Determining Realistic Retirement Income Adequacy

The Defined Contribution Institutional Investment Association (DCIIA) hosted an Academic Forum session measuring retirement income adequacy for participants and retirees.

David Blanchett, head of retirement research at Morningstar Investment Management, began the session by discussing the issue with retirement income adequacy algorithms. Even if participants have a good retirement income estimate, it’s unlikely to be correct, he said. “Replacement rates will target 70% even if that’s not what you’re looking for,” he added. “It can be a good starting point, but you have to try and figure out what you want to spend and be realistic.”

He urges financial plan advisers to ask about specific details related to the participant’s current day-to-day life—think about family size, home equity, income levels, etc. More importantly, ask how much the participant wants to spend in retirement, because even if an adviser has all of the participant’s information, it might not match what their aspirational goal actually is. “The ideal way is to get someone to tell you what they want their plan to be and then get them to that target,” he said.

Bonnie-Jeanne MacDonald, director of financial security research at the National Institute of Ageing at Ryerson University, found in her research that conventional replacement rates and living standards continuity were poorly correlated, at just 11%. “Around the world, our pension systems are based on assumptions. … [It] doesn’t tell us anything about retirement income adequacy,” she said.

MacDonald noted that replacement rates only use employment earnings to determine a standard of living. While earnings are a vital factor in measuring future income, it’s not the sole factor, she said. Look at a participant’s spouse’s earnings, government transfers, investment outcomes, house ownership, debt, tax-exempt savings and more. “All of these components can make a big difference to people’s living standards,” she said. “There’s no percentage that will capture this entire picture. It’s not whether or not the 70% is too big or too small—it’s insufficient information.”

A first step financial advisers should take when projecting retirement income is calculating current living expenses. Determine how much money workers are spending today and compare that with how much they can spend in retirement. Step two is projecting what the participant will likely spend while retired. This kind of information encourages the client to think through their spending habits, MacDonald pointed out. “Because it’s a cash flow, this resonates with people and they can begin asking themselves those questions on how they can fill that gap,” she said.

This tactic can even benefit younger workers, who could be two or three decades away from retirement. “For younger people, it’s going to give them an indication of the direction that they’re going to. It’s a good tool for financial literacy, because it helps people understand how retirement income works,” MacDonald added.