Cracking the Retirement Code: Income Replacement Rates
Will future retirees have enough income to maintain their pre-retirement standard of living? A retirement plan without an income replacement plan is just a savings account, which could fall short of participants’ needs in retirement.
Key Takeaways
With DC plans now the primary source of retirement income for most American workers, the burden of planning for a sufficient and continued stream of income in retirement rests with each participant.
A gap in understanding the ideal income replacement rate and participants’ misperceptions about target-date funds has exposed the risk that they will fail to convert their savings into adequate income.
Our national survey found that plan sponsors want to help. There is growing interest in helping participants protect their savings from market volatility and in offering guaranteed lifetime income options.
Even with its foundational role in retirement planning, one critical concept often baffles participants and employers alike: the income replacement rate. This term, crucial for establishing realistic savings goals, refers to the percentage of pre-retirement income retirees need to maintain their standard of living in retirement.
While the concept may seem straightforward, the 11th annual American Century Retirement Study revealed a concerning gap in understanding among employers and employees about the ideal income replacement rate—exposing the risk that participants’ retirement savings could fall short of their needs.
Unlocking the Mystery of Income Replacement Rates
Despite the importance of knowing how much income one needs to replace in retirement, employees, employers and industry professionals do not agree on an appropriate income replacement goal.
Stark Discrepancy in How Much Income Replacement Is Needed in Retirement
The wide-ranging answers, particularly among participants, underscore that many retirement investors are not making informed decisions about their retirement savings. It also reveals a need for the retirement planning industry to educate and guide employers and employees in setting realistic and sufficient income replacement goals.
DC Plans vs. DB Plans as the Primary Retirement Vehicle
Granted, the need for defined contribution (DC) plans to account for income replacement has evolved. Historically, DC plans began as supplemental savings vehicles to defined benefit (DB) plans. Over the past two decades, however, employers increasingly froze or even eliminated their traditional pension plans. The result is that DC plans now serve as the cornerstone of retirement planning for most American workers. This shift necessitates a reevaluation of how these plans are structured and utilized.
Recognizing this evolution, many employers are now working towards establishing income replacement rate goals for their 401(k) plans. Additionally, a few plans are defaulting employees into investment options that allow them to convert all or part of their savings into guaranteed lifetime income.
What Participants Get Wrong About Target-Date Funds
Why would employers consider a default retirement income option when they already have a target-date fund (TDF)? One of the most revealing aspects of American Century’s study is the disconnect between what plan sponsors believe they are offering and the expectations of plan participants.
62% of participants
believe target-date funds guarantee them income at retirement.
36% of participants
think they are guaranteed not to lose money.
46% of participants
prefer a TDF that helps protect their savings from significant losses even if it means waiting out periods of underperformance.
45% of participants
find a loss of more than 10% unacceptable when they are within five years of retirement.
Participants’ perceptions of TDFs highlight the need for clearer communication and education regarding the nature of TDFs and the risks involved. It also may explain why participants have a strong preference to have all of their account balances protected in the form of a default investment—and then choose the amount of guaranteed income to take at retirement.
The Advisor's Role: Educator, Advocate and Innovator
Even with workers' overwhelming interest in guaranteed lifetime income options, only about 5% of 401(k) plans in the U.S. currently offer such products. This gap points to the opportunity for advisors to step in to help employers align plan offerings with the needs and preferences of the workforce.
Employers’ responses to our survey showed their readiness to have these conversations:
A staggering 94% of employers feel a responsibility to aid their employees in saving for retirement and managing their funds in their post-work years.
Moreover, 80% prefer that employees keep their retirement assets within the company plan, underscoring the importance of providing options that allow for the conversion of savings into reliable income streams upon retirement.
The Path Forward for Retirement Income Planning
The findings from the American Century Retirement Study once again serve as a crucial wake-up call for the retirement planning industry. As we navigate an ever-evolving financial landscape marked by concerns over inflation, interest rates and market volatility, the need for robust, adaptable retirement planning strategies has never been greater.
By fostering a deeper understanding of the income replacement rate, clarifying the role and risks of investment options like target-date funds and evolving the structure and offerings of DC plans, we can work toward a future where all participants can adequately meet their income needs in retirement.
Authors
Senior Retirement Strategist
Advisors, Bring Clarity to the Retirement Income Conversation
Compare and contrast features and benefits of in-plan guaranteed income products.
Methodology: The participant survey was conducted between June 11, 2024, and June 27, 2024. Survey included 1,505 full-time workers between the ages of 25 and 65 saving through their employer’s retirement plan. The data were weighted to reflect key demographics (gender, income, and education) among all American private sector participants between 25 and 65.
The sponsor survey was conducted between June 10, 2024, and June 26, 2024. Survey included 500 plan sponsor representatives holding a job title of Director or higher, and having considerable influence when it comes to making decisions about their company’s retirement plan (either 401(k), 403(b), or 457 plans). The data were weighted to reflect the makeup of the total defined contribution population by plan asset size.
Percentages in the tables and charts may not total 100 due to rounding and/or missing categories.
Greenwald Research of Washington, D.C., completed data collection and analysis.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
You could lose money by investing in a mutual fund, even if through your employer's plan or an IRA. An investment in a mutual fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.