While there has been much discussion of the need to refine the common notion of a 70 per cent replacement rate in retirement, implementing a different approach will take some work, participants at an event in Toronto heard yesterday.
The challenge is few defined contribution pension plan members fully understand how their retirement savings work, Janice Holman, a principal at Eckler Ltd., said at the event on retirement income adequacy at the InterContinental Hotel in Toronto. Citing Benefits Canada’s survey of plan members, she said that on average, Canadian workers expect their retirement investments to yield an unrealistically high rate of return.
Unrealistic investment expectations mean online planning tools don’t work, said Holman. Take a 45-year-old employee who expects to retire at 65 and has a $60,000 salary, a 10 per cent annual contribution rate and a balance of $177,000 in pension funds.
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If the person anticipates living to 90 years of age and a four per cent investment return, retirement planning tools will predict of replacement rate of up to 80 per cent of the individual’s current income each year after retirement. But if the person plugs in an 80-year life expectancy, the tools will predict a replacement rate of up to 155 per cent. And for those who expect to live to 76 and earn a 10 per cent return, they’ll enjoy a retirement income that’s well above what they currently earn.
“If I just die 10 years earlier, my life looks great,” Holman said jokingly at the event.
But presented with the possibility that their retirement income could be triple what they’re currently earning, employees may choose to save less.
To address the issue, plan sponsors must aim to preserve employees’ working-life standard of living instead of relying on the oft-cited 70 per cent of an employee’s final salary, said Bonnie-Jeanne MacDonald, an actuary and researcher at Dalhousie University in Halifax, during the event in Toronto.
It’s possible to approximate a standard of living through consumption of goods and services by subtracting taxes, savings and money spent on others from an employee’s salary and dividing that spendable income between household members.
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Calculating a living-standards replacement rate involves considering factors beyond an employee’s salary in the last year at work. They include overall earnings, a spouse’s income, the number of children, home ownership status, other savings, taxes and debt, said MacDonald.
Employees should aim to have a 100 per cent living-standards replacement rate so they can continue buying the same goods and services after retirement they did before, she said. But if they plan on travelling a lot or saving money by eating out less, they can adjust that number.
Moving from theory into practice begins by assessing each plan member’s living-standards replacement rate, said Zaheed Jiwani, a senior consultant at Eckler. It involves calculating a person’s pre-retirement net income (gross income minus savings, taxes and deductions) and personal circumstances (spouse’s income, children, housing, province-specific taxes and health-care benefits and post-retirement health-care costs) and comparing it to the post-retirement net income.
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The next step is to model a thousand financial outcomes for each plan member, based on different economic scenarios that could emerge, such as the performance of equities, bonds, target-date funds and interest rates.
With that data, it’s possible to determine the likelihood of members reaching their target for their retirement fund. So far, the results are evenly split, said Holman. Forty-nine per cent of employees analyzed by Eckler have a low or very low chance of reaching their goals for their living-standards replacement rate, while 51 per cent have a moderate, good or very good chance of doing so.
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Holman pointed to a mid-sized employer whose defined contribution plan offered a base contribution from the employer and optional matching contributions from staff members. The initial results weren’t great: 81 per cent of employees had a low or very low chance to hitting their targets. That may have been due in part to the employees’ high salaries and rural locations that feature cheaper house prices, said Holman. With a generous proportion of income devoted to discretionary spending during their working lives, they’d need more retirement income to continue at that level.
Calculations, however, showed that if the employer implemented automatic enrolment in the plan and switched to a different target-date fund, the proportion of employees with a poor chance of hitting their target would drop to 69 per cent.