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Two Ways Employer Matches Backfire

When an employer offers to match 401(k) contributions—for instance, by pitching in an additional 50% of the first 6% of salary an employee defers into the plan—some very nice things can happen.

Individuals who might not otherwise have contributed may choose to save a few dollars in order to get the “free money” their employers are offering. And those who would have saved anyway get a helpful boost to their savings: a 6% contribution magically becomes a 9% contribution.

But the more I discuss contribution rates with people, the more I become convinced that employer matches should come with a big warning label.

The chief problem is that many employees seem to anchor on the match limit (e.g., 6%), interpreting it (at least unconsciously) as a recommended savings rate for themselves. I’ve even met people who thought the match was the maximum they were allowed to contribute. Indeed, statistics show that among workers who contribute to their 401(k)s, a majority contribute between 5% and 7% of their paychecks—right in the neighborhood of what employers typically match.

This is lower than the widely-circulated 10% rule of thumb for savings, and well below our usual recommendation of at least 20%. Assuming no other resources, someone who contributes just enough to get the full employer match will almost certainly need to slash spending in retirement.

There’s a subtler problem, too, which is that, from a cash flow standpoint, a dollar of employer savings is not as effective as a dollar of employee savings. Consider two individuals, one who saves 9% of salary without an employer match, and another who saves 6% with the match described earlier. Both individuals will experience the same dollar amount going into their 401(k) each paycheck, meaning that they will begin retirement with the same size nest egg. So far, so good.

But, the 9% saver, accustomed to living more frugally, will need a smaller nest egg to continue their working lifestyle into retirement. The saver with the employer match, accustomed to more disposable income, is more likely to face hard choices when they retire.

What can be done to ensure that something that should be unconditionally good—free matching dollars—doesn’t end up creating problems for the saver?

For starters, employers could be clearer about what their match limit means. This percentage is determined by a company’s finances and generosity, as well as certain nondiscrimination requirements. It is decidedly not a recommendation for what employees should contribute; if anything, it should be considered the bare minimum.

Employees can take responsibility, too, by consulting with a financial professional about how much they need to save to reach their retirement goals. Once they have a savings target, they should contribute the full amount themselves, ignoring what their employer might be pitching in. This way, matching contributions become an added bonus in retirement, rather than a license to spend more and save less during one’s working years.

Bottom line: By all means, take advantage of an employer match if it’s available to you. But don’t let “free money” cloud your judgement about your actual retirement needs.

By Jeffrey P. Ebert, PhD, CFP® / Financial Advisor Jeff holds the CFP® designation and earned his doctorate in social psychology at Harvard University. Jeff has expertise in retirement and education planning.

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