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The vast majority of 401(k)s are exacerbating pay inequity due to employer contributions that disproportionately benefit higher-income employees, Vanguard Group research has revealed.
The study, examining whether employers are optimizing their 401(k) match, has found that in two-thirds of plans, employer contributions exacerbate this issue, with 44% of dollars accruing to only the top 20% of earners.
Meanwhile, the bottom 20% of earners receive just 6% of employee contributions.
According to the analysis based on data from 2021, employers contributed $212billion to retirement plans.
The study finds the inequity to be “unsurprising,” due to the fact most 401(k) plans offer employer matching based on a proportion of salary.
However, when studying how employer contributions relate to income, the report also finds that the top 20% of earners received 39% of the company’s total pay, but 44% of its 401(k) contributions—an 11% larger share of employer contributions than income.
Meanwhile, those in the bottom 20% receive a 29% smaller share of matching dollars than income.
Why are some 401(k) formulas driving pay inequity?
Match formulas differ from company to company, meaning employer contribution costs vary widely.
The most common formula is a percentage match, where an employer matches a percentage of whatever the employee pays, up to a certain threshold of their income. For example, the employer matches 50% of employee contributions up to 6% of their pay.
Other formulas include nonelective contribution, where employers contribute a fixed percentage of pay each year, whether or not the worker decides to pay into the plan; and dollar caps, in which employe contributions are limited to a dollar cap, such as plan where the employer matches 50% of employee contributions on 6% of their pay, up to a cap of $6,000.
The study, in partnership with Yale University and the Massachusetts Institute of Technology, says that no single formula is a clear winner in terms of efficiency but dollar caps are more equitable.
The formulas are not mutually exclusive, and there can be some overlap between the different types.
The study finds that typically, percentage match formulas tend to lead to those with higher incomes receiving more.
“Matching dollars often exacerbates pay inequity,” said Fiona Greig, Global Head of Investor Research and Policy at Vanguard Group, speaking to The Wall Street Journal.
The study suggests one reason higher earners receive a greater share of contributions is because they are more likely to have the financial freedom to pay enough into the plan that they get a full employer match.
What should employers do?
The study recognizes that equity is not the only consideration for employers, and recommends a balanced approach. “We propose three criteria for plan sponsors and policymakers to evaluate match formulas: equity, efficiency, and cost,” the authors assert. “We believe that thoughtful plan design can improve outcomes along these three dimensions.”
While they argue dollar caps are an underused tool that could free up employer resources and improve equity, they admit that it may reduce the total compensation of high earners which could even put pressure on employers to increase wages.
Accordingly, they conclude the best formula may well depend on the company’s talent strategy and how it is faring against competition in the labor market.
The report lists several “safe harbor” employer contributions – standards that incorporate stronger equity considerations – including nonelective contribution.
“Nonelective contributions that decouple employer contributions from employee choices can also be designed to achieve equity objectives,” the authors state. “Adopting additional safe harbor standards with equity considerations could nudge plans toward more equitable designs.”
Other policies it says support equitable use of employer contributions include a basic match, an enhanced match, and a qualified automatic contribution arrangement; and statutory limits including an employee salary deferral limit, a total contribution limit, and a benefit compensation limit.
