Employers need to optimize all 401(k) matches, not just high earners: Vanguard

Although employer matches may be intended to incentivize workers to contribute to companies’ 401(k) plans, most of the evidence suggests that they have only a small effect on participation and saving, according to a new Vanguard survey, “Are employers optimizing their 401(k) match?”

The research, which was collected from more than 1,300 employer-sponsored retirement plans, finds that, while employer contributions are an important component of total savings, employee savings rates vary surprisingly little across plans with different matches. The study found that just 13% of employees save at exactly the match cap.

“Many people save in excess of the match cap, while others choose not to save at all in spite of incentives from typical match formulas,” Cormac O’Dea, an assistant professor of economics at Yale University, said. “This points to potential gains from more innovative match formulas that may encourage saving among those less likely to do so.”

Employer contributions disproportionately accrue to those with higher incomes, white workers, those with more access to liquid wealth and those with richer parent, according to the survey. Employer contributions are highly concentrated, with 44% of dollars accruing to the top 20% of earners. Many common formulas, including safe harbor designs, disproportionately benefit higher-income employees.

Plan sponsors have different objectives when they design their retirement plan. Some may aim to promote financial wellness and retirement security, while others may aim to win the war on talent.

In two-thirds of plans, employer contributions exacerbate pay inequity. Here are some key findings of the survey:

• Employer contributions are highly concentrated in the hands of top earners
• Top earners received an 11% larger share of employer contributions than benefit income
• In two-thirds of plans (68%), the top 20% of earners received a larger share of employer contributions than income. Many common formulas, including safe harbor designs, disproportionately benefit higher-income employees.
• Higher-income workers are more likely to participate and save more in the plan, resulting in larger matches
• Even among workers with similar incomes, more than half of employer contributions accrue to just a third of workers

Thoughtful plan design can improve outcomes. “Basically plan features that disproportionately increase participation and savings among lower income workers will likely result in more equitable outcomes,” said Fiona Greig, Ph.D., global head of investor research and policy in Vanguard’s Investment Strategy Group. These are the plan design features that Vanguard recommends:

1. Auto-enrollment
2. Immediate eligibility for participation, employer contributions, and vesting of employer contributions
3. Setting the default savings rate equal to the maximum match rate (e.g. if the match is $1 for $1 up to 6% of pay, then set the default savings rate at 6%).
4. More equitable employer match designs: e.g. nonelective contributions, matches with dollar caps (rather than % of income caps)

Employers should evaluate their plan design, along the following three dimensions, according to Vanguard:

• Equity: Are employer contributions equitably distributed? In other words, many employers distribute their match contributions to their employees in different income groups. Given that matching contributions are typically awarded as a proportion of salary, the top 20% of earners receive 44% of employer contributions, while the bottom 20% receives just 6%.
• Efficiency: Does the plan design encourage savings? An employer match is more efficient if it creates financial incentives for workers to save more. These financial incentives affect only workers who contribute up to the maximum match: These workers receive an employer match for every dollar they save. A match does not, however, create financial incentives to save more for those who save above the matching cap.
• Cost: How costly is the plan? Employer contribution budgets can be large: One in four plans spends more than 6% of compensation on employer contributions. Overall, Vanguard found that a dollar cap on matching contributions correlates with greater equity and lower costs. Employers could prioritize plan features that promote savings for lower-income workers, such as auto-enrollment, a higher default savings rate or immediate eligibility.

“I don’t think dollar caps are the silver bullet or even the thing I would start with,” said Greig, who said she would emphasize auto-enrollment, immediate eligibility and setting the default savings rate equal to the maximum match rate.  “And I would probably add a non-elective match before suggesting a dollar cap,” she said.

Related: Same income, same 401(k), different account balances? Plan design is key to wealth gaps

Policymakers, of course, could do more to promote equity, suggests the report. Adopting safe harbor standards that incorporate stronger equity considerations could nudge employer plans toward more equitable match designs, concludes the report.