Playing Catch-Up When Your Salary Stalls

Gauge the impact on your nest egg, then save more

The bear market has inflicted enough pain on retirement savings. But if you're among those whose salaries have stagnated, declined, or failed to keep pace with expectations this year, your retirement plan may be even further from your goals. Since salary levels play a key role in retirement payouts, you may have to "save more and work longer" to compensate for these lean years, says Olivia Mitchell, a professor at the University of Pennsylvania's Wharton School.

So you didn't get a 3% raise this year. This may seem like no big deal, but because of the power of compounding, losing even a small salary hike can produce big differences in benefits. This year, salary shortfalls are sure to be especially painful, since most people won't be able to make up for lost ground in the stock market.

Consider a 45-year-old man whose pay remains at $150,000 this year, instead of rising 3%, to $154,500. At 65, his 401(k) will hold $24,417 less, assuming he saves 10% of his salary each year and earns an annual return of 7.5%, according to Jack VanDerhei, a professor at Temple University's Fox School of Business & Management. If he has a traditional pension plan funded by company contributions, the salary freeze cuts his future benefits by almost $3,000 a year, assuming he works for 20 years and the pension pays 40% of his preretirement earnings.

Whether your salary falls or simply fails to keep up with expectations, it's important to gauge the impact on your retirement nest egg. That way, you can take steps to recoup losses.

Luckily, tax laws that went into effect this year make it easier to play catch-up. With 401(k)s, the maximum pretax contribution rises to $15,000 in 2006. Those over 50 can kick in an extra $1,000 now, and that rises to $5,000 by 2006. And most plans allow aftertax contributions once you've hit your limit. Defined-benefit pension plans offer no way to recover benefits lost because of stingier-than-expected pay raises. Still, you can compensate by increasing your other savings.

With 401(k)s, it's relatively easy to figure out how to make up for a salary shortfall. Compare what you expected to earn this year with what you are actually getting. The 45-year-old making $150,000 is being paid $4,500 less than he expected. Then, calculate how much less you are contributing to your 401(k) as a result. If the man puts 10% of his pay into a 401(k) each year, his contribution will be $450 less than it would've been had his pay risen. To make up for that deficit, he can increase his 401(k) contribution.

For traditional pensions, the catch-up calculation involves more guesswork. To find the formula for calculating benefits, consult your benefits department or "summary plan description." Most plans use years of service, salary, and a specified percentage. Take a woman who expects to stay with a company for 20 years. If her company formula's percentage is 2%, she will receive 40% of her final pay in retirement (20 years times 2% equals 40%).

When determining what salary to plug into the formula, most plans use an average of an employee's highest five years. So, to figure out how lower pay affects benefits, it's necessary to estimate future pay raises. Since this is difficult, you might fall back on a simple rule: Because most retirement payouts rest on an employee's highest salary, don't worry if you are far from retirement--you have time to make up for shortfalls. But if you are close to retiring, crunch the numbers, funnel catch-up cash into another vehicle, and hope your company is among those forecasting salary increases of 4% for 2003.

By Anne Tergesen

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