Universities (and other big employers) are Cutting Retirement Benefits. Tax Lawyers are Having Fits. What’s Going On?
This week brought a new round of announcements from universities, even very wealthy ones, that they would be cutting faculty and staff pay. Readers already know my views about schools with giant endowments asking their employees to sacrifice. Putting aside the question of whether current dining-hall workers or future millionaire donors should pay for today’s crisis (that’s a neutral framing of the issue, don’t you think?), the way that schools are trying to balance their books is particularly awful. At many of these places — and you will have to take my word for this, since most of my data come via emails from friends — universities are cutting back on retirement contributions instead of cutting salary. This is terrible tax planning, but it is a plan that has lots of support…from consultants who advise big for-profit businesses. Why are supposed charities acting like Wal-Mart?
First, a little more detail on what’s happening. At the institutions I’ve learned about, the plan is for the school to pare back or eliminate the employer’s contribution to employee defined-contribution retirement accounts. Big for-profits are doing it, too. At a for-profit entity, you’d call that a 401(k), after the section of the tax code that describes the rules for the accounts. At nonprofits the section is different — it’s 403(b) — but the rules are pretty much the same. So instead of reducing their workers’ salaries now, the university is basically taking a similar amount of money out of the workers’ retirement savings.
What’s great about 401(k) and 403(b) plans is that contributions are tax free. If your employer pays you $100 in salary, you pay several different kinds of taxes on those earnings: federal income taxes, state income taxes, payroll taxes. And even your employer pays some taxes, such as the employer’s half of the payroll tax (7.65%) and potentially some additional unemployment taxes. In contrast, contributions to a qualified retirement account are not subject to any of those taxes. But it’s not a totally free ride: you’ll pay taxes in retirement when you take the money out, and you’ll pay those taxes plus a penalty if you withdraw before you’re fifty-nine and half. Still, given that you get to reinvest your money year after tax-free, the tax savings are substantial.
The fact that 403(b) plans are great is what makes the current university approach so terrible: they are not only taking away worker pay, but also taking away the tax benefits the government is kicking in. And, bizarrely, they are also doing that to themselves. Consider two simple examples.
1. Slamford College reduces Myron’s salary by $100. This saves Slamford $107.65: the $100 in salary, plus the $7.65 in tax it would have paid on the salary. Let’s say Myron’s combined state-federal income tax rate is 32.35%. He also pays a 7.65% payroll tax. After taxes, the $100 in salary Myron is losing would have only left him with ($100 — (40% * $100))= $60 to spend. So Slamford can save $107.65 while costing Myron only $60.
2. Yarvard U. reduces its annual contribution to Cass’s 403(b) retirement account by $100. This saves Yarvard $100, since it would not have paid payroll taxes on the contribution. As a result of this reduction Cass loses $100, less the present value of his expected tax when he takes a distribution from his account. Let’s call that number around $10. That is, Cass could set aside $10 today, let it grow, and then use that 20 years later to pay his tax bill. So Yarvard’s decision costs Cass, after taxes, $90.
Any reasonable person would say that Slamford’s plan is much, much, much better than Yarvard’s. So what gives? Why is everyone today being so Yarvardish?
This is actually a familiar story to folks who were paying attention to employee benefits in the late aughts. I know, those are the people you desperately avoid at cocktail parties. But they know some useful stuff!
Like, during the Great Recession, a lot of big firms cut employee retirement contributions instead of salary. If you read what their compensation consultants were saying, you’ll see one big theme emerge: transparency. Workers (and employers) are worse off when employers cut benefits instead of salary. But workers are less likely to notice. And that means the employer is more likely to get away with it without adverse worker-relations consequences. The experts at Boston College delicately call this the “inertia” advantage (see page 5). (Hey! Are you for some reason one of those freaks who obsessively reads their retirement statements, and can’t believe that no one would notice a retirement benefit cut? Read this paper, then come back.)
Let’s now consider some alternative explanations. Maybe employers are actually being righteous in cutting retirement pay instead of salary. Suppose that lower-income workers at a given company don’t tend to soak up all of the available employer retirement benefits. Often, employer contributions include both a fixed component and then a match on top, so that workers who voluntarily contribute also draw down more of an employer contribution. Cutting the matching component, at least, would then tend to burden higher-income workers, or at least workers who have exhibited a revealed preference that they don’t have an urgent need for salary.
Maybe. But consider that there are other ways of accomplishing the exact same result without the terrible tax consequences. For instance, employers could simply look at each employee’s retirement contributions for the previous pay period, and reduce salary by that amount. Or they could use a less-precise but easier method, such as a progressive salary cut (maybe 0% for the lowest earners, ranging up to 10% or whatever at the top). It’s also worth mentioning that in the last recession universities were not so solicitous of support staff; that’s where most of the cuts were. So maybe color me initially skeptical that that is the motivation.
Another righteous explanation would be that schools are protecting employees who need liquidity. First off, if people who need money now are mostly lower earners, then we have the same potential solution as the first righteous objection: just use a progressive salary cut. But maybe some folks, even those among the school’s highest earners, might have special need for liquidity now. Those folks might prefer salary. Employers can’t really allow each employee to decide whether to get salary or retirement benefit cuts. The reason is…(extreme Ferris Bueller boring teacher voice) ERISA, non-discrimination rules…no wait, come back! Ok, I won’t explain all the details. Just know that if anyone is going to get benefit cuts rather than a salary reduction, pretty much everyone has to get benefit cuts.
Again, maybe, but there again would seem to be a lot of room for alternatives. Federal law allows employers who sponsor employee retirement plans to allow those plans to make loans to employees, secured by the employee’s vested retirement benefits. Section 72(p) of the tax code, and some associated regulations, set out the basic rules. Employees can borrow up to the lesser of ($50k or one-half their vested balance, but no less than $10k) without any tax consequences. The repayment term can’t be longer than five years, and the employer (or contract plan sponsor, such as Vanguard or TIAA) must charge the interest rates that would be charged by an unrelated commercial lender. Given that the employee has a secured balance, and employer obviously knows where to find the borrower wages for garnishment purposes, these are quite safe loans, and overall rates are super-low right now.
That’s just one formal legal alternative. The CARES act allows tax-free distributions from retirement accounts for households experiencing financial hardship. And employees of course can also pursue other avenues, such as employee assistance programs. Overall, it seems to me quite hard to believe that liquidity is the main driver of cut-benefits approach, but may be a factor for some employers in some situations.
Finally, some folks have suggested that universities believe employees who don’t need cash right now can achieve basically the same tax result by making additional contributions to their IRA accounts. This probably isn’t true for tenured faculty, but might be the case for some other university workers. Deductible IRA contributions phase out, so that households earning more than $124,000, or single individuals earning more than $75,000, can’t claim deductions. Also, annual IRA contributions limits are fairly low, at $6,000 per individual ($7,000 for those over 49). Households that were already making IRA contributions are unlikely to be able to add new contributions that are nearly large enough to offset proposed employer reductions, and many wouldn’t be able to get any tax benefit if they did.
So here we are at the end of the weeds. Do the announced policies look any better? A little. But it’s hard to credit these alternative explanations when the other one is literally right there in front of us…if only we could notice.
