Three Simple & Attainable 401(k) Changes that Can Shatter Wealth Inequality
I have a confession to make. I was so busy leading my investment organization and raising my family that I lost sight of the daily challenges of the people outside my career and social circles. I knew financial inequality was an issue, but I was blind to the hardships of low-income workers, many of which are front-line workers and minorities.
Prior to the pandemic, it was easy for me to overlook these workers and their families. Now that the pandemic has opened my eyes and heart to their sacrifices and stories, I feel compelled to act.
I teamed up with a former Fed researcher and investment expert, Steve Dean, to look at this topic in depth. Based on our research and experience, we believe that we have great tools at our disposal to help all workers build lifetime wealth — we do not need to wait for a government response or the perfect solution for wealth inequality.
We find that if companies are willing to revisit their 401(k) plan assumptions, and use their plans to help the employees who need it most, they can help their employees generate over $500,000 in wealth over a working career.
The bar has never been so low for our workers and the stakes so high for companies and society. We see some simple ways that companies can significantly improve the lives of their workers and help bridge society’s wealth inequality gap while also increasing their own social capital.
The Current Situation — Why This is so Critical
The wealth gaps between families of different income levels and between racial or ethnic groups are substantial — and they have not improved over time.
The primary drivers of wealth are income, savings, and investing. Company executives and board members can directly influence all three of these levers for their workers. As business leaders, we should recognize and own our role in the wealth outcomes for our workers. We have the power to help shape these outcomes and start a virtuous wealth cycle that will benefit generations to come.
A staggering gap in wealth
Median family net worth by income, 2019
…and by race or ethnicity
Source: Federal Reserve Board, 2019 Survey of Consumer Finances
For low-income families, it is a challenge to save money. In fact, only about one-third of the families in the lowest income quintile have any reported savings. The good news is that savings increasingly are held in retirement accounts like 401(k)s and the use of these accounts has grown solidly among low-income families.
We believe the increased use of retirement accounts creates an opportunity for companies to help low-income and minority families build more wealth. All that is needed is greater and more consistent savings added to the accounts.
Company 401(k) Plans Build Wealth — But Fall Short for Low-Wage Workers
While 401(k) plans have been successful in building wealth at the aggregate level, we should all be troubled by the different picture that emerges when looking at participants by their annual income level. It is clear that 401(k) plans are effective wealth creators for the highest earners, but are less effective for lower-paid workers.
Significant gaps in 401(k) wealth
Median defined contribution account balances by annual earnings levels
While these differences are striking, we are not surprised given the way companies structure their 401(k) plans. Most plans feature a match program where the employer “matches” an employee’s contributions up to a certain percent of the employee’s salary.
This matching contribution favors higher earners over low earners in two ways:
- Only workers who can afford to save will get a matching company contribution
- With employer contribution limits proportional to salary, higher earners can get larger contributions than lower paid workers.
These factors limit the number of low-income workers willing to participate in 401(k) plans, the amount they save, and the amount their employers contribute to the plans on their behalf.
Significant gaps in 401(k) participation
401(k) participation and contribution rates by income, 2018
For those low-income workers who do participate in their plans, their contributions are far less than those of high paid workers.
Significant gaps in 401(k) contributions
Annual 401(k) contribution by employee income
Employee contributions are based on Vanguard’s estimates of deferral rate by income bracket. Assumes employer match of 4.5%.
Three Ways to Make 401(k) Plans Work for Low-Wage Workers
We believe there are three key elements to making 401(k) plans work for low-wage workers:
- Direct contributions by employers — to ensure that all employees have a 401(k) account and benefit from employer contributions even if they cannot afford to match it with their own savings.
- Fixed dollar contribution target — to remove the bias that the percent of salary approach introduces towards higher earners.
- Default target date investment option — to get diversified exposure to high return assets.
Using a standard retirement model with some basic assumptions, we estimate that employers who follow these three steps and directly contribute a fixed $2,000 per year to their worker’s 401(k) account have the potential to help their employees accumulate $500,000 savings over their career.
The power of saving and compounding
Cumulative value of 401(k) balance
Assumes a starting balance of $0, $2,000 per year contribution and a 7% annual return. Contributions and returns are calculated monthly. These numbers are basic estimates. Actual outcomes will vary significantly based on actual inputs.
While we recommend that companies consider contributing $2,000 per year for each employee, even a contribution of $500 per year can build over $100,000 of wealth over a working career.
As leaders, we have a choice — we can sit by and allow workers to miss out on participating in their 401(k) plan, or we can help them build wealth and start the process of shattering the wealth inequality trap.
The coronavirus pandemic has changed our lives and perspectives. In the old world, it was easy to overlook the fast-food workers, the Amazon drivers, the grocery clerks, the agricultural laborers, and so many other low-wage, hourly workers who keep our economy running and serve our society. Now that we “see” these workers, we cannot turn our backs on them.
We have over 120 million people working in the private sector. While most of these workers can theoretically access 401(k) retirement plans, the majority do not receive any retirement contributions from their employers unless they save first. When it comes to savings and investing, a little can go a long way. A contribution of $2,000 per year could create over $500,000 in wealth over a full career.
Front-line workers have largely been left out of the wealth bonanza of the last 40 years. We feel that by taking a few simple steps, our country’s employers have an unprecedented opportunity to shift the savings and wealth dynamics of our people. Now is the time for action.