What is the logic behind a 50% of X% 401(k) contribution match?

Question

In the situation where an employer is contributing a match to a 401(k), apparently a common formula is to match 50% of employee contributions up to a percentage of their salary. I have also seen this phrased as "50 cents for every dollar".

If the amount is 50% match up to 6% of salary, this equates to "you put in 6% and we'll put in 3%".

Why would they choose to do this, instead of simply offering a match up to 3%?

The match is not more or less either way. It instead forces the employee to put in more money, which has no benefit to the employer. I don't see any advantage to the employer to do it this way, there is only disadvantage to the employee.

What is the logic behind offering a ratio match instead of a 1:1 match?

Answer 1

Many employees don't contribute enough to maximize the match, so the cost to the employer is not the same. Under the 50% of 6% strategy an employee contributing 5% would get a 2.5% match not a 3% and that saves the company 0.5%.

@TTT provided an excellent link in the comments below to a study titled "How much employer 401(k) matching contributions do employees leave on the table?" performed by Financial Engines, an independent financial advisory service. The information meaningful to this answer is on Page 5 (Page 7 of the PDF):

• 4,378,445 eligible employees were included in the study

• 1,077,775 of the eligible employees did not contribute enough for the full match; of them,

  • 285,386 Received zero match funds

  • 792,389 Received some match funds, but not the full match available

So 792,389 or 18% of the employees studied contributed in to employer 401(k) plans but not enough to maximize their available match.

Answer 2

This creates incentive for the employee to contribute more and increases the funds under management of the 401(k) plan. The size of the plan influences the fees that are charged in each of the funds offered. (The more assets under management, the better for those in the plan.)

More importantly, 401(k) plans are not allowed to discriminate in favor of highly compensated employees. That discrimination is determined by calculating the average deferrals by your lower compensated employees and comparing them to the average deferrals of your highly compensated employees. If highly compensated employees are saving too much compared to the rest of the pack, they will have some of their contributions returned the next year (with all the tax implications of that). Forcing everyone to contribute 6% to get the full match helps the plan to not fail the discrimination test and protects the highly compensated employees from losing some of their tax deferrals.

Answer 3

Another factor to consider is that it encourages employees to contribute more into to the plan so that they'll be able to comfortably retire. Getting the full match encourages people to put at least 6% in to avoid leaving money on the table; 100% of the 1st 3% would see a lot of people only putting 3% in instead. While 9% of your income is still a rather marginal amount to be saving; it will leave you in a much better place in your 60's than if you had only put in 6%/year.

Answer 4

401k contributions are exempt from employee and employer FICA withholding. The employer withholding is approximately 7% of the gross. The closer the employer match ratio is to 7%, the closer it is to paying for itself.

Example: Assuming an employee is match-maximizing and in very round numbers grosses 100,000 per year. A 50% match schedule is about $350 cheaper per employee than a 100% match schedule:

Default non participant: The employee will see about 7000 deducted for FICA, and the employer will pay 7000 to FICA if they don't participate.

First case: the match is 100%, 1-for-1 to a 5% cap, the employee will deduct 5000, and have 6650 withheld for FICA. The employer will pay 6650 to FICA. The total employer cost of withholding and match is 11,650.

Second case: If the match is 50%, 1-for-2 to a 5% cap, the employee will deduct 10000, and have 6300 withheld for FICA. The employer will pay 6300 to FICA. The total employer cost of withholding and match is 11,300.