Recently, there has been attention paid to retirement income projections as a way to help participants fully understand their future retirement picture. This is getting national attention because of the re-introduction of the Retirement Enhancement and Savings Act (RESA) which includes, in its bundle of changes, a requirement for benefit statements from retirement plans to include estimates of lifetime income at least once per year. RESA would go on to charge the Department of Labor (DOL) with creating the specifics for the estimates. You can read more about RESA in our regulatory update, but I’d like to take some time to dig into this portion of the act a bit more. So, what are retirement income projections, how are they calculated, and what good are they?
If RESA is approved, we can expect to wait sometime for the DOL to create their model. In the meantime, many in the industry have created their own calculators which allow participants to access this information. Additionally, the DOL has their own calculator that can be used.
Retirement income projections are an estimate of what your current account balance would translate to as a series of (usually) monthly level payments for life. These calculations can be simple or more complex. Great, you say, tell me my future! Well, since we have no crystal ball, we’ll need to make some educated guesses. We need three main things:
- How long will you live?
- What kind of investment return can you expect before retirement?
- What kind of investment return can you expect during retirement?
Everything else: your age, account balance, and (often) your retirement age are known data points. From there, the calculations are straightforward: calculate the growth of the pot of money until retirement, and then calculate the spend down to $0 over the expected lifetime post retirement.
The next question is, how to best estimate these unknowns. The DOL’s calculator uses its own Advanced Notice of Proposed Rulemaking (ANPRM) safe harbor guidelines. They quote a 7% return on investment before retirement, the rate of the 10-year constant maturity Treasury securities rate for after retirement and use the unisex mortality table available under section 417(e)(3)(B). Investment return estimates vary between calculators but tend to be within the reasonable estimates of 3%-10% during a career and 0%-5% post retirement.
The longevity estimates tend to be more varied. They can be based on a universally available mortality table, a proprietary mortality table, or perhaps a single average life expectancy. For example, according to the Social Security Administration a man age 65 today can expect to live, on average, to age 84 while a woman age 65 can expect to live to 86. So, an easy estimate, if you want to avoid mortality tables completely is assuming everyone will live to age 85.
Plugging in these estimates with the information known today, any of these calculators will spit out a retirement income projection.
Now that you’ve got your basic calculation, you can estimate more things and get more flavors. If you’re interested in what your monthly income at retirement is in today’s dollars, we’ll add an estimate of inflation. If you’d like to know what your monthly income would be if you kept investing at the same rate as today, you’ll need to estimate your annual income increases (or decreases) until retirement.
All of this is to say that there is no perfect way to predict the future, and all of the estimates we have at our disposal are only good on average and will vary from the experiences of an individual. However, they are good at ballpark estimations and allow participants to see how changing savings rates and behavior today can affect their future. Finally, it is also a good way to ground the nebulous idea of “I need money to retire” into a real discussion of dollars in and dollars out.
Plan sponsors can use these calculations to do a gap analysis and get a sense for the health of a plan as a whole. Gap analysis is also an important tool for tracking and monitoring the effectiveness of employee communication and education programs.
At the end of the day, retirement income projections are a tool to help understand retirement readiness for both participants and plans, but, like most projections, are only as good as the data and assumptions that go into them. Understanding the nuts and bolts of these calculations is an important part of monitoring the tool’s effectiveness.
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice. Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.