There’s been a lot written about “retirement readiness” of the American workforce – we’ve done it here in the JKJ blog too. And common themes are the ideas of “auto everything” for participants: auto-enrolled, executing automatic re-enrollment, and incorporating auto-escalation, and intelligently selected age-appropriate “default” Target Date fund offering. And these things really do all work in getting the vast majority of employees on the right track toward retirement readiness.
But what’s far less talked about is the lack of retirement readiness among higher-paid individuals. This doesn’t get much attention because a) it’s a smaller segment of the workforce population (and society at large) and b) there’s a (mis)perception that because those folks earn more money, heck, they’ll be just fine in retirement.
However, reality is these folks often have surprisingly low retirement readiness (as measured by pre-retirement income replacement ratios). For example, we ran a retirement readiness analysis (including social security projections) for a JKJ client last year, and looked at the results, broken down by wage earning level: and it turned out that those earning > $90,000 had, by far, the lowest replacement ratios of any income demographic.
Wait, How Does THAT Happen?
It’s a combination of factors, actually…
• First, yes, those workers earn more but they also spend more – even those who “live within their means” have grown to enjoy a certain standard of living during their pre-retirement years. Which means they also need more income in retirement to sustain that standard of living.
• Second, social security provides them fewer benefits (measured as a % of pay). For example, a worker earning $50,000 might receive a replacement ratio of ~40% from social security, but a higher paid individual earning $100,000 might have only ~20% or less replaced by social security – and, as income continues to rise, the % replaced by social security continues to drop.
• Finally, IRS caps. The 2015 limit of $18,000 in absolute terms feels high to most workers. But to someone earning, say, $200,000 it’s less than 10% of pay. Combine that with lower replacement from social security, a higher cost standard of living, and more tax bite (i.e., higher marginal tax rates at $200,000 than, say, a $50,000 worker), and all of this makes for a seldom-appreciated challenge among higher earners.
What’s To Be Done?
Admittedly this issue won’t get much press or headlines – because it impacts a small portion of the population that is perceived at large “not to have money problems” But this is real. And there are a couple potential answers…
1. Save more on an after-tax basis outside the retirement plan. The challenges here become a) the discipline to do so and b) tax erosion (both at the front end as well as ongoing as dollars grow in value)
2. Consider Roth contributions. Sure, the IRS limit is still $18,000. But when you look at the after-tax purchasing power of those contributions in retirement, it’s akin to having a pre-tax deferral cap of over $20,000. Alas those up-front taxes in a high bracket…
3. Non-qualified Deferred Compensation (aka “NQDC”). This is really the “solution of choice” among companies approaching & beyond 100+ total employees. The concept is creating a 401(k)-like plan but with no contribution ceilings – thus empowering higher-paid employees to save pre-tax & tax-deferred without any governmental caps.
Admittedly there are also flexibility & risk tradeoffs with NQDC plans – but when properly constructed, at financially strong companies, these are viewed as the optimal answer to the retirement readiness shortfall of higher wage earners.
Author: Ben Hall, ChFC, AIF®
VP & Managing Director – JKJ Retirement Services