Retirement Incentives Disproportionately Benefit White, High-Income Workers

When examining the factors contributing to the racial retirement savings gap in the U.S., researchers at the Massachusetts Institute of Technology found that the current system largely favors higher-income and white employees. 

Using a new employer-employee linked data set that covers millions of Americans, the academics found that the current system channels more tax and employer resources toward workers who are white, possess a college degree and have wealthier parents or spouses than it channels toward their similar-income coworkers who are Black or Hispanic, are single parents and have lower-income relatives. 

Lawrence Schmidt, an assistant professor of finance at MIT and one of the authors of the paper, explains that when a group of workers participates more in their employer retirement plan, they will inevitably enjoy more in terms of employer matching benefits and tax benefits.  

However, not all workers have the ability to contribute significantly to their retirement plans because of liquidity issues, and as a result, they do not benefit as much from employer matching. 

MIT’s data showed that Black and Hispanic workers with access to a 401(k) or a 403(b) plan and a modest degree of labor market attachment (at least $8,000 in annual earnings) contribute approximately 40% less than white workers. Employer matching also amplifies these contributions by an additional 0.7 and 0.6 percentage points, respectively, of salary. 

The researchers also concluded that employer matching and tax benefits are more unequally distributed than wages. While the median Black and Hispanic earners receive 75 cents and 79 cents, respectively, for every dollar of earnings received by the median white earner, median Black and Hispanic earners receive only about 50 cents for every dollar of matching contributions that median white earners receive.  

“We know that certain types of groups, especially those who enter their careers with low levels of liquid resources, [are] going to face this trade-off between: ‘Do I save for retirement?’ or ‘Do I save for a rainy day in case my car breaks down or something goes wrong in my apartment?’” Schmidt says. “In contrast, there are other people who start their careers with lots of liquid resources …” 

Liquidity Constraints  

Schmidt says when comparing those different groups of workers, even if they have the same job and are earning the same income, disadvantaged groups are going to find it harder to contribute funds to an “illiquid account like a 401(k).”  

The researchers found evidence that Hispanic and, to a greater extent, Black workers have stronger liquidity needs and may be more constrained by liquidity than their white counterparts. These same workers are also more likely to take an early withdrawal from their retirement accounts than white workers with similar worker-level characteristics, according to the research. 

Taha Choukhmane, also an assistant professor of finance at MIT and another of the paper’s authors, explains that even when comparing two workers who have similar incomes and who work for the same firm, the Black worker is almost twice as likely as the white worker to take an early withdrawal before reaching the age of 55. Choukhmane points out that the majority of retirement plan withdrawals in the U.S. come with a 10% tax penalty.  

“So not only are Black and Hispanic Americans getting less tax subsidies [by putting less] money in, but they’re also paying more tax penalties because they’re more likely to take an early withdrawal,” Choukhmane says.  

Choukhmane adds that one of the most common reasons for an early withdrawals is when someone loses their job, which does not exempt the withdrawer from the 10% tax penalty. 

Schmidt says many plans allow participants to take out loans, but the rules change when one separates from a job. For example, he says some plans will not allow a participant to take out a new loan after separating from a job, and many plans require that loans be repaid at the moment of separation.  

Therefore, he says one of the “biggest shocks” that workers could face is losing their job and not being allowed to take out a 401(k) loan, precisely the time when a loan could be most helpful. On top of that, at the time of separation, workers might have to find money they likely do not have in order pay back an existing loan.  

Schmidt says the “real concern” is that this lack of liquidity in retirement plans could deter people from participating in the first place.  

“We think about wanting to eliminate the leakiness of retirement [plans], and that’s why we have these policies, but given the many risks people face, [withdrawal penalties] can just prevent people from putting their money in these accounts at all, and therefore lose one of the best opportunities there is to build wealth,” Schmidt says. 

What Plan Sponsors, Policymakers Can Do 

The paper explored the idea of changing matching formulas to create more equity in retirement savings.  

For example, instead of matching contributions, which pay more to those who save more, plans can provide flat or non-elective contributions, in which everyone in the plan receives a 3% match, regardless of employee contribution. The paper suggested the roughly $300 billion devoted to retirement savings plans by the federal government ($119 billion) and private sector employers ($190 billion), much of it through matches, could be put to better use as non-elective contributions made to employees. 

From a policy standpoint, Choukhmane suggests a tax system in which all tax subsidies are proportional to income, instead of the current system in which the more taxpayers save in their 401(k) plans, the less they pay in taxes.  

“What we find is that if we change the way we design these incentives, you can have pretty large reductions in racial gaps, wealth at retirement, and gaps between those who have richer and lower-income parents,” Choukhmane says. 

While allowing 401(k) loans and penalty-free in-service withdrawals make it easier for people to tap into their retirement accounts, thus damaging their retirement savings, Choukhmane says it is important for plan sponsors to think about the other side of this issue. 

“If you make it easier for people to access the money when they need it, they’re more likely to put money in in the first place,” Choukhmane says. “There’s some evidence from other researchers that find that when plans offer a 401(k) loan option, participation increases.” 

For Black and Hispanic workers, as well as those supporting elderly parents, for example, liquidity is extremely important, and Choukhame says it is important for plan sponsors to review the conditions they have in place for taking out loans and early withdrawals.  

He says it is also worth exploring some of the new optional provisions in the SECURE 2.0 Act of 2022 that allow participants to set money aside for emergencies.