One of the biggest perks of 401(k) retirement plans is the opportunity for employees to earn “free money” through employer matching contributions; however, recent research from Vanguard Group reveals that this benefit disproportionately favors high-income earners, leaving lower-paid workers at a disadvantage. The reality for millions of low-income workers is the allure of free money but the ability to capture only a fraction of it. This structural inequity points to a shortfall in the current retirement landscape and should be an impetus for companies to consider redesigning their retirement benefit plans.
The Uneven Distribution Of Employer 401(k) Matching Contributions
The Vanguard study examined 1,352 retirement plans and found that nearly 50% of the $200 billion employers contribute to 401(k) plans annually benefits the top 20% of earners. In stark contrast, the bottom 20% receive just 6% of employer contributions. This disparity is rooted in the most prevalent matching formulas and underscores a design flaw: traditional matching formulas are predominantly percentage-based, as opposed to dollar-based, which often exacerbates income inequities.
For instance, a standard match of 50% up to 6% of salary means a worker earning $200,000 could receive $6,000, while someone earning $50,000 might only get $1,500. While this structure may appear equitable – everyone gets the same percentage – its real-world application skews heavily in favor of higher earners, especially given that higher earners are also more likely to contribute the maximum.
Global head of investor research and policy at Vanguard, Fiona Greig, explains, “Many match formulas are not serving low-income workers for whom these match dollars would be more material.” This disparity is exacerbated given that participation rates among lower earners remain low, often because they lack disposable income to contribute enough to qualify for the entire match. This leaves lower-income workers at a significant disadvantage in creating long-term financial security.
401(k) Employer Matching Is Critical For Financial Security
We should not underestimate the role of employers matching contributions in helping workers save for retirement. 401(k) matching contributions are hailed as a cornerstone of retirement saving. They play a vital role by incentivizing workers to contribute and augment their contributions. Employer matches are especially critical as accountability for retirement savings have shifted from the government and employers to individuals, and as 401(k)s now serve as many Americans’ primary retirement savings vehicle. According to Taha Choukhmane, assistant professor at MIT’s Sloan School of Management and co-author of the Vanguard study, employer contributions represent 24% of retirement plan wealth, which reinforces their importance in achieving financial security.
Alternative Approaches To Level The 401(k) Employer Match Playing Field
Companies could make some simple tweaks to level the playing field. “One way companies can help lower-paid workers get more matching dollars is by automatically enrolling them at a savings rate that captures the full matching contribution,” Greig articulated in a Wall Street Journal article.
According to Vanguard’s research, changing the employer contribution formula to one that caps contributions at a specific dollar amount rather than a percentage of salary would be the optimal way of reducing inequity. For example, the study showed that with traditional percentage-based matching, while the top 20% of earners had 39% of the income, they received 44% of their employers’ 401(k) contributions. Dollar caps drastically reduced the gap, with the top 20% receiving 35% of pay and 33% of their employers’ matching contributions on average. While this may be the most equitable approach, it is far from prevalent and only used by 4% of the plans in Vanguard’s study.
One company that has implemented a dollar-cap strategy is Microsoft. In 2016, Microsoft implemented a dollar-cap matching formula to serve lower-income employees better. The company matches 50 cents on the dollar up to $11,500. This ensures that lower earners, who often cannot contribute as high a percentage of their pay, still receive meaningful benefits. “Lower-paid workers received about three-quarters of the extra dollars Microsoft spent on its matching program when it adopted the new formula,” Thiele told the Wall Street Journal.
To foster a more equitable retirement program, employers should consider following Microsoft’s lead or implementing some of these strategies:
- Adopt Dollar Caps: By capping matching contributions at a set dollar amount, companies better balance distributions across income levels.
- Implement Automatic Enrollment and Escalation: Research from the National Bureau of Economic Research shows that auto-enrollment boosts participation by up to 40%. Pairing this with gradual contribution increases can help employees capture the entire match.
- Consider Flat Contributions: Offering a fixed percentage of pay or fixed dollar amount, regardless of employee contributions would ensure that all workers are benefiting, regardless of their ability to save.
- Deliver Targeted Financial Education: Financial literacy programs, especially workshops delivered at critical decision points or life events, can empower employees to make better, more informed savings decisions.
- Experiment with Flexible Matching Formulas: Innovative approaches, such as higher matches for the first few percentage points of contributions, can encourage lower-income workers to save.
Conclusion
The Vanguard study and Microsoft’s success with dollar caps demonstrates that leveling the playing field is feasible. The goal now is to motivate more companies to adopt these strategies to improve their employees’ retirement outcomes. For the millions of Americans relying on 401(k)s for their retirement income, these reforms could mean the difference between financial insecurity and a comfortable retirement.