by Jason Stephens
Plan sponsors may not be aware of the retirement readiness gap facing well-paid, key managers who are not top executives. Despite their relative affluence, these individuals are unlikely to be able to save enough for a comfortable retirement. Why does this barrier exist, and at what income level does it become more difficult to save sufficiently for retirement?
Plan sponsors are well aware that lower-paid employees face challenges in preparing for retirement, and many sponsors have taken steps address this issue. Yet, employees in the middle of their employment compensation pyramids also face challenges. These employees often cannot save enough in qualified retirement plans and reach limitations on Social Security. As a result, the gap between ideal and actual savings for these employees may be much greater than acknowledged and frequently go unaddressed. Our research indicates that individuals earning more than $200,000 a year cannot achieve a comfortable retirement relying on Social Security benefits and qualified plan savings alone.
Income Needed in Retirement
Academic research provides guidelines for how much income individuals will need in retirement. This threshold, often called the replacement rate, is the percentage of pre-retirement income needed to support a comparable standard of living in retirement. A replacement rate of 70 to 80 percent of average pre-tax earnings is desirable for most workers.
Acceptable replacement rates fall below 100 percent because retirees need less income during retirement. Lower taxes, reduced savings needs, and lower expenses make this the case. Social Security, federal, and state tax burdens decline, or go away completely, once individuals stop working. Retirees typically pay off mortgages, one of the largest single ongoing expenses paid by an individual or couple, and other recurring household costs shrink as lifestyle changes occur. In addition, savings plans and other corporate-sponsored qualified plans, becomes unnecessary after an individual leaves career employment.
Meanwhile, Americans are living longer, and they will need more savings to maintain their standards of living. Americans’ life expectancy at birth rose to 78.8 years as of 2013, up from 75.4 in 1990. If an individual is age 65 today, he should expect to live 19.3 more years, bringing him almost to age 85. These statistics are only averages and, typically, women can live up to ten years longer than men.
Stuck in the Middle
While well-paid employees in the middle of the employment compensation pyramid may seem positioned for a comfortable retirement, perception may outstrip reality. Social Security benefits will deliver a relatively small proportion of their pre-retirement income. To make matters worse, these employees may also have limited ability to take advantage of their qualified retirement plans.
Meanwhile, senior and C-suite executives face the same limits on Social Security and qualified retirement plan savings. Yet, high-level executives often have access to other forms of saving plans or income. Stock options, restricted stock, or employment contracts that provide additional retirement income may fill the gap. In contrast, lower-paid employees are able to take advantage of a large income replacement rate from Social Security benefits. They are also eligible to take full advantage of employer matches to their qualified retirement plans and are not limited by qualified plan nondiscrimination testing.
Caps on Social Security Benefits
Effectively capping Social Security contributions and benefits for workers earning more than $118,000 (in 2015), the program’s progressive benefit formula means that higher-paid employees earn lower benefits per dollar of Social Security taxes paid. As income rises, these benefits replace a shrinking percentage of pre-retirement income. At $200,000, Social Security benefits replace 11 percent, down from 23 percent at $100,000.
Limits on Access to Qualified Plans
What is the biggest barrier to high-paid employees? Limitations on how much employees can save in qualified retirement plans such as defined contribution plans stifle retirement preparedness. Three main variables create this barrier:
- Caps on employee contributions. For 2015, employees may defer up to $18,000 into a defined contribution plan, such as a 401(k) and 403(b) plan. Those age 50 and older can take advantage of a catch-up provision allowing them to set aside $6,000 more, capping the total at $24,000 a year for deferrals.
- Compensation limits. The annual compensation level eligible for qualified retirement plan contributions in 2015 is $265,000. That means compensation above this level is ineligible for employer-matching contributions.
- Top-heavy or nondiscrimination issues. When testing determines a plan as top heavy, higher-paid employees’ ability to contribute declines. This happens when highly compensated employees disproportionately take part in the plan. As an example, if non-highly compensated employees contribute 4 percent of pay, highly compensated employees can contribute only up to 6 percent of pay. This could keep them below the $18,000 (or $24,000) threshold. If this happens, employees cannot take advantage of matching contributions based on the percentage of salary deferred.
CAPTRUST’s Consulting Research Group developed a model to quantify the retirement readiness challenge for these well-paid employees. Our conclusion? Assuming they are planning for a 75 percent replacement rate, individuals will begin to realize a retirement income gap starting at $200,000 of annual income. We found that this gap increases as income rises, and we were able to quantify the falling replacement rates achievable based upon Social Security benefits and qualified plan savings.
Consider a 45-year-old with an annual salary of $200,000 who makes the most of her savings opportunities. She starts with a $200,000 401(k) balance at age 45 and makes the largest 401(k) contribution possible for the next 20 years. Along the way, she receives a 4 percent employer match. We also assume she takes advantage of catch-up contributions starting at age 50. Her hypothetical earnings rate is 5 percent and she retires at age 65.
In this scenario, withdrawals from her qualified plan replace 64 percent of her pre-retirement income at age 65. Social Security provides another 11 percent, assuming she maxes out her Social Security earnings until retirement. These two elements provide her a 75 percent replacement rate in this breakeven scenario. As income rises above $200,000, the replacement rate generated by the combination of Social Security benefits and qualified plan withdrawals declines.
Figure One shows the growing gap as income rises. At an annual income of $250,000, her replacement rate is 66 percent. The qualified plan provides 57 percent of her income. Social Security provides another 9 percent. Her replacement rate drops to 58 percent and 52 percent at $300,000 and $350,000 of annual income, respectively.
Our model assumes constant employment, maximum contributions, and a 5 percent investment return from age 45 to age 65. These hypothetical conditions do not always hold true in real life; people encounter financial crises that interrupt employment and savings, economic or health circumstances may force individuals out of the workforce and into early retirement, and financial markets are volatile and do not always provide a linear 5 percent annual return.
What Can Employers Do?
Many well-paid employees believe that maximizing qualified plan contributions will provide a comfortable retirement. Learning they will need to save more, perhaps much more than they anticipate, may surprise many of these employees. Educating staff about their retirement needs may motivate them to start saving and investing more of their income. Plan sponsors may also consider offering a nonqualified deferred compensation plan as a way to bridge the gap. These retirement savings plans can supplement key employees’ retirement readiness by providing them an additional way to save on a tax-advantaged basis. As an added benefit, these plans may also aid companies in attracting, retaining, and rewarding valuable contributors.
Key managers earning more than $200,000 a year will not be able to achieve the 70 to 80 percent replacement needed to retire comfortably based upon Social Security benefits and qualified plan savings alone. In fact, the higher the individual’s income level, the more severe the retirement income gap appears. Yet, perceptive employers can help these employees close the gap through targeted education and by making nonqualified plans available to this critical employee group.
 John Karl Scholz and Ananth Seshadri, “What Replacement Rates Should Households Use?” University of Michigan Retirement Research Center (accessed 3/8/2015)
 Life Expectancy Tables – http://www.cdc.gov/nchs/data/nvsr/nvsr61/nvsr61_04.pdf (accessed 2/25/15)
 Thomas Perls and Ruth Fretts, “Why Women Live Longer than Men” http://www.cmu.edu/CSR/case_studies/women_live_longer.html (accessed 4/4/2015)
 CAPTRUST Research.
 “IRS Announces 2015 Pension Plan Limitations; Taxpayers May Contribute up to $18,000 to their 401(k) plans in 2015” http://www.irs.gov/uac/Newsroom/IRS-Announces-2015-Pension-Plan-Limitations-1 (accessed 2/15/15)