(This essay was published in Hong Kong Economic Journal on 15 May 2013)

 

Corruption in high levels of government has become a topic of public concern following recent news reports alleging abuse of regulations and improper conduct by senior officials. One strand of that concern is that growing interaction between the Mainland and Hong Kong might cause corrupt practices from across the border to spread to local officials. In this essay, I consider how reintroducing a pension scheme, which is a form of deferred compensation, for senior civil servants can reduce the temptation to engage in such behavior.

 

What is a deferred compensation scheme? It is a scheme whereby part of an employee’s compensation is not received immediately but delivered at a later date. If an employee is found to have behaved improperly while in service, then he could be disciplined or discharged and, as a consequence, may lose either part or all of the deferred compensation.

 

In this way, deferred compensation imposes a penalty on civil servants and induces them to refrain from engaging in improper behavior. It has been widely employed as a disciplinary-linked tool by governments in many countries, mostly in the form of a pension scheme.

 

Before June 2000, the Hong Kong civil service had a pension scheme that contained such a disciplinary element. However, in order for this tool to work, there must also be a commitment to put it into practice when required. The willingness to withhold deferred compensation and make it contingent upon proper behavior is critical to its success as a deterrence.

 

The Penalty Element of Deferred Compensation

 

But first, let us consider how a deferred compensation scheme works in practice. It purposely underpays an employee when he is young and overpays him when he is old. This is illustrated in Diagram 1 below by the upward sloping wage W(t) line. On the vertical axis we plot the hourly wage rate an employee receives from employment. On the horizontal axis we plot the age of the employee. We assume that the employee starts working at the age of 20 and the mandatory retirement age is 60; he therefore spends 40 years working for government.

 

For convenience of exposition, I assume that the value of the worker’s hourly productivity does not change over his entire working life. The conclusions I draw from the discussion do not depend on this assumption. In the terminology of economics the hourly productivity is called the value of the employee’s marginal product or VMP(t) (邊際生產值). In Diagram 1 this is represented by the horizontal VMP(t) line, which implies that hourly productivity remains constant with age.

 

A deferred compensation scheme sets the wage rate at below the employee’s productivity when he is young, but above his productivity when he is old. This is represented in Diagram 1 as an upward sloping wage W(t) line. In mathematical terms we have W(t) < VMP(t) when the worker is young and W(t) > VMP(t) when he is old.

 

From the point of view of the government employee, although the VMP(t) line is horizontal and the W(t) line is upward sloping, their resulting present values are the same. The present value of an employee’s work contribution represented by the accumulated value of VMP(t) over a 40-year working period from age 20 to 60 is the same as the present value of received wages W(t) over the same period. In a lifetime or present value sense, the employee is fully compensated for his work.

 

But notice that because the employee is underpaid when he is young, he will only be able to get the full lifetime value of his work at his retirement date. If he leaves any time before the age of 60 he will receive less than the full compensation for the full value of his work. In a sense, it is analogous to a gratuity after completing a lifetime contract in the civil service.

 

(Note that this discussion does not directly apply to senior political appointments such as Secretaries and Deputy Secretaries, who are not considered to be a part of the civil service today. Their cases have to be considered separately but the same principles would still be relevant.)

 

The significance of deliberately underpaying a government employee when he is young and overpaying him when he is old means that if he is discharged before his retirement date for improper behavior, then he will not be fully compensated for his work. This is a threat of a penalty the employee will have to face throughout his working life in government.

 

Employees obviously will take great pains to prevent improper behavior such as corruption from being exposed. Uncovering such behavior is often difficult because of the clandestine nature of such activities. But exposure means not only possible criminal charges and loss of reputation, but also loss of deferred compensation. The constant threat of that penalty is probably the best deterrence against improper behavior that is difficult to detect.

 

Pensions and Mandatory Retirement

 

The mandatory retirement element is also an important feature of deferred compensation schemes. If an employee does not retire upon reaching the retirement age of 60 and continues to work, then the scheme no longer contains a deterrent element. At 60, the employee has already collected the full lifetime value of his work and so loss of deferred compensation can no longer be used as a threat. For this reason, retirement has to be made mandatory at the indicated age.

But another side of this situation is that the deterrent effect becomes weaker as the employee gets closer to retirement age. Can a deferred compensation scheme be devised to handle this problem?

 

The answer is yes. Pensions are the ideal deferred compensation for governments. Since they will continue to be paid throughout the retirement years, they extend the full lifetime value of an employee’s work up to the end of his life. The deterrent effect would therefore not end on retirement because the employee would always be under the threat of losing his pension if he was found to have conducted improper behavior during his working years.

 

Since realized life expectancy is not known beforehand, employees would naturally demand a higher lifetime compensation to insure against early death. People are in general risk averse and want a premium if they are consistently underpaid when they are young. This provides a rationale for why civil servants’ pay is often found to be higher than market pay for comparable skills even though lifetime employment is less common in the private sector than in government. Many observers fail to appreciate the unique deterrent element in civil service pay when they complain against civil servants for having both job security and higher pay.

 

Diagram 2 shows how a pension scheme can deter against improper behavior. A pension is a monthly payment made to an employee upon retirement at the mandatory retirement date for the rest of his life. Some average of the employee’s final salary, the length of his service, or both usually determines the amount of the pension.

 

To simplify the exposition assume again that the employee’s productivity is described by a horizontal VMP*(t) line. Next assume the employee is paid a wage rate W*(t) that is also constant with age and is drawn as a horizontal line. The wage rate paid to the employee is set below his productivity so that W*(t) < VMP*(t) throughout his working life. The deferred compensation offered to the employee is to pay him a pension with a value of P*(t) after retirement for the rest of his life. If he expects to live to the age of 80 then he will collect 20 years of pension. Again the conclusions I reach do not depend on these simplifying assumptions.

 

In this simple example, the design of the deferred compensation scheme can be quite straightforward. The employee is underpaid during his entire working life by an amount approximated by the present value of 40 years of income shortfall equal to VMP*(t) – W*(t), where 40 is the number of working years. The employee’s cumulative income shortfall will be compensated by a total pension approximated by the present value of 20 years of P*(t), where 20 is the expected number of years to be spent in retirement. The goal of the deferred compensation scheme is to select a reasonable pair of values for W*(t) and P*(t) so that the present value of the cumulative income shortfall would be about the same as the present value of the cumulative pension.

 

The Deferred Compensation Mechanism

 

If the employee’s contract is extended at the same wage rate as that received at the retirement date, then he is overpaid because, as Diagram 1 shows, at the age of 60 he is being paid above his productivity. It is therefore not uncommon to reduce the wage rate of employees who continue to work beyond the mandatory retirement age. On the other hand, if an employee takes early retirement then he is in principle undercompensated. If such retirement is voluntary it is possible that the employee has better things to do with his time.

 

Given a retirement age of 60, the value of the expected pension P(t) will depend on a number of factors. Its value will be higher (1) the longer the working life, (2) the shorter the retirement life, (3) the higher the discount rate, (4) the higher the perceived probability of employer pension default, and (5) the more risk averse the employee is concerning possible pension loss when the employer defaults.

 

The last two factors bring out the possibility of the employer defaulting on pensions. Pensions can be considered employer-issued debt held by employees. For this reason, only employees of highly reputable organizations are willing to accept pensions. Governments seldom default, but this is not true of all private organizations. It is not surprising that pension schemes are more commonly found in government organizations, but less common in private organizations. In the US less than 30% of employees in the private sector are covered by company pensions.

 

Governments of course can also default. This happens when taxpayers are unwilling to vote for higher taxes to cover large fiscal deficits and the government also has a huge outstanding public debt. It may also coincide with a radical change in the government and the new government refusing to fully honor the pension obligations of the previous government. A partial default occurs when the terms of the pension arrangements are altered. For example, pension payments may be reduced or the mandatory retirement age is postponed. Both adjustments effectively reduce the amount of lifetime benefits received by the employee and lower his lifetime wages in government.

 

The Confusing Effects of Provident Schemes and Pensions

 

Under the Hong Kong government’s previous pension scheme for its civil service, the mandatory retirement age was set at 55 prior to 1987, then moved up to 60. This followed increases in the life expectancy of men from 67.8 in 1971 to 74.2 in 1987 and for women from 75.3 to 79.7, which had several implications.

 

First, higher life expectancy always represents an increase in the present value of lifetime income for the employee because he collects more pension unless his wages are reduced relative to his productivity. Second, five additional years of work is offset by five fewer years of pensions. Normally we would expect VMP(t) – W(t) < P(t), therefore it is likely that lifetime income was decreased when the retirement age was extended from 55 to 60, although one could note that lifetime incomes had been increased to begin with due to a longer expected life.

 

Third, a longer expected life had the effect of allowing more compensation to be deferred even though it increased total lifetime income. A longer working life also increased the period an employee had an opportunity to conduct improper behavior or be exposed to such risks.

 

What is the net effect of these two factors on deterrence incentives is not intuitively obvious and was further complicated by another change that occurred in 1987, when the maximum commuted pension gratuity was adjusted from 25% to 50%. This is the percentage of pensions payable as a lump sum upon retirement and it was obviously a beneficial option for staff. But its effect on deterrence incentives was less obvious and would depend on whether these lump sum payments could be as easily recovered as forfeiture of pensions if improper behavior were exposed.

 

The government’s pension scheme was replaced with a Civil Service Provident Scheme (CSPS) in 2000. Civil servants appointed after 1 June 2000 were offered CSPS, while those appointed prior to this date remained on the pension scheme. The deferred compensation effects of the CSPS and the pension schemes on employee behavior are quite different. The CSPS does not contain an implicit penalty for deterring improper behavior.

 

Many jobs have some form of deferred compensation, but not all of them contain incentives to deter improper behavior. Retirement benefits like staff provident funds that are vested with the employee do not have deterrence incentives built into them. The reason is simple: vested benefits are an entitlement of the employee and are provided without having to be contingent on the employee’s performance. Vesting usually takes place after an initial period of five or ten years of continuous service after which it becomes the employee’s entitlement. Moreover such benefits can usually be collected in full upon retirement.

 

Until thirty years ago it was common for employers, employees and personnel managers to view deferred compensation, like pensions and provident funds, as a form of tax-free benefit. It was believed that the purpose of compensation deferment was to allow employees to receive more income and employers to pay less income by taking advantage of tax savings. It was an arrangement that the government did not object to and the handling of these matters was left to accountants to figure out.

 

This is a limited view of the uses of deferred compensation. The tax explanation also fails to explain why, for example, some organizations have pensions and others do not or why pension schemes have mandatory retirement ages. Our account provides a fuller explanation and demonstrates that deferred compensation is a tool against improper behavior.

 

The government is reported to be considering whether the retirement age should be extended to 65. It is appropriate to consider whether the pension scheme should be reintroduced as well. Operating both a staff provident scheme for new staff and a pension scheme for old staff leads to confusion over the purposes of deferred compensation. The deterrence incentive of a deferred compensation scheme is an important disciplinary tool that governments have over their civil servants. It should not be merely a retirement benefit.

 

References

 

Edward P Lazear, Personnel Economics, The MIT Press, 1995.

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