Cutting Salaries is Better than Cutting Retirement Contributions
During the 2009 recession many firms suspended 401k contributions. The tendency to do so during this recession has been relatively modest so far. TowersWatson reported that only 12% of employers in their survey suspended 401k contributions, and 23% are considering the move. A new development is that retirement contributions are now targeted by higher education institutions including Duke, Northwestern, Georgetown, Johns Hopkins, Chicago, USC, Michigan, BU, Washington University, Alabama, Pace, Drexler, American and many others. The sector faces significant challenges of uncertain enrollment, high cost of safely opening campuses and unfavorable demographics. Perhaps it is not surprising that the relatively generous higher ed employer contributions are targeted for cuts. However, there are many drawbacks to this strategy particularly as compared to cutting salaries.
- Cutting salaries reduces the tax bill for the employer
Unlike salaries, employer retirement contributions are not subject to FICA and Medicare taxes. Therefore, a cut in salaries would save the institution an additional 7.65% in taxes, while a cut in employer contributions does not save any additional money. - Cutting salaries reduces the tax bill for the employee
The tax advantages of a salary cut are even more significant for the employee. Employees who are within IRS limits to replace employer contributions with their own contributions, still have to pay the 7.65% FICA taxes on what they contribute. Employees who have reached the employee contribution limit have no tax-advantaged way to replace the employer contributions. For an individual facing a 30% marginal federal and state income tax, each $100 reduction in salary would save the institution $107.65, but reduce the employee’s take-home pay by only about $64. - The CARES Act makes it possible to turn retirement contribution into salary
Employees affected by COVID 19 can withdraw money from their retirement accounts with three years to either pay it back or pay taxes on these withdrawals. Thus, employees who need the money now can access it in a far more tax-efficient manner than if they were paid the money directly in their paychecks. - Cutting salaries is likely to be more equitable
Recently hired employees may not be eligible for employer contributions, and thus would not be affected by cuts in these contributions. Similarly, employees who leave before employer contributions vest will not be impacted by the cuts. Perhaps most disturbingly, the IRS limits employer contributions for highly paid employees. Currently, earnings above 285K of compensation are not eligible for employer contributions, and thus would not be subject to retirement cuts. - Missing out on retirement contributions during a recession can be costly
Employees whose retirement contributions were cut during the 2008/2009 recession only to be reinstated later, missed out on one of the longest bull markets on record. In fact, the pro-cyclical nature of contributions in defined contribution plans is responsible for their underperformance relative to defined benefit plans. - Cutting salaries better preserves the mix of salary and benefits in compensation
Since employer contributions are tied to salaries, salary cuts will naturally reduce employer retirement contributions while keeping the ratio of salary to retirement contributions constant. It is not clear why the current crisis would necessitate altering the mix of salary and benefits in compensation. If anything, making it easier for senior and higher paid employees to retire would likely reduce the overall wage bill and healthcare costs. - While easily reversible, cutting salaries can create long term savings
No institution will cherish the prospect of a one-year suspension in retirement contributions turning into a two-year suspension, or a permanent reduction, or a new series of cuts in the event that the financial situation fails to improve. Given the uncertainty of the extent to which the current shock is temporary or permanent, it would seem prudent to implement changes that, while easily reversible, could deliver a cost structure that is consistent with the new environment.
It is not clear why the leaders choose to pursue such a blatantly sub-optimal strategy for fixing higher education budgets. I would like to think that it is the desire to preserve the take-home pay of lower-paid employees rather than a lack of courage to face the new reality. If it is the former, there are numerous ways that salary cuts could be structured to protect lower-paid employees (e.g. exclude the first X dollars in earnings from any cut). Cutting retirement contributions falls into the same category as drawing on endowments and pausing building maintenance — it is a short-term fix that may come to haunt us.