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Early retirement and wealth transfers in universities—A comment
British Accounting Review (1988) 20, 69-71
EARLY TRANSFERS
RETIREMENT AND IN UNIVERSITIES-A
WEALTH COMMENT
K. RICHARDS University
College of Wales, Aberystwyth
David Simon’s interesting article on early retirement illustrates clearly the hidden subsidy which the policy of the Universities Superannuation Fund Ltd (USS) for pricing the purchase of additional years of pensionable service confers on those universities taking advantage of the scheme to reduce staff. Important though this point undoubtedly is, perhaps the crucial issue is whether the reduction in University staff benefits society as a whole which is presumably the ultimate objective of the whole exercise. This being so, a social cost benefit analysis might be more appropriate than a more narrow consideration of the financial transfers of wealth which may be involved. Before addressing these wider issues, a number of criticisms can be made of Simon’s analysis in its own terms. Firstly, on a minor point, readers might avoid confusion by noting that the references to equation (7) in Table 2 and on page 32 should be to equation (6) while the reference in Table 3 to equation (8) should be to equation (7). Secondly, in his present value calculations, Simon uses a figure of 6.4236% to discount the annual savings in employee costs to the University, this present value being compared to the capital cost of funding early retirements. Apart from the spurious accuracy of a figure with four places of decimals, the rationale given for this figure is that it represents the rate of return on the University’s investments in the previous year, presumably on the grounds that as the capital sum comes out of such funds, that this reflects the true opportunity cost involved. For an investment fund which has charitable status and hence pays no income or capital gains tax, this seems to be an unusually small yield. Given the fact that the fund must contain some equities, the figure of 6.4% cannot have taken account of any capital gains made by these investments which is a serious omission. As the discount rate appears to be too low, the present value of the annual savings must be an overestimate. If we discount the savings at a more realistic rate of 12% (which on past experience is conservative for a gross fund), the net present value amounts to about E2.4 million rather than the estimate of A3.4 million given by Simon. Thirdly, the author argues that the k3.4 million gain to the University 089CG939/88/010069 + 03 $03.00/O
0 1988 Academic Press Limited
70
K.
RICHARDS
must be reflected in a net loss of the same magnitude elsewhere and looks initially to the employee taking voluntary retirement as the source of part of this loss. There are errors in this analysis also, however. Although it is mentioned that one offset to the loss of salary is the interest gained on the lump sum received 10 years earlier than expected, no allowance is made for this in the calculation of annual cost to the member. This lump sum would amount to one and a half times salary or A22,500 in the cases considered here which at a rate of interest net of tax of say 8.5% would bring in an annual income of roughly Al900. In addition, the author assumes that the retiring employee would pay voluntary class 3 national insurance contributions. However, the employee would in fact be eligible for unemployment benefit* from the first week of retirement at a rate currently of about L31 a week plus about Al9 a week for an adult dependant, during which time he would be credited with Class 1 national insurance contributions and this would continue beyond the 52 weeks for which he was eligible for benefit provided he was registered as seeking work. Even disregarding the unemployment benefit payable for the first year of retirement, the total annual saving in contributions would be A983 and not A774 as stated. Taking this corrected figure together with the extra interest mentioned above makes the total annual cost to the member of about Ll700 rather than A3819. As for capitalising this figure to find the present value, Simon uses the same rate 6.4% as that used by the University, which is rather strange as the employee is likely to be a taxpayer and the University not, so that their opportunity cost rates should surely be different. Fourthly, having established that the present value of the cost to the employees is less than the savings to the University, Simon concludes that the remainder of the cost must be borne by the Pension fund-USS Ltd. This extra cost to USS is divided into four parts, of which one is the interest lost to the scheme of that part of the lump sum for which the member has already qualified. The present value of this cost is given by equation (3) on page 21. However, this formula seems only to allow for simple interest. Taking compounding into account the correct formulat should be:
Over the age of 60, unemployment benefit is means-tested against pension income. t Assuming end year receipt and the same symbols as used by Simon, the PV is:
l
r Smx Pv=l+r,+(l+r)* =-
Smx t
nr [ 1+r I
r(l+r) __-
Smx t +..,+
r(1 +r)m-l (1+r)”
Smx
EARLY
RETIREMENT
PVC--
AND
Smx t
WEALTH
~
TRANSFERS
71
nr
I l+r
1’
Thus in some circumstances, this cost could be substantially underestimated, although as Simon points out this particular element is passed on to the employers in the form of increased contributions to keep the pension fund fully capable of meeting its liabilities. Apart from the above criticisms, Simon’s analysis points clearly to the inappropriate policy of USS in not taking into account years already served by the employee when calculating the cost of purchase of additional years of pensionable service. As mentioned at the outset, however, we may need to ask the wider question as to whether society is better off in welfare terms as a result of early retirements. Simon’s analysis is based on the notion that because an individual institution is better off financially as a result of retiring some of its employees early, then some other parties must be worse off to exactly the same extent. Welfare economists, however, would recognise that a reallocation of resources can indeed make some people better off without making any one else worse off-a Pareto improvement. Alternatively, if some people are worse off as a result of some change, it may be possible for the gainers to compensate the losers and still be better off-the Kaldor criterion. In this instance it would be feasible to argue that a person who accepts early retirement must be better off in welfare terms otherwise why should he accept it voluntarily. He or she may be worse off financially, but better off in terms of increased leisure or freedom to look for another job. The university sector as a whole may gain in terms of greater efficiency in producing graduates due to economies of scale, greater use of underutilised physical and human capital and the replacement of older possibly less enthusiastic staff by younger staff better trained in modern techniques and costing less to employ. Though this journal may not be the appropriate outlet for such a study, it may be useful to note the wider context of the issue of early retirement. REFERENCE Simon, D. S. (1987). ‘Early retirement and wealth transfers in universities’, ing Review, Vol. 19, No. 1, pp. 17-33.
British Account-
EARLY TRANSFERS
RETIREMENT AND IN UNIVERSITIES-A
WEALTH COMMENT
K. RICHARDS University
College of Wales, Aberystwyth
David Simon’s interesting article on early retirement illustrates clearly the hidden subsidy which the policy of the Universities Superannuation Fund Ltd (USS) for pricing the purchase of additional years of pensionable service confers on those universities taking advantage of the scheme to reduce staff. Important though this point undoubtedly is, perhaps the crucial issue is whether the reduction in University staff benefits society as a whole which is presumably the ultimate objective of the whole exercise. This being so, a social cost benefit analysis might be more appropriate than a more narrow consideration of the financial transfers of wealth which may be involved. Before addressing these wider issues, a number of criticisms can be made of Simon’s analysis in its own terms. Firstly, on a minor point, readers might avoid confusion by noting that the references to equation (7) in Table 2 and on page 32 should be to equation (6) while the reference in Table 3 to equation (8) should be to equation (7). Secondly, in his present value calculations, Simon uses a figure of 6.4236% to discount the annual savings in employee costs to the University, this present value being compared to the capital cost of funding early retirements. Apart from the spurious accuracy of a figure with four places of decimals, the rationale given for this figure is that it represents the rate of return on the University’s investments in the previous year, presumably on the grounds that as the capital sum comes out of such funds, that this reflects the true opportunity cost involved. For an investment fund which has charitable status and hence pays no income or capital gains tax, this seems to be an unusually small yield. Given the fact that the fund must contain some equities, the figure of 6.4% cannot have taken account of any capital gains made by these investments which is a serious omission. As the discount rate appears to be too low, the present value of the annual savings must be an overestimate. If we discount the savings at a more realistic rate of 12% (which on past experience is conservative for a gross fund), the net present value amounts to about E2.4 million rather than the estimate of A3.4 million given by Simon. Thirdly, the author argues that the k3.4 million gain to the University 089CG939/88/010069 + 03 $03.00/O
0 1988 Academic Press Limited
70
K.
RICHARDS
must be reflected in a net loss of the same magnitude elsewhere and looks initially to the employee taking voluntary retirement as the source of part of this loss. There are errors in this analysis also, however. Although it is mentioned that one offset to the loss of salary is the interest gained on the lump sum received 10 years earlier than expected, no allowance is made for this in the calculation of annual cost to the member. This lump sum would amount to one and a half times salary or A22,500 in the cases considered here which at a rate of interest net of tax of say 8.5% would bring in an annual income of roughly Al900. In addition, the author assumes that the retiring employee would pay voluntary class 3 national insurance contributions. However, the employee would in fact be eligible for unemployment benefit* from the first week of retirement at a rate currently of about L31 a week plus about Al9 a week for an adult dependant, during which time he would be credited with Class 1 national insurance contributions and this would continue beyond the 52 weeks for which he was eligible for benefit provided he was registered as seeking work. Even disregarding the unemployment benefit payable for the first year of retirement, the total annual saving in contributions would be A983 and not A774 as stated. Taking this corrected figure together with the extra interest mentioned above makes the total annual cost to the member of about Ll700 rather than A3819. As for capitalising this figure to find the present value, Simon uses the same rate 6.4% as that used by the University, which is rather strange as the employee is likely to be a taxpayer and the University not, so that their opportunity cost rates should surely be different. Fourthly, having established that the present value of the cost to the employees is less than the savings to the University, Simon concludes that the remainder of the cost must be borne by the Pension fund-USS Ltd. This extra cost to USS is divided into four parts, of which one is the interest lost to the scheme of that part of the lump sum for which the member has already qualified. The present value of this cost is given by equation (3) on page 21. However, this formula seems only to allow for simple interest. Taking compounding into account the correct formulat should be:
Over the age of 60, unemployment benefit is means-tested against pension income. t Assuming end year receipt and the same symbols as used by Simon, the PV is:
l
r Smx Pv=l+r,+(l+r)* =-
Smx t
nr [ 1+r I
r(l+r) __-
Smx t +..,+
r(1 +r)m-l (1+r)”
Smx
EARLY
RETIREMENT
PVC--
AND
Smx t
WEALTH
~
TRANSFERS
71
nr
I l+r
1’
Thus in some circumstances, this cost could be substantially underestimated, although as Simon points out this particular element is passed on to the employers in the form of increased contributions to keep the pension fund fully capable of meeting its liabilities. Apart from the above criticisms, Simon’s analysis points clearly to the inappropriate policy of USS in not taking into account years already served by the employee when calculating the cost of purchase of additional years of pensionable service. As mentioned at the outset, however, we may need to ask the wider question as to whether society is better off in welfare terms as a result of early retirements. Simon’s analysis is based on the notion that because an individual institution is better off financially as a result of retiring some of its employees early, then some other parties must be worse off to exactly the same extent. Welfare economists, however, would recognise that a reallocation of resources can indeed make some people better off without making any one else worse off-a Pareto improvement. Alternatively, if some people are worse off as a result of some change, it may be possible for the gainers to compensate the losers and still be better off-the Kaldor criterion. In this instance it would be feasible to argue that a person who accepts early retirement must be better off in welfare terms otherwise why should he accept it voluntarily. He or she may be worse off financially, but better off in terms of increased leisure or freedom to look for another job. The university sector as a whole may gain in terms of greater efficiency in producing graduates due to economies of scale, greater use of underutilised physical and human capital and the replacement of older possibly less enthusiastic staff by younger staff better trained in modern techniques and costing less to employ. Though this journal may not be the appropriate outlet for such a study, it may be useful to note the wider context of the issue of early retirement. REFERENCE Simon, D. S. (1987). ‘Early retirement and wealth transfers in universities’, ing Review, Vol. 19, No. 1, pp. 17-33.
British Account-