Are 401(k) matching contributions all they are cracked up to be?

(This August 1 story has been corrected to fix the percentage of employer contributions to 40% instead of 58%, in paragraph 5)

By Mark Miller

(Reuters) - When you are saving for retirement in a 401(k) account, the standard advice is to put aside enough to capture your employer’s matching contribution. That makes sense, since the contribution represents a risk-free 100% return on every dollar you save.

The match is intended to be an incentive that encourages saving - but recent research shows there are better ways to get people to sock away their money. In many cases, the current structure of matching programs actually contributes to pay inequity - and they are not the most powerful incentives available to employers.

“When we first created an employer match, we thought that was the carrot - the incentive that would get people to participate,” said Fiona Greig, global head of investor research and policy at Vanguard and co-author of a recent research brief on matching contributions. “But now we have a much heavier hammer.” 

That hammer, she said, includes the rise of plan features like automatic enrollment, auto escalation of contribution rates and higher initial default contribution rates. “These are the things that, without opening your eyes or engaging in any way, cause people to participate and save more over time,” she added.

Matching contributions are a big, expensive feature of the 401(k) system. Vanguard notes federal government data showing that employers contributed $212 billion to defined contribution retirement plans in 2021 - about 40% of all dollars in the accounts.

Vanguard, one of the nation’s largest administrators of 401(k) plans, evaluated more than 1,300 large retirement plans that the firm administers. The research does not conclude that employers should stop matching employee contributions - far from it. But it did find that employee saving rates do not vary much across plans with different levels of employer matches. 

More concerning is the finding that employer contributions exacerbate pay inequity. The contributions are highly concentrated, with 44% of dollars accruing to the top 20% of earners. “Higher-income people tend to participate more, and they also tend to contribute more,” said Greig.

Indeed, a study by the Center for Retirement Research found that 59% of the tax deferral feature of 401(k) plans benefited the top fifth of earners, compared with just 3.7% for the bottom 40% of earners. The upshot is that employees who do not take full advantage of their employer match effectively get paid less than their peers, who save more, for a variety of reasons.

That gap spills over into a broader problem with inequity in retirement security. The U.S. has persistent disparities in savings by race and ethnicity, with Black households holding only 14% as much as white households, and Hispanic households just 20% compared with white households.

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There are plenty of opportunities to improve the equity of retirement security in the U.S. outside of the current features of 401(k)s. I would start with an across-the-board expansion of Social Security benefits, with extra bumps for low- and middle-income workers who have the least ability to save for retirement. 

   Improved access to workplace saving plans also could help greatly. Only about half of private-sector U.S. workers are covered by an employer retirement saving plan at any given time - and that figure has not budged much over the years. The lost opportunity to save at the workplace translates into far too many people retiring only on Social Security.

Seventeen U.S. states have moved to plug the gap with “auto-IRA” plans that mandate employers who do not offer their own 401(k)s to enroll workers in a government-sponsored plan. Eight of those states - including California, Illinois and Maryland - have launched their savings programs, and some policymakers hope to see the idea expanded nationally. Others have advocated what amounts to a national 401(k) plan featuring a government matching contribution for anyone lacking workplace coverage.

Vanguard’s brief points to opportunities to reform the matching-contribution system to make it more equitable.

The most common match programs use percentages - for example, 50% of an employee's contributions up to 6% of pay. Some plans contribute regardless of what the employee does. And some have employer contributions up to a dollar cap - for example, a 10% match on 6% of pay but capped at $6,000. But the researchers found little difference in employee contribution rates across various formulas.

Other 401(k) plan features do seem to be leading to improved investor behavior. Vanguard’s latest annual report on workplace plan trends found a record-high share of plans offering automatic enrollment, rising employee participation rates and record-high rates of deferral into retirement accounts.

And Vanguard is not suggesting that employer matches should be retired - rather, changes should be made that could make the matches more equitable. “These are big dollars being spent, and we think there are some ways that employers can evaluate their plans to make them more equitable and cost-effective.”

Plans that pair auto-enrollment with a dollar cap scored highest for equitable treatment of employees, Vanguard found. “Auto-enrollment causes everyone to benefit from the employer match, rather than leaving people to make the choice to not participate at all,” said Greig. “And that is really important in terms of equity.”

The opinions expressed here are those of the author, a columnist for Reuters.

(Writing by Mark Miller; Editing by Matthew Lewis)