Replacement Rate Studies Could Have Pitfalls

Plan sponsors are increasingly requesting replacement rate studies where each provider conducts an analysis to determine the potential impact or improvement of the given investment strategy on participants. In other words, they are using it to determine the “retirement success” of the participants if they use that provider’s or consultant’s product or solution, according to the research paper “Inaccurate Precision: The Danger of Replacement Rate Calculations.”

In many cases, the plan sponsor will supply a potential vendor with average (or median) plan demographics and ask the vendor for the expected replacement ratio at retirement for the average (or median) plan participant, explained David Blanchett, research consultant for Morningstar Investment Management and author of the paper. This approach can be dangerous because it does not take into consideration variables like outside assets and spouses, therefore making it nearly impossible to meaningfully compare the expected replacement ratio provided by two different vendors.

“You have a very incomplete picture of [plan participants’] retirement readiness,” Blanchett told PLANSPONSOR.

The paper explores the important differences in how one defines the expected replacement ratio, as well as explains how replacement rate estimates can vary based on different assumptions and provide varying levels of insight. Blanchett used assumptions including savings rate, inflation, market forecasts and retirement age.

According to the research, making relatively minor changes to a set of base assumptions can lead to a range in the median replacement rate for a plan to vary from 48% to 107%, and a range in the replacement rate for an individual to vary from 67% to 261%.

While the intentions of these replacement rate studies may be good, Blanchett said they will not help a plan sponsor make a “quality” decision among providers.

Instead, Blanchett suggested plan sponsors understand the methodology used to build the respective products and then select the approach that best matches the underlying goals and objectives of the plan sponsor. “You really have to understand the methodology instead, and understand how each provider reaches a solution,” he added.

Blanchett said he is concerned that the use of replacement rate studies could filter down market. Replacement rate studies are increasingly used in the large market, but Blanchett thinks small- and mid-sized companies could follow suit. “It’s reinforcing a bad decision, rather than moving people in the right direction,” he said.