The intrinsic inequity of 401k matching
January 5, 2022
This a topic that may be of particular interest to people in the Diversity, Equity, and Inclusion space.
I am a salaried employee in the United States. Most of the employers I have worked for have offered a 401k plan and some 401k matching to boot.
It’s a wonderful perk. Most financial advisors describe 401k matches as essentially free money, and it really is.
I do realize though that participating in 401k matching is an advantage that not everyone can enjoy. It’s a dimension of inequality in our financial system that I don’t see being discussed all that often.
In practice, the standard implementation of 401k matching leads to a widening gap between the financially well-off, and those that are not as privileged.
What is 401k matching #
I’ll only provide a very brief overview of 401k plans and 401k matching here just to set the context.
A 401k plan is a retirement savings plan offered by many US employers that employees can choose to participate in. Any funds contributed to a conventional 401k plan are treated as non-taxable by the tax authorities. Those funds in the 401k can then be invested and can hopefully grow.
401k matching is an additional benefit that some employers offer. The amounts and specific details vary from employer to employer, but essentially, employers offer to match employee contributions to a 401k plan up to a certain amount, usually defined as a percentage of contributions or some fixed amount, or both. This is extra money being put into a 401k fund that can grow until retirement.
For more details about 401k matching, check out the article on Investopedia.
The challenge of 401k matching #
It seems like a no-brainer to contribute to a 401k plan, if for no other reason than to nab the match. But sometimes it’s not so easy to do. Depending on an individual’s situation, it might be financially impossible to contribute to a 401k fund at all.
According to the Bureau of Labor Statistics, the mean annual wage in 2020 was $56,310. As a mean, that suggests there are quite a few individuals who earn below that particular value.
There are also a whole bunch of necessary expenses that need to be covered simply to survive. That includes:
- Housing
- Utilities
- Healthcare
- Food
- Student loans (I mention this debt intentionally because of how prevalent and large in scale this is)
- and more!
Being able to contribute to a 401k plan at all requires that a person have a certain amount of financial buffer between earnings and expenses. Sometimes, the buffer can be razor thin, even if there are no discretionary expenses at all.
The buffer gets even thinner if an individual is trying to grow liquidity by saving, such as for an eventual large investment (like a home purchase) or to simply put together an emergency fund for unexpected scenarios.
A simplified example #
Let’s say there’s a person, Alex.
Alex graduated college, and landed a salaried job. Just to keep the numbers nice and round, let’s say he makes $30,000 a year (as an aside, with the Federal minimum wage at $7.25 an hour, it would take 4137.93 working hours to earn that at a minimum wage rate, which comes out to about 517.24 8-hour workdays, or 1.42 years).
Let’s also say that Alex works and lives in a small city. For simplicity’s sake, let’s say the average rent in in the city is $2,000 a month for a two bedroom apartment. Alex is frugal, and decides to split an apartment with a roommate, so his share of the monthly rent is cut down to $1,000. Utilities like heat, water, and basic internet is another $100 a month on average for Alex.
Alex’s employer also offers a great health insurance plan, which costs $100 a month. According to the Kaiser Foundation, the average monthly health insurance premium for a single individual covered by an employer-sponsored plan is actually $104.
Alex enjoys cooking and doesn’t eat out much, so he mostly prepares his own meals. His monthly grocery bill is about $500.
According to the Education Data Initiative, the average monthly student loan payment for someone with a Bachelor’s degree is $448. Let’s say it’s actually $450 for simplicity.
So in a given month, Alex’s necessary expenses works out to $2,150 ($1,000 + 100 + 100 + 500 + 450). For a full year, that works out to $25,800 just to cover functional housing, health insurance, sustenance, and student loans.
With a salary of $30,000, that means Alex makes $4,200 more than the set of expenses so far. Assuming Alex claims the standard deduction on this tax filing, annual taxes works out to about $2,000 (this can vary based on the state that Alex lives in and any other particular tax situations). So really, Alex is left with $2,200 by the end of the calendar year.
That’s really not a lot of margin for error when it comes down to financial planning. That buffer could be wiped out by unexpected medical bills or any other unforeseeable expense.
In a situation like that, Alex probably doesn’t feel financially secure enough to contribute to a 401k, even though that’s the financially prudent thing to do in the long term.
“Just Make More Money” #
The obvious solution for Alex seems to be to just make more money, since the existing set of expenses is already cut down to a minimum.
Some people might criticize Alex for the student loans, but at this point in life, it’s a done deal and is an unavoidable sunk cost. It (usually) doesn’t even go away with bankruptcy. And realistically, student loans are burdens that a lot of Americans carry.
But remember: the mean annual wage in 2020 was $56,310. Which means there are probably a lot of people out there like Alex (in fact, Alex is probably in a more fortunate position than many people out there).
The reality is that there are a lot of people in a position where it’s uncomfortable, risky, or simply impossible to set aside funds for a 401k plan. They’re entirely missing out on the 401k match if available, even if they know that saving for retirement is a good idea in the long run.
People in this situation are making decisions around what economists refer to as intertemporal consumption. They’re striking a balance between spending now vs. saving for later, and that decision is often guided by perceptions around risk.
When the financial margins are thin, people inevitably have to prioritize spending now simply to survive.
Those that do make enough #
On the other end, there are plenty of people out there who do have enough financial buffer to contribute to a 401k. In many instances, these people also benefit from 401k matching as well.
In the long term, the benefit of 401k matching gets dramatically magnified. The S&P 500, a common bell-weather for financial performance, has averaged 10% annual returns. That sort of growth can really make investments early on balloon quite a bit.
Assuming a 22 year old is granted a $1,000 401k match, and the market continues to grow at a steady rate of 10%, and that investment isn’t withdrawn until the person reaches 59.5 years old (the withdrawal age specified by the 401k plan), that initial match can grow to a nominal value of $35,663.64 (calculated as \(1,000 * (1+.1)^{(59.5-22)}\) ).
Think about it: a person that is already financially well-off enough to be sufficiently comfortable to contribute to a 401k plan to secure a match of $1,000 stands to be $35k wealthier than someone else who is unable to do so. The divergence gets even larger with bigger and more frequent investments.
Conclusion #
There are of course a lot of extreme simplifications in this discussion and a lot of details aren’t considered (such as inflation, individual financial choice, and more), but I think the core idea remains: those that are better off now stand to become much, much better off in the future by being able to secure the benefit of 401k matching.
The inevitable outcome is that the wealth gap between the well-off and the not-so-well-off becomes magnified over time.
What this discussion highlights is an inequity that feeds upon itself. It does not propose a remedy of any sort. That’s perhaps a discussion for another time.