WHAT IS the single most important factor in determining the adequacy of a 401(k) participant’s retirement benefits?

That’s an easy question with an easy answer: the decision about whether or not to participate in the 401(k) plan. If an employee does not join the 401(k) plan and, therefore, does not defer, then he will have little, if any, benefits at retirement.

What is the second most important factor? Based on studies by Putnam, it is the level of employee deferrals. Obviously, the more the employee defers, the greater the benefits. However, the fact that the level of deferrals outweighs the quality of the participant investment decisions and the prudence of the investment options is not well-known.

In a recent study by the Vanguard Center for Research, “How America Saves: A Report on Vanguard Defined Contribution Plans 2004,” an example was given of the needed amounts of deferrals for a 30-year-old who planned to retire at age 65. The analysis assumed that participants would need retirement income equal to 75% of their final pay. The study then posited the question: What percent of pay would employee need to defer each year between age 30 and 65 in order to accomplish that goal, taking into account both the participant’s 401(k) benefits and Social Security?

Three more factors need to be taken into account to understand the conclusion of the study. The first is that employees who earn higher incomes will need to defer a higher percent of pay, since their Social Security retirement benefits will be a lower percent of their pre-retirement income. The second is that the deferral rate assumes that the plan does not offer matching or profit-sharing contributions. If it does, then the percent of needed deferrals should be reduced by the amounts contributed by the employer. Finally, the report assumed that the employee is not also covered by a defined benefit plan or other employer-sponsored retirement plan.

If our hypothetical 30-year-old employee makes $50,000, the employee will need to defer 17% of pay per year. If the employee makes $100,000, the deferral rate will need to be 20%. On the other hand, if the employee makes $25,000, the deferral rate will need to be 14%. Based on reports I have seen, the typical deferral rate is somewhere around 7% of pay. If we assume that, on average, employers are contributing another 3% of pay as matching and/ or profit-sharing contributions that gets the annual deferral to about 10%, or somewhere between 50% to 70% of the amount needed.

What Should Fiduciaries Do?
The first step is to educate participants on the amounts they need to defer to end up with adequate retirement benefits. In a perfect world, eligible employees would receive a notice of the amount they need to defer before they began participating in the plan. Then, the needed deferral rate would be updated every year and reported to the participant. The updated calculation would be based on current account balances, pay increases, projections of earnings (based on how the account actually is invested), and assumed retirement age. Each participant would be able to recalculate the required contribution, based on changes he wants to make in the assumptions, such as retirement age.

Second, plans should have ongoing education for participants, including the initial enrollment meeting, about the importance of deferrals, about how changes in the retirement age affect the amount of needed deferrals, about how changes in investment behavior can affect the needed amount of deferrals, and so on. That education should have equal footing with investment education and, to the greatest possible extent, it should be individualized to the participants.

Finally, employers and fiduciaries should revisit the concept of a retirement age of 65. It is possible, even likely, that the 65 retirement age is outdated. For example, most of today’s employees have Social Security retirement ages after 65. In fact, for most it will be 67. Fiduciaries should consider the impact of that change and should work with employers and providers to evaluate changing all retirement-related communications to employees, including any references to retirement age in participant education materials.

Because a later retirement age means a shorter retirement lifetime, greater compounding of earnings, and additional deferrals, it can make a remarkable difference in reducing the amount of annual deferrals needed for retirement adequacy.