Are 401k Plan Sponsors Poised to Cut a Popular Feature?
The company’s 401k match acts just like crossfire injection, once a very popular feature in early 1980s muscle cars. It gives your 401k savings a turbo-boost of free money. As a result, your account will grow faster, received better downside protection and, ultimately, get you to a secure retirement faster. Ironically, this was not their original purpose. In fact, you might be surprised to learn the 401k match, for the most part, has failed to meet its primary objective. As a result, many plan sponsors have reconsidered their matching strategy. This may disappoint some employees, but it makes sense.
With the advent of the 401k plan, plan sponsors sought to use their traditional profit sharing contribution into an incentive to encourage more employees to save more of their own money. But that’s not the only reason why plan sponsors contribute to retirement plans. John F. McAvoy of Waterstone Retirement Services in Canton, Massachusetts, says, “There are three main reasons for an employer match: 1) The company is profitable and those profits would be taxed if not shared with the participants as a match; 2) A Safe Harbor match allows the employers/owners to maximize their 401k contributions; and, 3) A match promotes good will with the employees.”
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Rick Mason, president of Corporate Markets for ING U.S. Retirement Solutions, based in Windsor, Connecticut focuses on the employee recruitment and retention aspect of the match. “While some plan sponsors offer a matching contribution to take advantage of tax benefits,” he says, “most sponsors typically offer a matching contribution to attract and retain top talent at their company. If all other factors are equal, a company that offers a match – or at least a more attractive formula – may be the tiebreaker for many candidates.”
Beyond this, though, the company match has become more of a strategy to encourage employees to add to their retirement savings accounts. Rich Rausser, Senior Vice President of Client Services at Pentegra Retirement Services in White Plains, New York, says, “Matching contributions help to motivate employees to participate in the plan. A matching contribution also increases deferral rates among all employees which improves retirement outcomes and retirement readiness.”
Why is it important for companies to encourage their employees to save? Aside from “it’s the right thing to do,” there are actually compliance reasons why this is necessary. “It helps with nondiscrimination tests,” says Robert Richter, vice president of SunGard’s wealth & retirement administration business in Jacksonville, Florida. He adds, “Highly compensated employees are subject to deferral limits that are based on non-highly compensated employee contribution rates. If non-highly compensated employees defer at low rates, then it will limit the amount that the highly compensated employees can defer. Safe harbor plans are a way to eliminate that test, but in order to use the safe harbor provisions the employer is required to contribute to the non-highly compensated employees either a minimum matching contribution or an across-the-board contribution, even for those who do not defer.”
The employees, on the other hand, see the company match as only one thing. “An employee matching contribution is free money,” says McAvoy. “The match provides an instant return on the savings investment,” he says.
Indeed, many financial professionals use the employee match to convince people to save for retirement. “The message is fairly simple: if you don’t defer, then you are giving up free money. Where else can you get an immediate rate of return of 50% or 100% (depending on the rate of the employer match)?” says Richter.
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There’s something more important about the employee match. Like crossfire injection, it provides an inside power boost to the employee’s retirement savings account. This can have profound – and positive – implications when the employee retires. “For many Americans, their 401k plan is the cornerstone of their retirement savings,” says Mason. Employers who offer the added benefit of a company match as part of their 401k plan are setting up their workforce to be more retirement ready. By offering ‘free money’ to their employees, it not only encourages participation in the plan, but at a contribution rate that is likely higher than if a match was not offered so that participants are able to take advantage of the match.”
As Table 3 shows, the impact of this “free money” can grow substantially over the decades. In the example here, the employee defers $100 per month and the employer matches 50 cents on the dollar. Over time, the money saved grows at a rate of 8% per year. After ten years, the match produces $9,178 in extra savings. After twenty years, the match produces $29,549 in extra savings, more than the employee’s total salary deferral. The effect is more pronounced after thirty years, when the match produces $74,766 in extra savings, more than twice the amount of the employee’s salary deferral.
Table 3. The Impact of Company Matching in a 401k Savings Plan
Despite the plain evidence cited in the table, too many employees fail to take advantage of the company match. “Many participants do not understand the long-term compounding affects and how it can change their life,” says Michael T. McKeown, Director of Research at Aurum Wealth Management Group in Mayfield Village, Ohio.
The lack of action is particularly acute among younger workers who stand to benefit the most from long-term compounding. “They don’t understand it,” says Dale Terwedo, an advisor at Terwedo Financial Services, in Edmonds, Washington. “They’re young and they’re not thinking that far down the road. Sometimes, they also have priorities that get in the way of saving towards retirement.”
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“Many employees believe they cannot afford to save for retirement,” says James R. Peters, author of The Prosperity Track. “Unfortunately, those who think they can’t afford to save, can’t afford not to save for retirement.”
Rachel Hawili, Director, Corp. Services at Hefren-Tillotson, Inc. in Pittsburgh, Pennsylvania says, “Employees fail to take advantage of a 401k match because they either don’t understand how it works or don’t think they can afford to save their own money into the retirement plan.”
Jim Sampson, Managing Principal at Cornerstone Retirement Advisors in Warwick, Rhode Island has a more nuanced take on the reluctance of employees to act on the employer match. He says, “We live in a world of instant gratification, and people are so focused on paying the monthly bills, that a ‘50-cent match’ doesn’t get their attention. We need to get back to basics and help folks see how much that ‘50-cent match’ can add up to over time.”
At the same time, we’re seeing reports that auto-enrollment has been a much more effective way to encourage employees to save. In light of this, some plan sponsors are considering to stop the match altogether. Other research suggests there’s a better way. “Behavioral finance studies have shown that sponsors are subliminally telling their employees what to do when they set their defaults,” says Sampson. “If they set the match at 50% of the first 6% of pay, many employees will save 6%, because they think that’s what they are supposed to do. So if a company is trying to get more bang for the buck on the same matching budget, stretching the match can be very effective. Instead of 50% of the first 6% (which nets the employee 3% of their pay), why not set the match at 30% of the first 10%? Or 25% of the first 12%? The company spends the same 3%, but employees will save more of their pay to receive those dollars. They do need to be concerned with watering down the match too much, because employees may de-value it and not save altogether.”
The company match has helped many employees accelerate their savings rate beyond what they could do by themselves. Sampson’s concern is well placed. In an attempt to outthink employee behavior, plan sponsors might be taking away a valuable tool that employees have come to rely on. After all, for all it’s cool appeal, GM stopped producing cars with crossfire injection after only a few years.
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on how to create an investment policy statement that defines a set of menu options consistent with the concepts outlined here.