Retirement Inputs

Retirement income calculators are becoming more detailed than ever, but the industry is realizing that participant engagement must be factored into the equation to make an impact.

According to the 2013 Retirement Confidence Survey (RCS) from the Employee Benefit Research Institute (EBRI), many employees (45%) still guess at their savings needs rather than perform a systematic, retirement-needs calculation. Eighteen percent indicated they do their own estimate and another 18% ask a financial adviser, while 8% use an online calculator and another 8% read or hear about how much they need.

Twenty-four percent of workers who have done a calculation, compared with 13% who have not, estimate they need to accumulate at least $1 million for retirement. At the other end of the spectrum, 21% of those who have done a calculation, compared with 37% who have not, think they need to save less than $250,000 for retirement.

Workers who have done a retirement savings-needs calculation are also more likely to feel very confident about affording a comfortable retirement (20% vs. 7% who have not done a calculation). In fact, employees who have done a retirement savings-needs calculation tend to have higher savings goals than workers who have not done a calculation.

Donn Hess, managing director at J.P. Morgan Retirement Plan Services in Overland Park, Kansas, says retirement income calculators do not necessarily draw participants in—although they love the idea of the tool. “We certainly didn’t see usage from participants who most needed to engage with it,” Hess says of J.P. Morgan’s Retirement Dream Machine calculator tool. “It’s great to have a calculator, but if you build it, people don’t necessarily come.”

According to J.P. Morgan’s data, 23% of participants will access the Dream Machine at some point in their tenure with the plan. Although this number sounds low, Hess says it is relatively high, considering how passive participants are in their retirement planning. The normal usage for a tool like this is typically single digits, he says.

For retirement income tools and programs to be successful, the retirement industry must understand the behavioral science behind participants’ retirement planning, says Greg Kasten, CEO of Unified Trust Company in Lexington, Kentucky. Providers, plan sponsors and advisers must keep in mind that participants’ behaviors will not change, so the system must be built around their behavior. “Participants have profound amounts of inertia,” he says, and retirement income calculator tools “go against the grain of inertia and procrastination.”

As shown by the EBRI data, procrastination can cause participants to go their entire lives without using a retirement income calculator tool, Kasten says. “The system basically has to do the retirement income calculation [for them]. The [tool] is sort of a must-have for plan sponsors, but it’s terribly ineffective at doing what we need the retirement plans to do, which is [help participants retire] with an adequate benefit.” 

Detailed Assumptions

Over the years, retirement income calculators have improved, by including more detailed assumptions and responding to what participants want.

J.P. Morgan began calculating retirement income in 1997 and built the Retirement Dream Machine in 2005. Originally, J.P. Morgan created the tool to display what an individual needed to save in a lump sum figure. “The main learning from that was, one, it was incredibly off-putting. People reacted very negatively to the amount,” Hess says. “And, secondarily, the thing it taught us was to adjust for inflation so we could do an apples-to-apples comparison.”

Prudential Retirement also originally used a lump sum figure for its retirement income calculations, but Mike O’Sullivan, the company’s e-business director in Hartford, Connecticut, says one large number was overwhelming to participants. “They also found it to be a number that they really couldn’t relate to,” he says. “We found that shifting to a monthly [income figure] was hugely important for people.”

Prudential made that shift to monthly replacement figures when it updated its retirement income calculator in 2007. The company also displayed the calculator on its website’s homepage and created a free mobile application (app). “We try to make it very simple and very straightforward,” O’Sullivan says.

For participants engaging with Prudential’s calculator, calculations can include details such as salary increases, contribution rates, current balance, asset allocation, income from Social Security and outside assets. The tool assumes an 80% income replacement in retirement and makes specific recommendations about how to close retirement gaps.

In the future, Prudential would like to make the calculator more relevant and personalized regarding income levels, financial literacy and demographics, says Eric Feige, vice president of digital strategy at Prudential’s Woodbridge, New Jersey, location. The company expects to roll out a new version of the calculator this year.

J.P. Morgan’s Retirement Dream Machine has also gone through changes. Today, it shows participants their retirement income projection while taking into account assumptions such as annual salary, contribution rate, current balance, Social Security and outside accounts. Social Security is calculated based on normal Social Security retirement age, as per federal regulations. 

Annual Increases

The assumed income growth rate is 5% each year. Income growth rate represents the average increase in salary expected over time, which is the approximate historical rate of growth (including inflation) for a typical person’s salary. The projection considers the Internal Revenue Service (IRS) annual compensation limit, indexed periodically. The contribution amount is based on current election in a defined contribution (DC) plan, and the annual retirement income estimate and initial risk category are calculated using the investments currently held in the retirement plan account.

In addition, when calculating how a participant’s total retirement savings will translate to income, the Retirement Dream Machine makes some assumptions about drawing down on a steady basis but does not necessarily assume the purchase of an annuity, Hess says. To translate the total portfolio from a lump sum into an annual income number, J.P. Morgan estimates a yearly income for the total portfolio as if it had exchanged the portfolio for an age-certain fixed annuity, although again the company does not necessarily assume or recommend that a participant will exchange his entire portfolio for an annuity.

Hess says his company tested several options but found it was best to present projected income as a value adjusted for inflation and in terms of an annual salary, because many participants have no monthly budget and are more accustomed to an annual figure.

J.P. Morgan has also changed its messaging about retirement income over the years. The company’s messages to participants used to suggest a target of 75% to 80% income replacement, but today the “judgment” has been stripped out, Hess says, and substituted with messages such as, “You’re on track to receive XY dollars at retirement.”

At the plan sponsor level, J.P. Morgan still establishes a target income replacement rate, the minimum being 70%. At the participant level, however, it is now communicated in terms of the dollar amount the participant is projected to receive in retirement, versus the percentage of income he will need. In terms of measuring plan success, Hess says, studies range from 70% income replacement to more than 100%.

J.P. Morgan also introduced “social norm” messaging to participants. For example, the employees can see via the company website how someone with similar demographics (for example, in their age or income bracket) saves for retirement, which helps them improve their savings. “We’re giving them comparisons in the behaviors—we don’t give them comparisons in the targets,” Hess says. 

The Role of Retirement Income Calculators

A retirement income calculator should answer three questions: 1) Are you saving enough money to retire when and how you want?; 2) Is your asset allocation appropriate?; and 3) How much risk can you afford to assume? says Paul Saganey, president of Integrated Financial Partners Inc. (IFP) in Boston.

Ideally, he says, participants should revisit the retirement income calculation on a yearly basis, as variables in a person’s finances can change.

It is particularly important for plan sponsors and advisers to encourage younger participants to use a retirement income calculator, because they still have time to save more and adjust their allocations, he says. “Unfortunately, the reality of a retirement income calculator is people don’t really look at it until close to retirement,” he says. Not much can be done at that point except to increase savings significantly or work longer.

In Saganey’s experience, many participants calculate their retirement needs after they have paid their children’s college tuition. “And, at times, it’s a little bit too late,” he cautions. “If younger people at least knew what their target [number] was, I think you’d see them participate more aggressively [in their retirement plan].”

Interaction

The silver lining is that, among participants, the younger cohort is more likely to use retirement income calculators, interactive charts and mobile apps in preparing for retirement. More than 60% of retirement plan participants younger than age 40 said they found the calculators most helpful in preparing for retirement, according to an American United Life Insurance Co. (AUL) survey. This compares with 51% of participants ages 41 to 50 and 41% of those 50-plus.

Older generations gravitate toward reading materials instead of calculators to plan their retirement. Two-thirds (67%) of those older than 50 found articles most helpful, compared with only 45% of respondents ages 20 to 30, AUL’s survey found.

Even if participants wait until they are near retirement to use a calculator, all is not lost—Saganey says the tool can provide a sense of how long it will take to be “financially independent,” meaning they can work if they choose. Many participants are now choosing to work part-time in retirement, although some out of choice rather than financial necessity.

The age at which workers expect to retire is slowly rising, according to EBRI’s 2013 RCS. In 1991, just 11% of workers expected to retire later than age 65. In 2013, 36% of workers report they expect to wait until after age 65 to retire, and 7% plan not to retire at all. The percentage of workers expecting to retire before age 65 is now half what it was two decades ago, down from 50% in 1991 to 23% in 2013.

Retirement income calculators can also give the participant a sense of how far he is from achieving his ideal retirement lifestyle. If the participant wants to retire beachside in Florida versus inland, for example, the calculation can better help him determine how attainable this is, Saganey says. 

Retirement Income on Statements

Because of the low usage of retirement income calculators, many companies are going a step farther to include income calculations on participants’ statements.

J.P. Morgan includes participants’ income calculations on its quarterly statements. The most important communication tactic is simply to show people projected income replacement; this results in a 7% to 11% increase in that figure if participants repeatedly see their projected income amount, Hess says.

Great-West Retirement Services, a division of Great-West Financial, in Denver began including income projections on participants’ fourth-quarter 2012 statements, says Charlie Nelson, the division’s president. Participants’ statements included a monthly projected retirement income based on the individual current account balance, historical contributions to their retirement accounts and some standardized variables and assumptions.

Prudential Retirement also includes a retirement income calculation on participants’ statements once a year in a monthly income figure. 

Mandatory Income Projections?

Although providing retirement income projections is, for the time being, up to the discretion of the company, this could all become mandatory with a green light from the Department of Labor (DOL). In February, the DOL released its regulatory agenda for 2013. According to Fred Reish, partner and chairman of the Financial Services ERISA [Employee Retirement Income Security Act] Team at Drinker Biddle & Reath’s Los Angeles office, the agenda includes a proposal to require retirement income projections on participant benefit statements.

According to Reish, the DOL says it will explore whether and how a benefits statement should and could express participants’ accrued benefits in a defined contribution (DC) plan as a lifetime income stream in retirement as well as an account balance.

Bradford Campbell, counsel at Drinker Biddle & Reath LLP’s Employee Benefits and Executive Compensation Practice Group in Washington, D.C., said during an audio conference for the “Inside the Beltway” series that the agency issued an advanced notice of proposed rule-making, in essence asking what it should consider when crafting the proposal for the regulation.

According to Reish, the projections will be “garbage” if the DOL gets this wrong, but the agency cannot leave the industry wide open for making its own assumptions and calculations, because some will make extreme projection decisions that will make it appear participants will fare much better—or worse—than in actuality.

Greg Kasten, CEO of Unified Trust Company, agrees that providers must be cautious when giving retirement income projections for this reason. If the projections are far from actuality, it could provoke participant lawsuits down the road. Companies that are going to provide projections must ensure their calculation methodology is sound and extremely detailed, he says.