Minor Saving Increases Can Achieve 75% Income Replacement

Vanguard defined contribution plan participants’ saving rates may be close to providing adequate income replacement in retirement, new research shows.  

The research paper, “The Vanguard Participant Saving Rate Index,” assesses whether participants in DC plans where Vanguard is the recordkeeper are saving optimally in their current workplace retirement plan. The paper says that 9 in 10 participants can achieve optimal saving rates in their workplace retirement plan with modest increases.

According to the research, 7 in 10 Vanguard DC plan participants are saving for retirement at rates that would enable them to attain a 65% income replacement rate, and a minor increase in elective deferrals—by 1, 2 or 3 percentage points—would enable 7 in 10 to achieve a 75% replacement rate.

Plan sponsors can help to boost participants’ insufficient saving rates by increasing their use of automatic enrollment—deliberately set at a proper default. That, combined with a robust employer match, is a powerful tool for employers to use to increase saving rates, the research suggests.

Auto-Aspects

The paper says that half of Vanguard plan participants are saving at or above their income-based target saving rates and are saving effectively. But that figure drops to 40% upon analysis of data on all employees eligible to participate in the plans, including those who have opted out.

The research separates eligible employees—the workers who have access to a DC plan through their employer—from plan participants, who are the employees actually participating in the plan, via either self- or auto-enrollment.

By year-end 2021, 56% of plans, and 75% of plans with 1,000 or more participants, were using auto-enrollment, and 58% of plans defaulted at a deferral rate of 4% or higher, compared with just 32% 10 years ago, data show.

“Plan design—both the default enrollment rate and the value of employer contributions—remains a powerful driver of participant saving rates,” the paper says. “Higher automatic enrollment defaults and generous employer contributions, in the form of incentive matching contributions and/or other nonmatching employer contributions, increase the probability that participants will save effectively.”

The paper notes that auto-enrollment with a default deferral rate of 6% or higher “was a strong predictor of participants saving effectively.” It also warns that there are significant risks to setting a low floor for the default.

“Results indicate that automatic enrollment designs where the default is 1% or 2% lead to fewer participants saving effectively than when the default deferral design is 0%, as it is under voluntary enrollment,” says the paper. “Participation rates in automatic enrollment plans with low defaults are higher than those in the typical voluntary enrollment plan, although when focusing on participant total saving rates, setting low enrollment defaults can underserve many participants who would be more likely to save at higher levels in a voluntary enrollment plan.”

Equity Returns and Automatic Escalation

Amid myriad competing priorities for participants’ paycheck dollars, plan sponsors should set default deferral and escalation rates for their plan “no lower than the levels whereby employer contributions are maximized and a participant’s total saving rate can reach at least 12% to 15% within five years,” says the paper.

Vanguard’s “2021 Economic and Market Outlook Report” shows that the projected 10-year equity return estimates may place additional emphasis on the importance of participants saving sufficiently. 

The data show that average participant-weighted equity allocation is 77%, and the median is 87%. Using the Vanguard Capital Markets Model, the research suggests that “returns will be muted over the next decade.”

For example, it projects that the 10-year nominal annualized return for an 80% equity allocation will be “between 3.6% at the 25th percentile and 7.3% at the 75th percentile,” with a median projected return of 5.5%. And, with long-term inflation expected to be in the 2% range, real returns—adjusted for taxes and inflation—are estimated between 1.6% and 5.3%, or 3.5% at the median, for an 80% allocation.

This means that for a middle-income saver targeting a 75% replacement ratio, the necessary total saving rate would be 13%, from 12% in Vanguard’s baseline model. For a high-income saver, it increases to 16% from 15%.

“Given subdued return expectations over the next decade and more modest withdrawal rates, higher-income participants should focus on maximizing their contributions in their retirement plan as well as consider retirement savings options outside of the plan,” the paper states.

The Vanguard researchers analyzed approximately 1.9 million eligible employees and 1.5 million actively contributing participants in approximately 880 plans for which Vanguard has completed compliance testing as of December 2020.

The paper was written by written by Jeffrey Clark, retirement research thought leadership author and senior product owner, and Jean Young, senior research associate at Vanguard.