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401(k) Contribution Matches Not Really “Free Money”

Posted By Jim On 01/25/2012 @ 7:15 am In Personal Finance | 17 Comments

401(k)s are making everyone poorer. [3] That’s the conclusion from a study by the Urban Institute [4] in which they analyzed qualified defined contribution plans, the official category of 401(k) plans, and concluded that employers reduce worker salaries when those workers are eligible for 401(k) plans with matching contributions.

Toder and Smith looked at a Census database on pay and pension plans, and how much employers contribute. They looked at workers who had 401(k) plans in which their employers contributed to retirement savings automatically or by matching employee contributions and compared them with workers who had either a 401(k) with no employer contribution or no 401(k) at all. All else being equal, they found that workers at companies that contributed to their employees’ 401(k) accounts tended to have lower salaries than those at companies that gave no retirement contribution. In fact, for many employees, the salary dip was roughly equal to the size of their employer’s potential contribution.

In other words, if your employer said they’d match your contributions up to 3%, they were probably offering you a salary that was 3% lower than what they would be offering if there were no 401(k) available to you. The actual figures are less dour but that’s the gist.

This isn’t that much different than cash back credit cards (work with me, it’ll make sense shortly). When I make purchases with a cash back credit card to buy a box of cereal, I get a very small percentage of that back to me as the cash back reward. If I were to make the same purchase with cash, I get nothing back. The box of cereal costs the same to me regardless of my method payment, so paying with cash subsidizes those who are paying with a credit card. I’m paying a higher price because the seller knows some people will pay with a credit card and that credit card charges a fee. Since he doesn’t know how someone will pay ahead of time, he simply assumes everyone uses a credit card and raises prices. If someone doesn’t, he wins. If they do, well he’s covered.

It’s the same with the 401(k). A company knows how much it can afford to pay a new employee. It deducts all the fixed costs, such as how office space and a computer, along with benefits, like medical insurance and the 401(k), and arrives at the salary figure. The 401(k) contribution looks like “free money” to the employee, because it is, but it really comes out of their total compensation. Since the 401(k) is optional, unlike a pension, the company “wins” in the case when an employee doesn’t contribute and get the matching funds. If they do, well it’s all been taken into account when setting salaries.

The takeaway from this is clear – if you can, you have to contribute to a 401(k) if your employer is offering matching funds. Your employer is assuming you will and they’re paying you less because of it. What this also means for workers who don’t have access to a 401(k) or don’t get matching funds, don’t be too upset because it just means your employer is paying you more.


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[3] 401(k)s are making everyone poorer.: http://moneyland.time.com/2012/01/12/how-401ks-make-many-americans-poorer/?iid=pf-main-lede&hpt=hp_t3

[4] study by the Urban Institute: http://crr.bc.edu/images/stories/Briefs/IB_11-15_508.pdf

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