During the 2000 to 2002 recession, we saw, for the first time, the widespread suspension of 401(k) matching contributions as a tool for reducing costs. As the economy improved, the matching contributions were, for the most part, resumed. In the current recession, matching contributions are being suspended by many more companies . . . more than 20% or more of the S&P 500 companies have suspended their matching contributions. While I suspect that, when the economy improves, matching contributions will be re-instated, that remains to be seen.
The suspension of matching contributions is now an accepted form of cost savings to be employed in economic downturns. In many ways, the suspensions make sense. For example, the suspensions are preferable to a company going out of business, to layoffs of additional employees, to cuts in paychecks, and/or to reductions or eliminations of medical insurance. However, I do not believe that most employers are fully aware of the long- term impact of the suspensions.
With that in mind, I want to introduce you to the “Russell 10/30/60 Retirement Rule.” In its essence, the “rule” is that, for each $10 contributed by an employee to a 401(k) plan, his account will earn another $30 during his participation and, after retirement, his rollover IRA will earn another $60. So, each $10 of deferrals results in $90 of investment earnings.
Now, change the analysis from the employee’s deferral to an employer’s matching contribution.
For each $10 of matching contributions, the participant’s account will earn $30 during his working career and his IRA will earn $60 during retirement.
Assume that the employee makes $50,000 a year and defers 6%, or $3,000. That $3,000 deferral would generate $9,000 of investment earnings during the working, or accumulation, years and $18,000 of earnings during the retirement years. If the employee stopped deferring, he would have $3,000 to spend currently, but would lose $30,000 of retirement benefits.
Moving to the matching contributions, assume that the plan sponsor matched 50¢ on a dollar for the first 6% of pay. That means that the employee would have received a $1,500 matching contribution on the $3,000 deferral. The matching contribution would generate $4,500 of investment earnings while the employee was working and another $9,000 of earnings during retirement, for a total of $13,500 of earnings on top of the $1,500 match.
If the employer suspends the match for one year, the employer would save $1,500, but the employee would lose $15,000 of retirement income. To create an even worse scenario, assume that the employer skipped two years of matching contributions during the recession at the beginning of this decade and then skipped another two years of matching contributions during the current recession. While the combined employer savings would be $6,000, the cost to the employee would be $60,000 in retirement benefits. Imagine how much $60,000 would mean—in terms of standard of living—for a retired employee whose working compensation was $50,000 a year. Obviously, it is significant.
The decision to suspend contributions is a difficult one. The purpose of this article is to help with the analysis by demonstrating the long-term impact of a suspension of 401(k) matching contributions.
Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.