertheless, an important metric used to help determine if a person is on track for adequate retirement savings is the income replacement ratio.

Most retirement experts counsel their clients that a person needs to have income in retirement that replaces between 70-85 percent of their final year’s salary. This amount represents the income necessary to maintain the standard of living in retirement that they enjoyed while they were working, and replacement income comes from many sources, including Social Security, the current retirement plan, retirement plans from previous employers and other savings. While it might not be true for all employees, it is assumed that a person will require less income in retirement than during employment.

For the purpose of measuring plan success in meeting participants’ targeted replacement ratio (using 80 percent of an employee’s projected final year’s compensation as a reasonable replacement ratio), the calculations focus on the accumulations from employer and employee contributions to the retirement plans offered by the plan sponsor, as well as assumed Social Security payments.  Generally, plan sponsors will be unable to capture all of the potential replacement income sources, outside IRAs and prior plan accounts for example, for all of its employee participants in the plan.  However, the information that is available allows a sponsor to create a baseline measure to compare to future results so the sponsor can track the progress of the plan and its participants.

How Are Calculations Performed?

The calculation of a participant’s replacement ratio requires some indicative census data (date of birth, annual compensation), some current plan data (account balance, deferral percentage, asset allocation) and some assumptions for the future (age at retirement, future increases to compensation, inflation rates, future returns on investments). Using this information, along with an agreement on the assumptions to be used, the record-keeper (associated with the plan’s advisory firm) should be able to project a future account balance based on historic rates of return for the investments being used by each participant.

Translating that into a rate of participants on target for meeting their retirement savings needs, the record-keeper typically will indicate what portion of the population has a 100 percent chance of reaching the 80 percent replacement income target. With this information as a baseline, the plan sponsor might undertake initiatives to increase the participation rate or the average deferral percentage.

Next Steps

Plan sponsors should ask whether their plan record-keeper or advisor can provide them with these plan statistics, particularly a calculation of the percentage of participants who are on track to meet their replacement ratio. While most have the capability to project an individual participant’s replacement ratio, they might not have the capability to aggregate the numbers on a plan-wide basis.

Armed with this information, plan sponsors can drive initiatives to improve the plan’s success in preparing participants for retirement.

The Financial Professionals of Summit Financial Corp (700 District Avenue, Suite 900, Burlington, MA 01803) offer access to Securities and Advisory Services through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser.

Third Party Administrator (TPA) services offered by Summit Financial Corporation are separate and unrelated to Commonwealth Financial. 

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