The Inequity Trap: How 401(k)s Drive Earning Gaps Between Workers

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A new study from Vanguard outlines a predictable yet troubling reality: The vast majority of employer contributions to 401(k) plans benefit higher-income employees rather than their working-class counterparts.

The study, conducted by economists from MIT, Yale, and the U.S. Census Bureau, found significant disparities in employer matches to 401(k) contributions among different demographics. Black and Hispanic workers, who typically earn lower wages compared to white workers, tend to contribute less to their 401(k) plans. As a result, they often miss out on the employer matches that higher-earning workers benefit from. 

Clearly, this is an issue. 

Here’s how most defined contribution 401(k) plans work: A share of an employee’s earnings is withheld from their paycheck and then partially or even fully matched by a contribution from their employer. The contribution formula typically includes 50% employee contribution and 50% employer contribution, up to 6% of the employee’s salary, but employers are free to change or lower their contributions at any time. The employee is then solely responsible for managing investments, both during active working years and after retirement. 

At first glance, these types of plans appear advantageous for employees. 401(k) contributions are deducted pre-tax, and if an employee is consistent and generous with their savings, it can theoretically lead to a sizable amount of retirement savings. However, the troubling reality is that many workers, particularly those who earn below a sustainable living wage, rarely contribute the maximum amount to their retirement savings because they struggle to pay for their regular expenses.

Disparities between low-income and high-income older workers’ retirement accounts have increased significantly over the past decade. In 2019, only one in ten low-income households had a retirement account balance, compared to about one in five in 2007. In contrast, approximately nine in ten high-income households maintained a retirement balance during this period. For those with savings, the median amount was significantly higher for upper class households, while any change for other income groups was not statistically significant. Additionally, racial disparities persisted, with a higher share of white households holding a balance compared to households of other races. White households had about double the median balance of households of all other races. 

Based on  2019 data, the median Black worker earns 24.4% less per hour than their white counterparts. As a result, a disproportionate share of employer 401(k) matches are awarded to the higher earners, who are overwhelmingly white. The underutilization and ineffectiveness of 401(k) programs disproportionately affect Black workers, as highlighted by a 2023 report from the U.S. Government Accountability Office (GAO), which details how these gaps harm several minority groups. 

Efforts to incentivize employees to make larger contributions have had uneven results. The study shows that increasing the match by the employer does not typically affect the employee’s contribution rate. 

While 401(k)s can benefit high-earning, financially literate workers, it is significantly riskier than a defined benefit pension plan. This is because defined contribution plans can easily be depleted through improper spending or poor investment returns. Many workers who lost a huge share of their retirement savings during the 2009 Great Recession are only now back to their high water marks from 15 years ago. If the market heads south in the final years before a retiree walks out the door, their retirement savings could get wiped out. 

This risk is significantly minimized with a pension, largely due to professional management and risk pooling. Once a pension has vested after the allotted years of service, it provides a continuous income for life, allowing for a more secure retirement with far more latitude. This consistent income enables workers to invest more aggressively into additional retirement savings accounts beyond their guaranteed base, rather than managing a single pool of diminishing dollars.

Defined benefit pensions do not have to rely on employees making more significant contributions to receive maximum benefits, nor are they as impacted by the whims of the stock market. Most importantly, a pension plan does not require advanced financial literacy and active management. Pensions allow investment professionals to do the work. Pensions are not a gamble and are a much less risky investment.

An Economic Policy Institute analysis stated that the shift from defined benefit pensions to 401(k)-style plans “has been a disaster for lower-income, black, Hispanic, non-college-educated, and single workers.” While 401(k)s benefit higher-income, overwhelmingly white workers, defined benefit pension income is more evenly distributed among recipients of different races compared to 401(k) income.

Simply put, pensions are the most reliable, equitable, and fair retirement option for everyone.