Why Is It Recommended to Save 15%?

Most retirement experts currently recommend saving 15% of annual income. “There is mathematical backing to what we suggest,” says Roger Young, senior financial planner at T. Rowe Price.

There seems to be a consensus among those in the retirement plan industry that individuals should save 10% to 15% of their salaries in order to have a secure retirement. From where did this suggested savings rate come?

Katie Taylor, vice president of thought leadership at Fidelity in Boston, says the firm used to suggest a 10% savings rate, but after delving more into the numbers, it now suggests a 15% savings rate—including both employee savings and contributions from employers.

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Roger Young, senior financial planner at T. Rowe Price in Owings Mills, Maryland, says his firm also suggests a 15% savings rate. “There is mathematical backing to what we suggest,” he says.

According to Young, the 15% suggestion is something T. Rowe Price has analyzed, starting with a model of what amount of income people need to replace in retirement. Its model factors in what individuals are currently spending, what they are likely to spend in retirement, taxes in retirement and the fact that individuals may stop saving once they’ve retired.

“We assume people need to replace 70% of their income in retirement, which could be different based on whether spending habits change. Then we look at how much income Social Security will replace, which could also vary heavily by income and marital status,” Young explains. “We also assume a beginning withdrawal rate of 4% per year. There is a lot of back and forth of opinions on whether this is reasonable, and though it is not a failsafe number, we believe it is reasonable.”

Other assumptions T. Rowe Price makes is that the pre-retirement investment return is 7% before taxes and income grows over time. “We tried not to be too aggressive in our assumption about what people can save early in their career, so our suggestions assume people start to save at age 25, starting with 6% of income and increasing over the years,” Young says.

T. Rowe Price comes to a suggestion of what multiple of income individuals need to have save by a certain age, and what percentage of income they need to save to get to that multiple.

For example, according to a T. Rowe Price Retirement Perspectives article, a 35-year-old would be on track if she’s saved about one year of her income. Most 50-year-olds would be on track if they’ve saved about five times their income. If considering a household, use the older partner’s age and the total income and total retirement savings of the household. The firm’s modeling suggests individuals can get to these numbers by saving 15% of income each year.

Similarly, according to a Fidelity Viewpoints article, after analyzing reams of national spending data, Fidelity concluded that most people will need somewhere between 55% and 80% of their pre-retirement income to maintain their lifestyle in retirement. However, Taylor notes that, realizing Social Security will provide much of that income for many, Fidelity concluded that 45% of that replacement income will come from people’s personal savings.

“Fidelity has done modeling, and in our point of view, a goal of saving 10 times final income is applicable for people who make $50,000 to $250,000 per year, which covers between 85% and 90% of workers based on our market share of participants,” Taylor adds.

The Viewpoints article gives a hypothetical example, “Consider Joanna, age 25, who earns $54,000 a year. We assume her income grows 1.5% a year (after inflation) to about $100,000 by the time she is 67 and ready to retire. To maintain her preretirement lifestyle throughout retirement, we estimate that about $45,000 each year (adjusted for inflation), or 45% of her $100,000 preretirement income, needs to come from her savings. (The remainder would come from Social Security.) Because she takes advantage of her employer’s 5% dollar-for-dollar match on her 401(k) contributions, she needs to save 10% of her income each year, starting with $5,400 this year, which gets her to 15% of her current income.”

Fidelity’s estimate is assuming individuals save for retirement from age 25 to age 67. If people start saving later or have a gap in savings, the 15% annual savings rate will need to be increased to reach the goal. For example, a chart in T. Rowe Price’s Perspectives article shows that if a 40-year-old has not saved any of her income for retirement, she will need to save 22% per year to reach the appropriate income replacement goal.

Is 15% the right savings rate for everyone?

Of course, as with every recommendation, there are caveats.

People who make more than $250,000 at retirement age may need to save more than 15% of income to have the lifestyle they want in retirement, notes Taylor. And, people who make less than $50,000 at retirement age may need to save less, in part because Social Security will replace a higher percentage of their pre-retirement income.

Young agrees that low-earners could save a lower percentage of income; however, he warns, “A low-earner now may not always be a low-earner. As salary goes up so does lifestyle/spending, and a lower savings rate may not work so well.”

Young also points out that the more an individual is saving today, the less they are spending, so this may decrease the multiple of income they need to save. As a simple example, he says someone who is saving 10% of income is keeping 90%, while someone who is saving 20% of income is keeping 80% and therefore spending less. “Spending in retirement is a function of what a person is spending before retirement, which is why someone saving more may need a lower multiple of income replacement,” he explains.

While individuals with incomes in the lower range may have difficulty finding enough money to save, those who are very high earners may have difficulty finding vehicles for their savings, Taylor notes. But, if they’ve maxed out contributions to their employer-sponsored defined contribution (DC) plan, they can look to other tax-advantaged accounts, such as health savings accounts (HSAs).

Young says high-earners should be given more advanced financial advice. “They should sharpen their pencils a bit and not rely on a rule of thumb,” he says.

Although people are different and have different situations, as for the 15% recommended savings rate, Young says, “We don’t want to give people false confidence and want to err on the side that will suggest the right percentage for most people.”

Do You Have What It Takes to Obtain Fiduciary Insurance?

When assessing whether or not to take on a sponsor as a client, the insurers “have really sharpened their pencils,” says Nancy Ross, a partner and head of the Employee Retirement Income Security Act (ERISA) Litigation Practice at Mayer Brown.

With litigation on the rise, experts say that it is more important than it has ever been for retirement plan sponsors to have adequate fiduciary insurance. And as a result of the increase in litigation, carriers have become more selective about sponsors they will cover.

“These are interesting times right now,” says Rhonda Prussack, senior vice president and head of fiduciary and employment practices liability at Berkshire Hathaway Specialty Insurance in New York. “There is a tremendous amount of class action litigation naming plan sponsors and their agents, particularly with respect to private company employee stock ownership plans (ESOP) and fees. None of this litigation seems to be slowing up. In fact, those claims are going more and more down market, particularly the fee cases. Everyone has to be aware of their fiduciary duties, make sure they have processes in place around these duties and work with an insurance broker to make sure they have adequate fiduciary insurance coverage in case they are sued.”

As to how much insurance a sponsor needs, generally 10% of the plan assets is a good rule of thumb, Prussack says. However, the sponsor has to consider the “size of the plan and the complexity,” she says. “That answer might change if the plan is an ESOP sponsored by a non-publicly traded company. It is not uncommon for companies with large plans with $1 billion or more in assets to purchase towers of insurance of $75 million to $100 million or more.”

A tower is created by coverage by several insurance carriers, explains Nancy Ross, a partner and head of the Employee Retirement Income Security Act (ERISA) Litigation Practice at Mayer Brown in Chicago. “If you want $100 million in insurance, you certainly might have different carriers,” Ross says. “Generally, one carrier will only provide up to a certain level of coverage, say up to $25 million. Then the next two might each cover $15 million apiece.”

While 15 years ago, fiduciary coverage was typically a rider to a company’s directors’ and owners’ (D&O) policy, fiduciary insurance coverage has since been carved out as a standalone, Ross says. If a sponsor thinks their D&O coverage extends to fiduciary insurance, they could be in for a surprise, she notes.

When assessing how much insurance to have, it is critical for sponsors to consider how high their defense costs could run, Ross says. “In a complicated ERISA class-action lawsuit alleging fiduciary breaches, your defense fees can run anywhere from $10 million to $20 million. So, if they run on the high side and you have a $50 million policy, will the remaining $30 million be enough to cover the cost of being hit with a judgement?”

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What fiduciary insurance carriers consider when assessing retirement plans

Should a company be turned down for insurance by one carrier, this would not put a Department of Labor (DOL) audit target on their back because the DOL would only discover that once an investigation had begun, Prussack says.

 

If a claim is made against a company, it could result in their being unable to obtain fiduciary insurance for several years, says Nathan Boxx, director of retirement plan services at Fort Pitt Capital Group in Pittsburgh.

 

When assessing whether or not to take on a sponsor as a client, the insurers “have really sharpened their pencils,” Ross says.

 

First and foremost, she says, “they are looking to see if there has been a history of litigation and claims filed against the company. The other big consideration is the company’s fiduciary governance structure. They want to see if there is a fiduciary committee in place and if the proper delegations are in place to give the committee the authority to run the plan. Is there an investment policy statement? How often do they meet? Do they have plan counsel and an adviser? All of these factors would arguable mitigate the risk of being sued.”

 

Prussack agrees: “Insurers really like to see that there is as much expertise as possible in running the plans. If they have a 3(21) or 3(38) fiduciary, we would view that as a positive. As ERISA requires that plan fiduciaries exercise an expert level of prudence and the folks managing their plans typically lack that level of expertise, we would view it as a positive.”

 

Berkshire Hathaway Specialty Insurance also looks to see “if the company is financially stable, whether there have been any DOL audits, or any delayed contributions to the plan. Those are typically the types of problems you will see in smaller plans,” Prussack says.

“With larger plans, we delve more deeply into the plan’s financial history and investments and how they are performing,” she adds. “We look at how robust their fiduciary process is for selecting and monitoring investments and third-party providers, whether it is the recordkeeper or the investment managers. We also delve deeply into how they assess fees to the plan and the participants. We look to see if there have been any changes to the plan that might upset participants, such as termination or annuitization of a defined benefit plan, a change in the investment lineup, a cut in retirement benefits or an increase in costs passed along to retirees. We really try to examine the totality of the risk and look for the kinds of behaviors that could trigger litigation or make participants upset.”

 

Other red flags that carriers look for are offering company stock in the plan or whether or not they are an investment firm offering proprietary funds, Ross adds.

 

As for what sponsors should look for when selecting a carrier, they definitely should get multiple quotes and bids, look at the carrier’s claims paying ability and frequently reevaluate their insurance coverage to ensure it is adequate, Boxx says.

 

“One thing I think is valuable is to look for a carrier that has operated in the space for a while and is familiar with the lawsuits,” Ross advises. “A good carrier will know the plaintiffs’ attorneys, how they operate and what they are looking for, be that a settlement or to push forward with the lawsuit. That can help the sponsor brainstorm for the best defense strategy.”

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