Declining pensions and retiree medical coverage, combined with increasing life expectncy, inflation and health care costs, contribute to new data from Hewitt Associates suggesting that the current 70% to 90% pay-replacement model for retirement income adequacy is now inaccurate. Workers instead will need to replace a staggering 126% of final pay at retirement.

"Full-career employees who actively save in their 410(k) plans from an early age and have both pension plans and subsidized retiree medical coverage are in good shape for retirement, but employees in that situation - or who will be in that situation in the future- are a very small minority," says Alison Borland, defined contribution consulting practice leader at Hewitt.

Given the amount of income necessary to fund a secure retirement, employers must stress the importance of saving and planning early. Currently, the time when workers begin thinking seriously about retirement and actually doing so is less than two years, according to the Employee Benefits Research Institute.

One in five retirees report thinking seriously about retirement only six months before they left the company, while another one in five report giving serious consideration a year beforehand, EBRI finds. With another 28% giving 18 months of thought, that means that nearly three in four employees are spending less than two years giving serious consideration to their retirement options.

"Without changes in behavior, most workers will either need to significantly reduce their spending or work longer in order to have enough money to last through retirement," Borland says.

Savings lagging

EBRI's 2008 Retirement Confidence Survey suggests that workers who have performed a retirement needs calculation are twice as likely as those that have not to try to accumulate at least $1 million prior to retirement.

Currently, more than 1.2 million employees, 67%, are expected to have met less than 80% of their projected needs at retirement, data suggests.

Employees currently contributing 8% of pay to a 401(k) can replace 96% of pre-retirement income by age 65, which equates to approximately 80% of what is needed to replace preretirement standards of living, Hewitt data states.

Unfortunately, data also shows that upward of a quarter (26%) of employees do not participate in their company's 401(k) plan. Of those that do, most (61%) contribute less than 7% each year.

Identifying income gaps

Employer-subsidized retiree medical coverage, a fast disappearing benefit (less than 40% of companies still offer it), has a significant impact on employees' ability to save for retirement. On average, data suggest that employees who have retiree coverage and save in a 401(k) see only a 12% income shortage in retirement, compared with 25% for those without coverage, and 87% for those who don't have coverage and don't participate in a 401(k).

"While the availability of Medicare - including the new Medicare prescription drug coverage - represents a substantial asset available toward meeting postretirement medical needs, medical inflation and declining employer subsidies for retiree health benefits can quickly erode the retirement income level generated by 401(k) and pension plans," Borland says.

Increased life expectancies also contribute to unplanned income gaps.

"When traditional targets were put into place [researchers assumed] similar medical spend and that companies would subsidize retiree medical coverage," Borland explains. Traditional targets also didn't factor in inflation (tracked at 3% for this study) or a pending Social Security crisis (also disregarded for purposes of this report).

Hope is not lost

However, according to Hewitt, employees who make small improvements to their retirement savings plan may be able to bridge the gap and achieve the necessary income potential by working as little as two years past age 65.

Borland suggests four best practices that employers can use to help educate employees:

1. Encourage 401(k) plan participation. In order to encourage a greater percentage of income contribution, consider chaging your match maximums, Borland says. Matching dollar-for-dollar up to 3% is the same cost to the company as matching 50 cents on the dollar up to 6%, and will in turn encourage employees to save in greater percentages.

"Perform an annual retirement checkup," Borland suggests. Getting employees to reconsider their contribution levels on a more frequent basis makes retirement a front-of-mind concern.

2. Consider working just a little bit longer and saving just a bit more. "If you look at someone who starts saving early in their career, even by two years, the ultimate balance will go up 10% to 20%, due to interest," Borland explains. "Delaying retirement for two years has such a huge difference because Social Security will be higher, you'll have accumulated more assets, and life expectancy is that many years shorter."

Borland points out that the additional two years should also include a 2% jump in savings.

3. Invest smarter. The saying, 'Work smarter, not harder,' also applies to retirement. Pay attention to annual costs deducted from retirement savings accounts.

4. "Encourage employees to utilize retirement decision-making tools," Borland says. Investing a significant portion of assets in equities has a significant impact. Don't jump around - pick an appropriate plan and stick to it.

Hewitt's study tracked nearly two million employees at 72 large U.S. companies.