A common challenge for sponsors of defined contribution retirementplans is measuring the success of their plans in meeting theiremployees’ future needs.

When offering a retirement plan of any kind, sponsors need theresources to determine the “plan health” or overall success oftheir defined contribution program.

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Many approaches have been used historically, including:

• Participation rate. This is one of the mostpopular measurements. It divides the number of employees makingpayroll deduction contributions to the plan by the number ofemployees eligible to contribute. For example, if an employer has100 eligible employees and 70 of them are making contributions tothe plan from their paychecks, the plan’s participation rate is 70percent.

• Average deferral rate. Thisis another common metric. Based on participants who are makingdeferrals to the plan from their paychecks, this measurementquantifies the average percentage of compensation that each personcontributes.

• Diversification. An additional importantmeasure is to gauge diversification among investment asset classessuch as stocks, bonds and cash equivalents to determine how welldiversified the plan participants are as a group.

All of these measurements provide some indication of how theplan is performing, and in each case, the higher the percentage,the more advantageous it is for the plan and the participants.

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However, none of these metrics capture what most plan sponsorsare trying to determine – what percentage of the employeepopulation is on target to meet their retirement needs. This ismuch more difficult to assess.

Income replacement ratio

There are a number of challenges in determining the percentageof participants who are on track to meet their retirement savingsgoals. After all, the savings goal for one person can differgreatly from that of another.

Nevertheless, an important metric used to help determine if aperson is on track for adequate retirement savings is the incomereplacement ratio.

Most retirement experts counsel their clients that a personneeds to have income in retirement that replaces between 70-85percent of their final year’s salary. This amount represents theincome necessary to maintain the standard of living in retirementthat they enjoyed while they were working, and replacement incomecomes from many sources, including Social Security, the currentretirement plan, retirement plans from previous employers and othersavings.

While it might not be true for all employees, it is assumed thata person will require less income in retirement than duringemployment.

For the purpose of measuring plan success in meetingparticipants’ targeted replacement ratio (using 80 percent of anemployee’s projected final year’s compensation as a reasonablereplacement ratio), the calculations focus on the accumulationsfrom employer and employee contributions to the retirement plansoffered by the plan sponsor, as well as assumed Social Securitypayments.

Generally, plan sponsors will be unable to capture all of thepotential replacement income sources, outside IRAs and prior planaccounts for example, for all of its employee participants in theplan.

However, the information that is available allows a sponsor tocreate a baseline measure to compare to future results so thesponsor can track the progress of the plan and itsparticipants.

How are calculations performed?

The calculation of a participant’s replacement ratio requiressome indicative census data (date of birth, annual compensation),some current plan data (account balance, deferral percentage, assetallocation) and some assumptions for the future (age at retirement,future increases to compensation, inflation rates, future returnson investments).

Using this information, along with an agreement on theassumptions to be used, the record-keeper (associated with theplan’s advisory firm) should be able to project a future accountbalance based on historic rates of return for the investments beingused by each participant.

Translating that into a rate of participants on target formeeting their retirement savings needs, the record-keeper typicallywill indicate what portion of the population has a 100 percentchance of reaching the 80 percent replacement income target.

With this information as a baseline, the plan sponsor mightundertake initiatives to increase the participation rate or theaverage deferral percentage.

Next steps

Plan sponsors should ask whether their plan record keeper oradvisor can provide them with these plan statistics, particularly acalculation of the percentage of participants who are on track tomeet their replacement ratio.

While most have the capability to project an individualparticipant’s replacement ratio, they might not have the capabilityto aggregate the numbers on a plan-wide basis.

Armed with this information, plan sponsors can drive initiativesto improve the plan’s success in preparing participants forretirement.