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80% Salary Replacement Rule: Origins and Exceptions for 401k Retirement Savers to Consider

December 10
00:17 2013

It’s been around so long, many have begun to question whether it has any basis in reality or is simply another urban legend. The fact it’s often cited as “the textbook” number only detracts from its credibility. Yet, nearly every retirement adviser, 1176253_60089186_cutting_money_stock_xchng_royalty_free_300financial planner and tax consultant faithfully follows the rule. Some may question it, only to return to it as a convenient proxy. What is it? Where is it used? How has it been justified? And why could it be the single most critical data element that will stand between a comfortable retirement and working longer?

We’re talking about the “80% Salary Replacement Rule.” It’s one of the important assumptions financial professionals make when determining how successful a retirement savings program will be. It’s used to calculate how much money retirement savers must contribute to their retirement plans. It’s also a key component when computing a saver’s Goal-Oriented Target (i.e., the annual return requirement, to use language from the CFA Institute).

Readers interested in learning about a tactic 401k plan sponsors use to increase employee savings might want to read this: Plan Sponsor Alert: Behavioral Finance Reframing Future of 401k

Although it’s often referred to as “the textbook number,” the true source of the number habitually goes unmentioned. The process for determining this “replacement ratio” has been in existence for more than three decades. It began early in the Reagan administration. “We built on methodology established in the 1981 President’s Commission on Pension Policy, but then updated it with key findings from the Aon/Georgia State Replacement Ratio studies,” says Rob Austin, Director of Retirement Research at Aon Hewitt in Charlotte, North Carolina.

Austin tells “the research starts by assuming a participant will want to maintain the same standard of living after retirement. Specifically, this means that current income is adjusted for expected changes at retirement including: elimination of retirement savings; changes in taxes; and, changes in expenditures including medical costs. Overall, this methodology produces an average need in the first year of retirement of 85% of pay.”

In fact, the replacement ratio does vary from year to year as well as across the range of salaries. The number is higher for higher salaries because, at those salary levels, Social Security replaces a smaller percentage of the salary. Still, the 80% rule of thumb is actually fairly sound. It also has the benefit of being an easier number to work with (it being divisible by ten). For many professionals, however, it really suggests more of a guideline. While it represents a good (and, as we’ve seen, an empirically justified) starting point, specific circumstances based on the individual lifestyle choices of retirement savers may require adjustments to the number.

For more information, read: Retirement Readiness: The One True 401k Benchmark Every Fiduciary Should Measure

David Rae, a Certified Financial Planner in Los Angeles with Trilogy Financial Services, says, “Exceptions to the 80% rule are people who are entering retirement with a paid-off house, with a low tax base, and low cost of living.” On the other hand, Rae says, “Those who want to retire early should save even more. If your health is good and you retire early, I’m going to assume you are going to have a very active retirement. The more active you are the more you are likely to be spending on things like travel, or even gold. On the opposite side if your health is poor, you may spend even more on health care costs. The biggest threat is poor health that won’t kill you. That means high medical bills for a long time.”

What happens if a retirement saver hasn’t saved enough, based on whatever replacement ratio they use? Daniel Cassidy, Managing Director at P-Solve in Boston, Massachusetts, says retirement savers will adjust by “working longer, lowering their standard of living, moving to lower expense state, moving in with children, and all the normal things people will do to adjust when budget is not met.”

Readers might also like this: What Drives a 401k to Work So Well

One of the objectives retirement savers should have is to review their specific situation at least once a year or whenever a life changing event occurs. (This, by the way, is another one of those “rule of thumb” the textbook demands you follow.) An annual review allows the saver to identify any exceptions to the 80% Salary Replacement Rule sooner rather than later. How can one expect see these exceptions? Rich Rausser, Senior Vice President of Client Services at Pentegra Retirement Services in White Plains, New York, says, “In some cases, this is the result of a well thought-out plan. In other cases, it is hard to see some of this coming, but it highlights the need to be as prepared as you can by saving earlier and more often.”

Rob Drury Executive Director, Association of Christian Financial Advisors in San Antonio, Texas, sums up what many in the industry believe when he says, “The 80 percent rule is probably a pretty reasonable benchmark, and one I’ve seen to be fairly reliable; but I question why, with all the modeling tools available, one should not plan using more specific figures. Granted, any method relies on speculative assumptions, but the better the numbers and the methodology going into the planning, the more reliable that planning will likely be.”

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

Interested in learning more about hot to create a better 401k plan and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on benchmarking, including how to create a plan “report card” to better evaluate its effectiveness.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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