Even in their generosity, employers can unwittingly be unfair.
That's one of the biggest takeaways from a new Vanguard report that looks at the 401(k) matching contributions that employers typically put into employees' retirement accounts.
Employers labor over the right matching formula, with many choosing to match 50 cents for every dollar employees put into their accounts, up to 6% of their pay.
The popular “50% on 6%” match, however, has some shortcomings in that it rewards higher-paid workers more. Employees making $100,000 who contribute 6% of their pay, or $6,000, to their accounts get an employer match of $3,000. Those making $50,000 can only get $1,500.
One way to make the employer matching contribution more equitable is to cap the dollar amount. Employers could, for example, cap the match at $2,500, so that all workers — regardless of income — would have a chance at receiving the same maximum employer contribution.
Traditional percentage-based matches, such as 50% on 6%, are “disproportionately flowing to top earners,” said Fiona Greig, global head of investor research and policy at the Vanguard Group, summing up the top-line finding of Vanguard's report released in May.
If employers want to promote retirement security among their workers as their “North Star,” employers need to start thinking about who needs the match dollars most and how they can channel the money “to move the needle on retirement security to the greatest effect,” she said.
Of the estimated $200 billion that employers contribute to workers’ retirement accounts annually, the bulk goes to high earners, according to the report that Greig co-wrote with researchers from Yale University and the Massachusetts Institute of Technology.
The report found that the top 20% of earners receive 44% of total employer contributions. The bottom 20% of earners, in contrast, receive just 6%. The findings occurred despite statutory limits in place to cap the level and share of employer contributions available to high earners.
Dollar caps and equity
Putting a dollar cap on how much workers receive results in more equitable allocations of employer match dollars across income groups, Greig said.
“In some instances, it can put a ceiling on the match dollars going to the top earners, but in other cases it can raise the floor considerably on just how much match dollars may be available to low-income workers,” she said.
Greig explained that of the 10 most popular matching formulas, dollar-cap matches were the most equitable.
Nevertheless, dollar-cap matches are rare, with only 6% of workplace retirement plan employing them, a trend that some experts believe may shift as employers increasingly think about diversity, equity and inclusion in their plans.
“I would think maybe we would start to see an upswing now that employers are so focused on equity in retirement plans, more so than they have been in the past,” said Melissa Elbert, partner and head of defined contribution solutions at Aon.
“You can help push more of your benefit dollars to lower-paid workers,” Elbert said, explaining that doing so can help equalize an employer’s “benefit spend across populations.”
Jana Steele, a senior vice president and defined contribution consultant at Callan, echoed similar views, saying that as plan sponsors look at equity as a factor in their decision-making, dollar caps “may be something to consider.”
The plan sponsors currently using dollar caps, however, are not citing equity as the reason for their use. Some employers put dollar caps in place because it sometimes “sounds like a bigger amount” than if expressed as a percentage of pay, said Rob Austin, head of thought leadership at Alight Solutions.
A dollar cap amount like $5,000 may seem a lot bigger than 4% of pay to some employees, especially those with smaller salaries, he said.
“If employers are really trying to sweeten the pot in areas that are typically more lower paid and perhaps a little bit higher turnover, this is something that can resonate with and attract people to their jobs through that larger amount,” Austin said.
Other employers use dollar-cap matches to assist with their non-discrimination testing. “By capping the match, it means that your highly compensated employees are receiving a lower matching contribution than they might receive otherwise,” said Callan’s Steele.
Steele explained that the lower contribution amounts for high earners makes it easier for employers to pass their non-discrimination testing.
Still, other employers use dollar caps because they make their contribution cost more predictable.
“By knowing the number of participants and the maximum matching allocation that they can receive each year, the plan sponsor knows what the maximum matching cost is going to be,” Steele said. “It can be a way to control costs.”
Dollar caps also cost less. Of the 10 most common matching formulas, dollar caps are the least expensive for employers.
A dollar-cap match costs employers 2.7% of their total benefit compensation, beating the popular “50% on 6%,” which costs 3.6%, according to Vanguard’s report.
The cost savings could be used to pay for other plan enhancements, such as auto-enrollment and immediate eligibility, which experts say also play a huge role in making plans more equitable.
“You can use the cost savings to implement other plan design changes or provide other benefits that are going to support your workforce,” Aon’s Elbert said.
Dollar caps, however, are not ideal for all organizations, particularly those looking to attract high earners because the matching contribution will be lower than with a traditional percentage-based match.
“If they're in a very competitive field, it might not be a great fit for them,” Callan’s Steele said. “Although it is more equitable from a numbers perspective, it does end up being a little bit of a negative for their higher earners.”
Vanguard’s Greig agreed, saying that if the goal is to “win the war for talent and particularly of top earners,” then dollar caps are likely not going to help.
“Depending on how they’re designed, they can reduce the incentive or the contribution for top earners,” Greig said.
Disadvantages
To get around this issue, employers often offer high earners a non-qualified deferred compensation plan, an ancillary retirement savings plan that allows high earners to sock away money beyond what they’re allowed to with their 401(k) plans.
Dollar caps have other disadvantages. They’re difficult to program and add administrative complexity to retirement plans, according to industry experts.
Because dollar caps are uncommon, they’re more difficult to program from a payroll or record-keeping perspective, Callan’s Steele said.
Aon’s Elbert added that they’re also hard to keep up to date because they need to be indexed with inflation and are tricky to set for employers with workers spread out across the country.
“It’s potentially hard to come up with a dollar cap that’s going to work for your entire population because of geographical differences in the cost of living,” Elbert said.
As Alight’s Austin sees it, the decision to implement a dollar cap isn’t easy, as it will be seen as a “takeaway” for some but a “win” for others.
“It’s going to have winners and losers,” he said. “The question is, are there enough winners that outnumber the losers and if the winners are where an employer might want to focus their attention.”
