Should Startups Offer 401(k) plans for employees?

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Saving for retirement is one of the greatest and most daunting financial burdens faced by Americans, and has become increasingly paramount in a world of reduced pensions and increasing uncertainty surrounding  the long term viability of Social Security.

Companies operating in the U.S. frequently offer retirement savings programs to their employees as part of their employee benefits packages. The most common of these is a retirement savings vehicle called the 401(k).

What is 401(k)?

A 401(k) is a retirement savings plan sponsored by an employer, whose unusual name comes from an Internal Revenue Service (IRS) tax designation status. Money put into 401(k) plans is “qualified,” granting it a special tax status with the IRS. More specifically, a 401(k) lets workers save and invest a portion of their paycheck on a pre-tax basis, meaning that funds are diverted from payroll to a 401(k) investment account before taxes are taken out. Taxes are not paid on the money that is set aside until the funds are withdrawn from the account, often during the worker’s retirement. In a way, this is a sanctioned form of tax arbitrage, as most people will have a lower tax rate in retirement than they do while they are working full time, assuming that they will be earning less at the time of retirement. The IRS caps the annual amount of pre-tax funds that an employee can contribute at $19,000 in 2019, an amount that is adjusted annually for cost of living.

In general, 401(k) plans are popular benefits with employees, with 80% - 90% of participants in a recent study finding value in the program:

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*2017, Investment Company institute, Survey of 401(k) plan owners.

"Offering" 401(k) plans

Employees often ask potential employers, “Do you offer a 401(k) plan?” The reason for the question is that, although it is very common, employers are not required by law to offer 401(k) plans to their employees especially in higher compensation industries.

What it means to “offer” a 401(k) plan is that an employer, known as the 401(k) “sponsor”, has engaged a 401(k) administrator to manage the process of carrying out the plan, which includes documentation, payroll allocation and integration, fund custody, statements, processing, and compliance.

A startup has to make an explicit decision to offer a 401(k) plan, just like a decision to offer any other perk or benefit to employees, such as free lunches or a holiday party. The cost for employers to offer a 401(k) plan is twofold: there is the explicit monthly cost of the third-party administrator (this is often paid on a per employee per month basis) and the time and administrative cost of implementing, promoting and managing the program.

If a startup offers a 401(k), it thereby allows its employees to divert some of their pre-tax wages to the 401(k) retirement savings account. This is most often administered as either a percentage of payroll or a specified dollar contribution each pay period.

According to data from Guideline, a leading provider of 401(k) products to startups, 83% of employees participate in their companies’ 401(k) plan, with the average employee contributing 8% of their annual income.

“Matching” 401(k) contributions

Once a business has decided to offer a 401(k) plan to its employees, it can then decide to offer what is often referred to as “matching.” Matching means that the business contributes to the employee’s 401(k) plan directly, in addition to the salary the employee already receives. This “match” supplements whatever amount the employee has elected to contribute per pay period and is additional compensation to the employee, although it is not taxable to the employee.

Matching is usually offered as a percentage of the employee’s contributions, but can also be subject to a maximum percentage of the employee’s salary. For example, if a company offers up to 50% match of employee contributions, an employee earning $100,000 who contributes 8% of their paycheck ($8,000) annually will receive an additional $4,000 for a total annual contribution of $12,000. However, if a company agrees to match only up to 3% of salary, the employer’s contribution cannot exceed $3,000.

Matching serves to reward employees for saving for retirement and is a good way to drive participation in a company’s 401(k) plan; however, matching is expensive. While the cost of administrating a 401(k) plan for a small startup can be under a few thousand dollars a year with administrative fees, even a low, single-digit matching percentage will typically add thousands of dollars to payroll costs assuming reasonable participation in the 401(k) plan among employees. 

Should startups offer 401(k) plans?

Startups are in a war for top talent, not only against the larger tech companies that offer rich benefits, but also against other startups. Employees that join a startup are typically willing to sacrifice some of the perks associated with larger employers, but they are also acutely aware of where the market is for startup benefits.

"90% of small businesses don’t offer 401(k)s. However, tech workers increasingly expect 401(k) plans. "

The earliest employees that join a startup likely will not have high expectations for a 401(k) plan given the nascency of the organization they are joining. In fact, according to Guideline data, 90% of businesses between 1-100 people don’t offer 401(k) plans. That said, once a startup has over ~10 people, tech employees will start to expect the company to offer a 401(k) plan. 401(k) matching, however, is less common and therefore a more differentiated benefit. In other words, employees will expect a 401(k) at even a small technology organization, but will not be surprised if a smaller startup does not offer 401(k) matching.

According to Guideline data, 54% of their customers – which include many startups – offer a 401(k) match to their employees.

Selecting a 401(k) provider for a startup

Since startups often lack time and resources, it’s best to select a lower cost offering that easily integrates with your existing payroll provider as this will reduce the administrative burden associated with it.

One great option for startups is Guideline, which starts at $39/month plus $8/participating employee and automates all the heavy lifting involved in offering a 401(k) plan — things like plan administration, compliance and reporting. A tech-forward offering like Guideline allows startups to focus on what’s most important: providing a valuable employee retirement benefit. As part of the Brex Rewards program, Guideline will offer three months free for all Brex customers.

Other options include Human Interest and Betterment.

Brex Experience

We share our own experiences solely  to provide transparency to startups that are navigating the same decisions as we did. This is not an official endorsement of any decision path or product decision.

Brex did not initially offer a 401(k) match, but after growing to about 8 full time employees, we began receiving an increasing number of requests from candidates for 401(k) benefits. Brex was 10 months post founding and past our Series A when we decided to offer a 401(k) program. Brex used Guideline to administer the program and integrated the 401(k) offering with our payroll software.

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