Lecture 4Benefits

This lecture focuses on benefits paid to employees over and above their wage. As much as 30 to 40 percent of total costs firms pay for each employee are nonwage benefits or legal obligations. In the first part of the lecture we catalogue different categories of benefits. Then we discuss why any firm supplies employee benefits over and above its legal requirements. The essential argument against doing this is that workers typically prefer making their own consumption decisions, rather than have some else spend their compensation on their behalf.

Categorizing benefits

1. Moving assistance2. Health & dental insurance3. Life & disability insurance4. Financial planning5. Direct provision of goods and

services

A more detailed breakdown

Source: Based on information from the U.S. Department of Labor, Bureau of Labor Statistics, National Compensation Survey: Employee Benefits in Private Industry in the United States, 2003; and Employee Benefits Study, 2003 ed. (Washington, DC: U.S. Chamber of Commerce, 2004).

How is a typical dollar on benefits spent?

Source: U.S. Bureau of Labor Statistics, 2008.

Hourly employee compensation plus benefits

Role of the federal government in benefits

Job offer and relocation help

These might include:

1.Moving expenses

2.Free accommodation on apartment/house hunting trips

3.Temporary living expenses

4.Start date flexibility

5.Flexible start date for other benefits

These services drive a subsidy wedge between some local candidates and those living outside the region.

Why do firms try harder to attract some candidates versus others, as opposed to simply offer higher wages?

Source: U.S. Bureau of Labor Statistics, www.bls.gov/ncs/home.htm.

Workers in the private sectorwith health benefits

Types of health insuranceThere are several types of plans:

1.Traditional (copayments plus deductible, relatively rare)

2.PPO/POS/HMO (preferred provider organization, point of service, health maintenance organization)

3.CDHP (consumer directed health plan) high deductible HBA (health reimbursement account), HSA (health savings account)

4.Medicare (for elderly, accounts for 15 percent of federal budget) and Medicaid (means tested)

5.COBRA (Consolidated Omnibus Budget Reconciliation Act) temporary insurance for laid-off workers, divorced dependents, and others with similar “qualifying events”.

Flexible Spending Accounts (FSA)

An FSA allows an employee to set aside a portion of earnings to pay for qualified expenses as established in the cafeteria plan, for medical and dental expenses, and also for dependent care (both child and adults).

Money deducted from an employee's pay into an FSA is not subject to payroll taxes.

A limitation of an FSA is that (essentially more than $500 of) funds not used by the end of the plan year are lost to the employee, known as the "use it or lose it" rule.

Dental insurance is often structured similar to a pre-payment or layaway plan.

Paying to be healthy

These plans differ on four main dimensions:

1. Choice of health provider: PPO versus HMO

2. Insurance or directed savings: Either of the above versus FSA and traditional

3. Size of deductible: CDHP versus HMO

4. Eligibility of employee: Medicare Medicaid and COBRA versus the rest.

Note that employees might prefer to make very different choices. Firms that can accommodate diversity in preferences have an advantage over those that cannot.

Worker’s compensation plus life and disability insurance

The primary purpose of health insurance is to pay for measures that maintain or restore good health.

The prospect of an accident is another common reason for insuring against personal uncertainties. More than 18% of Americans live with a disability, and one quarter the US workforce suffer a disabling injury before retiring.

Companies are legally obliged to purchase insurance that compensates workers injured on the job.

Life insurance (whole life and term) is sometimes also offered to employees as part of a group policy.

Disability benefits, short term (STD) and long term (LTD), are (partly) covered by Social Security.

Financial planning for retirement

The four main sources of retirement income are:

1. Social Security; tax on employers (FICA) that (partially) funds retirement income.

2. Defined benefit plans; specified monthly benefit on retirement is predetermined by a formula based on the employee's earnings history, tenure of service and age

3. Defined contribution plans; employer’s contribution is determined by formula, and employee typically has discretion about where income is invested

4. IRA (Investment retirement arrangement) are self funded; under the traditional or classic withdrawals are taxed, and under Roth deductions are taxed.

Worker participation in pension plans

Source: U.S. Bureau of Labor Statistics, www.bls.gov

Direct provision of goods and services

In addition firms also distorts the choices of workers by selectively subsidizing certain activities:

1. Vacation, sick leave, and PTO (paid time off)

2. Personal and professional development (though further education for example)

3. Facilities such as a gym, daycare or cafeteria

4. Transportation and parking

5. Social activities (such as bowling nights, team softball, but not usually wine tasting evenings)

6. Discounts on concierge, laundry, shopping, oil changes, ball park tickets . . . you name it.

Percentage of companies with various paid-time-off plans

Source: U.S. Bureau of Labor Statistics, www.bls.gov.

Valuing different forms of compensation

Other considerations aside, a firm is indifferent between paying their employees monetary compensation or goods and services to the same value.

Compensation in money, or generalized purchasing power, gives the worker discretion about how to allocate the resources he or she has earned.

Different workers are heterogeneous about their preferences and tastes.

Therefore providing employees with the same benefits is more costly than letting the employees decide how to allocate their income or wealth.

The role of a human resources group

The more a firm interferes in the consumption and savings decisions of its workers, the larger the human resources group necessary to administer these activities.

This distracts the firm from specializing in its core competencies, might bond workers to each other, but might also expose latent frictions.

The marketing and production departments are scalable. Increased marketing supports higher prices, and increased production raises sales.

However HR is not inherently scalable. The main ways HR can expand by itself is to involve the firm more deeply in the employees’ lives, or increase turnover.

Why isn’t all compensation monetary?There are five main reasons to offer benefits instead of wages to employees, namely to:

1. satisfy legal requirements

2. avoid taxes

3. sort candidates when selecting workforce

4. align worker goals with the firm

5. extract rents from infra-marginal employees.

If none of these factors are relevant, it seems hard to justify why employees should receive anything but wages as compensation.

However if one or more these factors is important, then there is scope for rent seeking by the firm.

1. Legal fiduciary obligations

Federal Insurance Contributions Act (FICA); funds Social Security and Medicare

Federal Unemployment Tax Act (FUTA); requires firms to pay experience rated premiums for unemployment insurance.

Affordable Care Act (ACA); mandates (will apply to) firms with over 50 full time employees to offer health care coverage to its employees and their dependents.

State laws on workers’ compensation; firms must pay premiums to cover accidents, injuries at work, and the like.

2. Tax AvoidanceIf firms can deduct costs of expenditure by their employees, then personal income and payroll taxes may be avoided.

The IRS has guidelines and enforces rules about what is deductible and what is not.

For example a supermarket cannot legally expense the cost of produce paid its workers as a wage in kind.

However airlines and amusement parks can and do provide free rides to its employees.

Many employee/employer relationships avoid taxes by using gym facilities, and also computers for personal use, owned by the company.

3. Sorting job candidates (at a ski resort)

The structure of benefits helps determine the pool of job applicants.

Ski resorts routinely allow all their workers (including child minders, waiters, cleaners and maintenance workers) to ski for free.

This is clearly a tax avoidance measure, but also helps connect the ski resort staff with its clientele.

The wealth of the latter group exceeds the former, sometimes by orders of magnitude, but the staff have an advantage of excellent skiers.

This ameliorates demographic differences, producing greater cooperation on both sides, thus increasing demand and reducing costs.

4. Aligning internal goals (at a university)

A fundamental problem at an academic institution is how to replenish faculty to continue to produce new research and teach well.

Old faculty wear down from teaching, and they were educated with old ideas, so do not have the advantage of 4 plus years of recent full time graduate study.

Yet old faculty are ideally placed to judge which new ideas are likely to be fruitful (having already tried many of the unfruitful ones themselves)

Hiring promising new junior faculty threatens them with obsolescence. How can the deans deter senior faculty from recommending the promotion of low quality sycophantic junior faculty?

4. Turnover and renewal at a university

Universities address this problem using three tools:

1. relatively flat wage profiles over the life cycle

2. exacting tenure requirements

3. generous contributions to retirement income.

Tenured professors are not fired for incompetence.

Setting high standards makes it hard for professors to tenure personal assistants.

Flat wage profiles reduce the financial incentives to never retire (although many professors die on the job).

University mandated contributions to retirement wealth also make it a more desirable option. (Similarly golden parachutes encourage CEOs to groom their successors.)

SummaryWorkers prefer to make their own decisions about how to spend their compensation rather than have the HR department decide for them. This is the primary reason for paying employees with generalized purchasing power.

However directly providing benefits help companies to satisfy legal requirements, avoid taxes, sort candidates when selecting workforce, align worker goals with the firm, and extract rents from infra-marginal employees.

Since employees have different preferences, the cost of administering them increases with their provision.

Firms balance how much an HR department is allowed to shape the lives of employees outside the workplace in order to earn rents of the type described above.