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Will You Outlive Your Retirement Accumulation?How Deferred Compensation Plans Can Help You Accumulate MoreBy William L. MacDonaldChairman, President & Chief Executive Officer Retirement Capital Group, Inc. Retirement may seem a long way off, especially for younger and middle aged executives. There are vacations to pay for, homes to build, buy and furnish, children's college education to save for, etc. However, unless executives start saving significant dollars for retirement, as early as possible, they may not be able to accumulate enough funds to generate the standard of living that is desired in retirement. Using basic savings scenarios, this article will illustrate the importance of saving for retirement through company-sponsored deferred compensation plans. To keep this article relatively simple, we have assumed that the executive is able to save for retirement through a combination of a qualified 401(k) plan and a nonqualified executive deferred compensation plan (sometimes referred to as a 401(k) wraparound plan). Accordingly, all savings rates in this article are meant to imply the combined savings rates between both available plans. Retirement - How Much Money Will Executives Need? Financial planners generally agree that to maintain the standard of living they enjoy while earning a paycheck, retirees must replace approximately 70% of their final pre-retirement pay. Retirees need less than 100% of their prior earnings, because their expenses generally are less. For example, by retirement age a home mortgage is often paid off, children have completed college, commuting and other work-related expenses are eliminated and Social Security taxes and perhaps income taxes are reduced. After establishing the "replacement income" - in other words, the percentage of final pay - an executive will need after retirement, we move to the next step: determining available sources of replacement income. Social Security is one source but unfortunately for highly compensated individuals, it only covers a very small portion of their retirement needs. Other sources of retirement income include personal savings and IRAs, and payments from company-sponsored retirement plans. Chart 1 - Retirement Income Needs Chart 1 illustrates retirement income needs for three sample executives who plan to retire in 2005 with final salaries of $100,000, $200,000 and $400,000. To retire at the desired age and at their current standard of living, today's executives will need to generate, from a combination of personal savings and company-sponsored retirement plans, income equaling 50% to 65% of their final pay. Executives will probably not be surprised to learn that because Social Security discriminates in favor of lower-paid workers, high wage earners actually need to generate a greater percentage of their pay to complement Social Security income. Calculations shows, for example, that an executive retiring with a $100,000 final pay will need to replace approximately 50% of pay; an executive retiring with a $200,000 final pay will need to replace 60% of pay; and an executive retiring with a $400,000 final pay will need to replace about 65% of pay to maintain the same standard of living enjoyed before retiring. Numerous factors determine whether deferred compensation plans will meet the above income replacement goals. This article discusses four principal factors:
How Much and for How Long Should Executives Contribute to Their Plans? Chart 2 illustrates the total annual contributions (employee plus employer match) that must be made to deferred compensation plan during 10, 20, 25 and 30 year careers to meet three different income replacement goals: 50%, 60% and 65% of final pay. We have chosen 10, 20, 25 and 30 years to illustrate a range of typical employment careers. To calculate how much income deferred compensation plan can generate, these examples assume salary increases of 3% each year and investment return (or a crediting rate of interest) of 7% per year although its important to be conscious of the fact that accumulation values in both qualified and non-qualified plans are subject to the volatility and market risks of the investments selected to fund the plan. Finally, we have assumed that the employer does not sponsor a defined benefit pension plan and that the executive does not have additional sources of personal savings. 50% Income Replacement To meet a 50% income replacement goal, an executive's deferred compensation plan account must receive total annual contributions of 38.14% over 10 years, 15.58% over 20 years, 11.11% over 25 years, or 8.28% over 30 years. To retire comfortable at age 65, an executive who first starts saving for retirement at age 40 will need total annual contributions of 11.11% of pay for 25 years. If the same 40-year-old executive prefers to retire at age 60, annual contributions of 15.58% are required. If annual contributions of between 10% to 15% of pay are not affordable, a lower annual contribution of 8.28% of pay is possible. In that case, however, this 40-year-old executive must continue working until age 70 before retiring. 60% Income Replacement To meet 60% income replacement goal, the following total annual contributions would be required; 45.77% over 10 years, 18.57% over 20 years, 13.33% over 25 years, or 9.33% over 30 years. To retire comfortable ay age 65, our same 40-year-old executive just starting to save for retirement, will need contributions of 13.33% of pay every year for 25 years. 65% Income Replacement To further illustrate how Social Security support decreases as pay increases, consider the contribution rates for executives who need income replacement of 65%. To meet this 65% income replacement goal, either total annual contributions of 49.58% over 10 years, 20.12% for 20 years, 14.44% for 25 years or 10.76% for 30 years are required. In this case, our 40-year-old executive will need annual contributions of 14.44% of pay for 25 years to afford a comfortable retirement at age 65. Chart 2 - Total Annual Contribution Required Chart 2 illustrates two important dynamics:
Employer Contributions Reduce How Much the Executive Must Save As an incentive to save in the plan, some employers provide plan participants with additional money by matching a portion of their savings. The percentage of pay that is matched varies among plan sponsors. The amount of the match varies as well. The addition of an employer matching contribution can significantly reduce the percentage of pay your executives need to contribute. A 50% match on a contribution equal to 10% of pay, for example, translates into 5% of pay - a significant portion of the total percentage needed to build post-retirement income. 50% Income Replacement With a 50% employer match, the executive must contribute 25.43% for 10 years, 10.32% for 20 years, 7.41% for 25 years or 5.52% for 30 years. 60% Income Replacement The executive must contribute 30.51% for 10 years, 12.38% fro 20 years, 8.89% for 25 years, 6.62% for 30 years with a 50% employer matching contribution. 65% Income Replacement Again, with a 50% employer match, the executive must contribute 33.05% for 10 years, 13.418% for 20 years, 9.63% for 25 years or 7.17% for 30 years. Investment Return Makes a Difference In each of the previous examples, the crediting or investment rate of return was assumed to be exactly 7% every year. If the actual rate of return over the 10,20,25 or 30 years is not 7%, a different annual contribution rate will be required - a higher contribution if the rate of return is higher than 7%, and a lower contribution if the rate of return is higher than 7%. Chart 3 illustrates what happens to the percentage of pay required when the rate of return fluctuates by 1 or 2%. To meet a 65% income replacement goal after 25 years of plan participation, total annual contributions of 14.44% of pay are needed if the interest rate is 7% per year. If the rate of return is 8% per year, annual contributions of 12.54% are required. Finally, if the rate of return is 9% per year, annual contributions of only 10.86% are required. Chart 3 - total Annual Contribution Required
Under Alternate Rates of Investment Return
Using Account Balances Before Retirement One of the advantages of both 401(k) and deferred compensation plans is the opportunity for executives to withdraw a portion of their account balance before retirement. Unfortunately, taking money out of these plans before retirement can significantly increase the amount the executive must contribute each year to meet the desired income replacement goal. For example, assume an executive wants his plan account to generate retirement income equal to 65% of his final pay after 25 years of service. This employee would need a total annual contribution of 14.44%. But, if this same employee withdraws $10,000 in each of plan years 11, 12, 13 and 14 to pay for college expenses, the 14.44% annual contribution requirement will increase to 15.59%. Timing also influences the effect of plan withdrawals. Once plan participants withdraw money from their accounts, they no longer accrue investment credits or earnings on the amount of that withdrawal. But the earnings that have been posted up to that point continue to be invested or earn additional interest credit. The longer executives' money stays in their accounts before they withdraw it, the longer it works for them through investment or interest crediting. If participants withdraw money relatively early in plan membership, they must contribute more to the plan over time than if they make the withdrawal later, after years of investment or interest crediting have bolstered their accounts. Imagine, for example, that an executive aims to replace 65% of final income after 25 years of saving. If the executive never makes a withdrawal during that time, the goal can be met with annual contributions totaling 14.44% of pay each year. If this executive withdraws $40,000 in year 20, the total annual contributions must increase to 14.75% of pay for all 25 years. If this same withdrawal is made earlier, in year 15, the annual contribution requirement rises to 16% of pay for all 25 years. And, if the same $40,000 withdrawal is made as early as year 10, the annual contributions increase to 15.68% of pay. Another important point to keep in mind is that, generally, withdrawals before age 59 from qualified 401(k) plans are accompanied by 10% penalty taxes that further increase the cost of the withdrawal. Withdrawals from nonqualified plans, however, are not subject to this penalty. Effects of Interest Accumulation So far, this article has addressed the question of how much executives need to save in deferred compensation plans in terms of a percentage of annual pay. This makes it very easy to see exactly how much executives need to save every year to retire comfortably. But it's also important to call attention, in dollars, to the significant account balances that can accumulate in these plans. Dollar accumulation shows the powerful role that interest plays in building account balances. For the following example, assume that salaries increase by 3% annually, plan contributions represent 14.44% of pay (9.63% by the employee plus 4.81% by the employer) and that plan accounts post an annual 7% rate of return. A 40-year-old executive currently earning $100,000 who has targeted a 65% income replacement goal needs to accumulate an account balance of approximately $1.2 million, or almost 12 times current pay, to retire after 25 years at the targeted standard of living. Of the total $1.2 million accumulated in the plan over 59% represents interest accumulation. Employee contributions make up 27% and the employer matching contribution adds another 14%. If this executive decides to retire after 20 years at age 60, he or she will have accumulated an account balance of $797,096. This equates to a replacement ratio of 47%, well short of the required 65%. If this same executive continues to work until age 70, he or she will accumulate an account balance of $2.0 million, more than 20 times current pay. This balance equates to a replacement ratio of 87%, much more than is needed to retire comfortably. After 20 years, earnings represent 51% of the total balance of this same account. After 25 years, earnings compose 59% of the total and after 30 years, earnings account for a whopping 65%. Obviously, there is a strong advantage to leaving money in a deferred compensation plan account for as long as possible. Also, as the account grows, the selection of the appropriate investment allocation becomes even more important. Chart 4 illustrates the total balances (segmented into contributions and earnings) that can accumulate over 10, 20, 25 and 30 years for the sample executive.
Chart 4 - Breakdown of Account Balance
Conclusion To fund a comfortable standard of living in retirement, especially if no other sources of retirement income are available, executives must understand:
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