Incentive Mechanism: Retirement Savings in the Small Business Labour Market

Small businesses find themselves in a precarious situation within the labour market as they compete with larger employers for the same pool of workers and find it difficult to offer the same level of salaries, brand recognition, and benefits as corporate employers. Of these areas, the most significant is an employer's ability to provide retirement savings. A thorough understanding of how retirement benefits work as an incentive mechanism gives insight into how small businesses attract and retain workers when wages alone cannot provide sufficient motivation to choose a small business over a larger company.

Analysis of Labour Market Competition and Small Business Disadvantage
Wages represent only one element of a worker's total compensation package when determining which employer to work for in a competitive labour market. Total compensation, in addition to wages, also includes fringe benefits that are offered to workers, such as health insurance, flexible work schedules, and employer-sponsored pension and retirement saving plans. Larger firms have a larger workforce to spread these costs over, thereby reducing the cost per worker when compared to smaller firms. For small businesses, however, the same contribution represents a proportionally larger financial commitment.

The disparity in the proportionate cost of providing a retirement savings plan between large and small firms creates an inherent disadvantage to small businesses in hiring and retaining a specific group of employees. Workers with longer time horizons, particularly younger employees with a better understanding of compounding interest from retirement savings, will therefore prefer employers that provide a structured retirement savings plan over those that do not. According to the US Bureau of Labor Statistics, the percentage of employees working for small businesses who have access to employer-sponsored retirement savings plans is significantly lower than for employees of large businesses, creating a gap between the two employers, which directly affects small businesses' ability to hire and retain skilled employees. Therefore, a small business that does not offer a retirement savings plan is effectively competing with an incomplete total compensation package.

Retirement Savings as an Incentive Structure
Employer-sponsored retirement savings plans can be viewed from an economic perspective as a type of deferred compensation — a mechanism through which the employer offers future compensation in exchange for the employee's current labour. This structure creates incentives for both parties.

For the employer, contributing to an employee's retirement savings plan is viewed as a reliable method to establish a long-term commitment to an employee. In addition to creating a commitment to the employee, employer-sponsored retirement savings plans create a "lock-in" effect whereby employees that have accumulated their retirement savings with their employer are less likely to change employers due to the potential impact of changing employers on their ability to contribute to the retirement savings account, the vesting period for the contributions, and the potential for compounding of contributions that exist at their current employer. Therefore, both employer and employee can create significant tax-advantaged savings opportunities through an employer-sponsored retirement savings plan.

While employees may benefit from a tax-advantaged retirement account because it provides them with a higher effective return than an equivalent cash wage (which gets taxed in the period earned), employees who understand this will optimally choose to work with an employer that provides them with (or offers) retirement savings vehicles — even if the overall salary is slightly lower — and therefore, small businesses will be able to use the trade-off of salary vs. retirement savings as their advantage in attracting talent.

Employee Retention and Labour Supply Elasticity
The retention benefits of retirement benefits are directly related to the labour supply available to each company. In situations where the employee market is very mobile, any employer who provides an employee with a more attractive total compensation package will shift their labour supply curve in the employer's favour, reduce turnover and stabilise their workforce. Small businesses operate with less organisational slack than large companies and, therefore, absorb the costs of staff turnover more acutely.

The cost of an employee departing (recruiting, training, and getting the employee up to speed) can be significant when measured against the size of the organisation. Thus, a retirement benefit that reduces the likelihood of turnover could be seen as an economically viable option even though it is considered a direct expense at the time it is incurred. This supports the concept of efficiency wage theory. The efficiency wage theory states that offering a total compensation package above the total market wages decreases the turnover rate and increases the productivity of the work force, and this is reflected in a lower total cost of labour in the long run. In essence, the employer's retirement contributions form part of the above-market total compensation package and therefore produce the same effects of improving retention and performance. This is true for small businesses that are not able to match corporate salary levels.

What Does All This Mean for the Small Business Owner?
The small-business retirement savings market demonstrates that firms can compete on more than just price. Labour markets are not just about paying higher wages; they are multi-dimensional markets that include: the structure of the total compensation package, the credibility of the employer's long-term commitment, and the tax-efficient characteristics of various benefits.

Small businesses that view retirement savings as a "nice to have" rather than a "must have" may greatly undervalue the strategic advantage to be obtained from offering such benefits. In a tight labour market, where skilled workers are able to make meaningful decisions between employers, a well-structured retirement savings plan can provide a substantial competitive advantage to small firms, even when their headline salaries are relatively constrained. The economics of designing incentives is not an abstract economic theory; it is a very real tool for competing for talent in the labour market.