By Jay Coon
The United States and the world are suffering through an economic crisis of proportions not seen since the Great Depression. City fire departments and fire districts are forced to take drastic steps to save money while continuing to provide fire and emergency medical service (EMS) to their communities. Many times, after companies are closed, the EMS and fire services are reduced to level that is inadequate and dangerous to the public and firefighters.
The voluntary separation program (VSP), introduced by many desperate cities and fire districts, is a way to persuade employees near retirement age to leave a little earlier and save the agency some money. In some cases, VSP can allow districts to avoid laying off new employees in whom they have just invested as much as $125,000 per employee in training. What is a VSP and how can we determine if it is in the best interests of the fire department and its employees?
The VSP is just a fancy name for a buyout of an older employee. Here’s how it works: Fire departments offer their older employees an amount of one-time money loosely predicated on their wages and seniority. For example, the Sacramento (CA) Fire Department (SFD) offered its employees a VSP equal to their weekly wage multiplied by their years of service, with a $50,000 cap.
To some it may seem crazy for departments to offer thousands of dollars to an employee to motivate that person to retire early at a time when money is very dear and the employee is planning on leaving in the near future. It may seem even more bizarre for many employees to turn down this windfall at a time when they need the money and are near retirement.
For a department that is forced to close companies, the VSP makes economic sense. If the value of the VSP is close to the present value of the forgone retirement, it makes economic sense to accept the buyout. But before either party gets involved with a VSP, both the fire department and the employee should be aware. A VSP can work very well if it is administered correctly. It can save the departments money both in wages and retirement costs by motivating older employees to retire early. It can also be a complete boondoggle, causing the fire department to waste thousands of dollars by paying employees to retire who wanted to retire anyway. If the fire department that offers a VSP is not completely aware of all the nuances involved, it can very easily just be throwing scarce funds away. Therefore, it is important to examine the benefits and pitfalls of a VSP.
The Fire Department Perspective:
Most city fire departments receive their revenue from a sales tax that historically closely shadows the business cycle. As the economy goes, so goes the fire department’s revenue stream. A fire department has several reasons to offer the VSP to its older employees when it faces budget shortfalls resulting from a changing economy:
- It reduces the labor costs, which typically consume up to 80 percent of most fire departments’ budgets. With their work force reduced, they can now “brownout” companies or, in the worst case, temporarily close companies to save money.
- Departments have frequently invested up to $125,000 in training each new employee. Furloughing new employees means this investment may be totally lost. Many workers who get a layoff notice may find work at other departments, go back to school, or seek work in other fields.
- Fire chiefs know that when the economic climate improves, they will need to hire again. They will have to spend the same or more money in training new hires. It is more cost-efficient over the long run to retire older employees and to hang on to newer ones who can be expected to stay for the next 15-20 years.
- Fire departments that close companies also benefit from a reduction in their variable costs for fuel, electricity, and vehicle maintenance when they close or brownout fire companies.
The most common mistake fire departments make is to offer a VSP that is too small, causing only employees who have already decided to retire take advantage of it. It is evident that any limit on the VSP other than that generated by present value analysis will tend to favor those who make less money within the organization. This flies in the face of the goal of VSPs, which is to encourage higher-paid, older employees to leave early. In some cases, if the initial offer were only $15,000 dollars more, it would attract enough employees that the department would not have had to reoffer the VSP. In the long run, the department would most likely save money.
Another drawback of offering too little money is that it often means that a department must hold the VSP acceptance period open well into the new fiscal year. Thus, instead of realizing salary and benefit savings for an entire year, it only receives them for part of the year. In the end, the fire departments waste money by paying employees to leave who have already decided to retire or pay money to employees who work well into the new fiscal year. It would be better for cash-strapped fire departments not to offer a VSP than to offer one that is too low to persuade undecided employees to retire early before the start of the next fiscal period.
An example for the fire department:
If the fire department can lure a captain to retire a year early, it can expect a substantial savings if it leaves the full-time employee (FTE) position vacant for one year. In this example, we assume a captain makes $90,000 per year and has a benefit package worth $40,000 per year.
Salary and benefits | $130,000 |
Money not spent training furloughed firefighters | $125,000 |
Total saving per year | $255,000 |
Less: VSP offer $65,379 |
|
Net saving for fiscal year 189,621 |
It is clear from this example that if the fire department could persuade this captain to retire, there would be a substantial savings. If the VSP avoids laying off new employees, there is an even greater savings. The total savings for a department the size of Sacramento (with a budget of $90 million) would be about one percent for every four employees who accept the VSP. Now we will examine whether this is a smart economic decision from the employee’s perspective.
The Employee Perspective
If an employee has already decided to retire, the VSP is a windfall; this person will accept the money and retire. If, however, the employee is undecided, then the VSP settlement must make economic sense. By economic sense, we mean the present value of the lost retirement should be close to the VSP settlement. As employees approach retirement, they usually have an amount of money that they feel they need to receive every month to be financially comfortable. The target market for most buyouts are employees who are nearing retirement, but are planning to stay one more year to reach the monthly figure that they have decided on. Firefighters, like the rest of the country, will continue to have house payments, college expenses, and health care costs follow them in to their retirement years.
Fire department employees’ feelings vary greatly as they approach retirement age. Some wanted to retire yesterday; some never want to retire. The majority of firefighters’ feelings fall somewhere in the middle. They are looking forward to retiring, but have not thought it completely through. Many may have health issues or worries about how to finance their children’s education. These firefighters are the target market for the VSP.
The VSP has some readily apparent advantages for employees who accept it. They get to retire a year early and get up-front money. There is a drawback, however. Since retirement pay is often based on years of service, retiring early can mean a reduction in yearly pension benefits. This can make a big difference over the course of many years.
VSPs and tax shelters have an irresistible appeal to most people who are approaching retirement. Employees with adequate preparation can legally defer the income so the tax consequences are not as painful. Fire departments that assist their employees in understanding the tax ramifications associated with a VSP buyout could make their VSP offering more appealing. Firefighters who do not have the expertise to navigate their money through qualified retirement plans have let this problem become a deal-breaker. Some have even turned down a VSP because of tax issues only to learn later that they could have deferred much of their settlement had they consulted a tax expert early on in the process. Any employee who is presented with a VSP should get tax advice prior to agreeing to the VSP. Even firefighters with no interest in business find it difficult to receive a VSP check for $50,000 only to have to turn around and give Uncle Sam $16,000 or more.
An example for the employee:
To perform this calculation, consider a hypothetical employee who, if he refused a VSP buyout and worked for one additional year, would enhance his yearly pension benefit by $3,400 per year. The firefighter must decide whether to forgo an increase in his pension of $3,400 a year for the rest of his life or to accept the VSP buyout. He must determine the value of $3,400 per year over the next 25 years, assuming he lives that long. In terms of standard economic analysis, he must figure out the present value (PV) of an income stream of $3,400 per year. Basically, this is just the present value of an annuity calculation. This formula is more complicated than a normal annuity formula because it assumes the amount of the annuity grows, which in this example increases the value of the VSP by approximately $13,000 per year. A normal annuity formula just adds the discounted value of money to be received in the future. In any case, annuity calculations can be a little tricky for both the department and firefighter to make.
Although this formula may look a little daunting at first, annuity calculations can be easily done on most inexpensive business calculators. The rate of growth of most retirements is based on a cost of living adjustment (COLA) that is built into them. The COLA are usually tied to the Consumer Price Index (CPI). The CPI is derived by measuring the change in the cost of buying a predetermined basket of goods over time.
CLICK HERE to download an Excel spreadsheet that will let you calculate VSP numbers.
Present value analysis determines that the VSP settlement or buyout should be close to $65,379 dollars to compensate a retiree for losing $3,400 per year for the next 25 years. Enter your retirement income figures into this formula at the following web link to calculate the present value of your forgone annuity and determine if the VSP is a good deal or not.
So far, the decision, even if it entailed some unfamiliar ways of thinking, seems simple enough. If the department offers our hypothetical employee $65,379, the employee will not lose by retiring early and forgoing the additional $3,400/year he would have accrued in pension benefits.
Here is a brief explanation of how we arrive at numerical sums when using interest and discounting calculations. If someone owes money today and they ask if they can pay the debt one year from now, than in effect they are borrowing the money for one year. How much they owe one year later is determined by multiplying the amount they owe, times one plus the interest rate agreed upon. This is the amount of money owed plus the interest earned by the lender of the money. When we discount money to be received in the future (retirement), we just do the opposite. We divide the amount of money to be received in the future by one plus the interest rate. This reduces the amount, which makes sense because money to be received in the future is not as good as money received today.
Deciding on the interest rate is always the most contentious part of any discounting analysis, because it significantly affects the outcome. As the interest rate (discount rate) increases, the future value of the retirement goes down. If the department had decided to let present value calculations determine the value of the VSP offered, the department would want to use a larger interest rate because it would in turn lower the VSP offer. The firefighters, of course, would prefer a smaller interest rate, which would result in a larger VSP being offered to them.
For firefighters approaching a promotion or raise, a limited VSP payout can rarely meet their breakeven requirements. If a fire department is obligated to give their employees a large raise in the next year, it is a waste of money in most cases to try and buy them out a year early. Looking at the table below, it is easy to see that it would be cost-prohibitive for the fire departments to offer a large enough VSP to either an employee expecting a promotion or large raise.
Amountt | Number of years | Interest rate | Growth rate | Value of the VSP |
$2,000 | 25 | .04 | .02 | $38,458 |
$6,000 | 25 | .04 | .02 | $115,374 |
$10,000 | 25 | .04 | .02 | $192,291 |
It is evident by now that the VSP is a complicated mechanism that can save money for cash-strapped fire departments, but it is rife with issues that can affect the outcome of the VSP offer. It should not be a first line of defense in any department’s arsenal to address budget shortfalls. Departments should only use it in dire economic times, knowing full well that it can produce good results for both sides only as long as everyone understand its many nuances. It should only be used by fire departments as a last ditch effort, by departments that must close companies and are facing the reality of furloughing younger employees who will have to be replaced when the economic climate improves. Sometimes, fire departments that offered the VSP and the employees that accepted were less than enthusiastic with the outcome in hindsight. Fully examine the implications of a VSP before offering one, or accepting.
Jay Coon, a 23-year veteran of the fire service, is a captain with the Sacramento (CA) Fire Department, assigned to Rescue 20, the city’s heavy rescue company. He has been an FDIC H.O.T. instructor for eight years.
Subjects: Firefighter buyout packages, voluntary separation program, firefighter retirement and wages