Calculating Employee Compensation

Still absent from much of the discussion regarding state and local government budget deficits is an attempt to properly assess rates of worker compensation. But if one performs this exercise, normalizing for all present and future benefits, it immediately becomes clear that the true compensation of public employees is significantly higher than is being commonly reported, and this fact should be taken into account when arguing what may be the most effective and equitable way to eliminate deficits and avoid public sector bankruptcies.

It is common when considering how much one is paid by their employer to reference the annual gross income as the primary measurement – the number that appears on the IRS W-2 form, for example. But in reality this is a very misleading indicator. How much an employee makes should be calibrated according to how much it costs the employer each year in total direct expenditures for the employee not only for wages, but all present and future benefits. This grossed-up amount, in-turn, must be applied to the number of hours the employee actually works each year. This adjusted hourly rate can then be normalized, for example by multiplying by 2,080 (52 weeks at 40 hours per week) to create a rate of annual compensation.

The reason this is important is because rates of compensation, as opposed to base wages, are far more reliable indicators as to whether or not a workforce is relatively overpaid or underpaid compared to their counterparts. For example, a landscaper’s assistant working for a private non-union labor contractor may earn minimum wage, $8.25 per hour. Added to that is the employer’s contribution to social security and medicare, and a handful of other assessments such as workman’s compensation – all of which theoretically will come back to this worker at some point as a future benefit. These minimal assessments will add about 10% to this person’s compensation, meaning they are actually earning just over $9.00 per hour. Since they get no vacation or sick time at this entry level, their annual compensation is not $17,160 per year ($8.25 per hour times 2,080 hours per year), but actually $18,876 per year ($8.25 per hour times 110% times 2,080 hours per year).

In the private sector, this “overhead” that is actually compensation that directly benefits the employee can vary, with the 10% figure representing the low end of the spectrum. At the higher end, a private sector worker who makes, for example, $65,000 per year, may also have several benefits that increase their actual compensation. They will earn the employer’s payments on their behalf, which amounts to an additional 10% for social security and medicare. They will also potentially have their health insurance paid for, adding as much as another $12,000 per year or more. Sometimes there is an employer’s matching contribution to a 401K plan, possibly adding up to another 5%. If you add this all up, these lucky employees actually earn not $65,000 per year, but $86,750 per year ($65K times 115% plus $12K). In addition, the private sector employee may not work 2,080 hours per year – they may have 10 paid holidays and 10 vacation days, meaning they only work 1,920 hours per year. If you normalize this for a full year that totals 2,080 working hours ($87K divided by 1,920 times 2,080), you get a real annual compensation of $93,979 per year, or an “overhead” of 45%.

This range, between 10% and 45%, is pretty much representative of non-union, private sector overhead, and is a useful way of assessing how much employees are really making in compensation. The reality, with employer contributions to 401K plans becoming quite rare, along with contributory health care plans, is the private sector worker’s overhead compensation probably averages around 30%, if not lower.

Schwarzenegger attempted to
reform government to reduce deficits,
but was crushed by special interests.

In the public sector, compensation packages typically trend towards the higher end of this range – but what really gets them over the top is the value of their pensions and retirement health benefits. To begin this analysis, it is useful to compare how pensions are measured in the public sector, then compare that to the defined benefit that private sector workers get, i.e., social security.

Public sector pension benefits are calculated by multiplying a negotiated percentage amount by the number of years the employee works. This total percentage is then applied to the final annual salary of the worker. For example, it is common for city and county workers in California to get 2.7% per year towards their retirement, meaning if they work 30 years and retire at age 55, to calculate their retirement you would multiply 2.7% by 30, and apply that percentage to their final salary. For example, if they work for 30 years and are making $65K when they retire, they will earn 2.7% times 30 times $65K when they retire, or $52,650 per year in retirement pension benefits.

California state workers on average earn somewhat less than this; they will get 2.0% per year typically towards this retirement calculation – do the math and you will see that a California state worker who completes their employment after 30 years at a final annual working salary of $65K will get an annual retirement benefit beginning around age 55 of $39,000 per year.

To compare this to social security, you have to work backwards. If you reference the “Social Security Estimator” webpage, you will see that a person who pays into social security, retiring at age 65 (ten years later, working 40 years instead of 30 years) with an ending salary of $65K, will earn $19,308 per year in social security payments. This annual amount, earned after 40 years instead of 30 years, is only 49% of what state workers will typically get, and only 36% of what city and county workers will get. If you use their terminology, it equates to 0.7% per year, versus 2.0% or 2.7% per year for government workers.

Returning to how this applies to total compensation, the way retirement pensions and health benefits affect real compensation in the public sector, normalized for all benefits, is quite dramatic. During the years public sector employees work, the funding requirements of their future benefits need to be paid. While ongoing funding allows interest to be earned, the real return of these funds is not likely to exceed 5% per year, if that. Despite a run of excellent returns in recent years, fueled by unsustainable debt fueled economic “growth,” in general funds large enough to service pensions for millions of workers cannot experience real growth greater than the rate of overall economic growth for the economy at large. A good global fund should not be expected to grow faster than the sustainable rate of global economic growth, which has never exceeded 4% historically (ref. Humanity’s Prosperous Destiny); this is a realistic if not optimistic real rate of return, adjusted for inflation. Let’s also assume a public employee works for 30 years, retires at age 55, lives to be 75, and started their career earning a salary paying one-half as much as what they earned by the end of their career, with the increases spread evenly through their 30 year working life. Assume these are merit increases since we are dealing with real dollars, and similarly, since we are using real dollars, assume no cost of living adjustments during retirement. All of these assumptions, please note, will lower the amount of funding required each year. Assume they are state workers, meaning they “only” get 2.0% per year applied to their retirement calculation.

The math is somewhat complex, but here is the result: At a return of 4% per year, a state worker will have to have an additional 19% of their salary contributed to their pension fund each year they work in order for the fund to accumulate enough to pay them their defined pension until they reach the age of 75. During the years they work, they will also have to have annual contributions made for their future health benefits – to say these amounts would be at least 2.0% more of their salary, which is about what medicare requires, would be a generous understatement, since public employees often receive supplemental health coverage for the period prior to age 62 when medicare eligibility begins, and they often receive coverage to supplement medicare as part of their retirement. For a state employee making $65K per year, this 21% of salary set-aside for their future health care and pension must be paid each year, and this is part of their compensation. Just as an aside, a city or county worker who gets a 2.7% per year pension plan, earning $65K per year at retirement, with a fund earning a realistic 4% per year, would require 27% (including the understated 2% for future health benefits) on top of their salary put into a retirement fund each year. Those in public safety who earn a 3.0% pension package, under these assumptions, would require 31% of their salary to be paid each year to adequately fund their retirement benefits.

It doesn’t end there. Public employees don’t work as many hours each year. Instead of 10 holidays, usually they get at least 15. Instead of 10 days of vacation, over their career, on average, if you include “personal days” as well as vacation time, public employees get at least 30 paid days off annually, 50% more than private sector workers. This is not to mention the “9/80″ program where they get to work 9 days every two weeks instead of the normal 10 days, so long as they work an extra hour per day – hmmm, lunch at the desk and a few minutes early to arrive and a few minutes late to leave – sounds like a typical salaried job in the private sector, but never mind – and what about teachers who get summers off?

Where does this put us? If an executive in the private sector making $65K per year is going to actually make, best case, $94K per year, with an overhead of 45%, what is the overhead, and true compensation for a public employee?

Using the state worker as an example, you will take $65K, add 21% for funding future retirement benefits, add $12K for health benefits (apples and apples here – in reality health benefits are on average much better for public sector workers), normalize for 30 paid days off per year instead of 20, and you get an adjusted compensation of $102K per year, or an overhead of 58%.

It is important to note that a private sector workers overhead component of their total direct compensation of 45% is the absolute high end, whereas the overhead for a state worker in this example of 58% is the low end. For example, if you do the same analysis for a city/county worker on the 2.7% per year plan, you get a normalized annual compensation of $108K, with an overhead rate of 67%. If you account for the impact of additional benefits such as the “9/80″ programs that amount to 26 more paid holidays a year, a city/county worker making $65K per year really makes $122K per year; an overhead rate of 89%.

There’s more. In previous decades, workers in the public sector exchanged lower salaries for better benefits. That is, they would get overhead benefits of, say, 60% vs. 30% in the private sector because a job that paid $65K in the private sector would only pay $50K in the public sector. Those realities – aside from the oft-cited “overpaid private sector executives” (probably less than 1% of the private sector workforce and hence totally irrelevant) – have now been flipped. Public sector workers now make more in base salary than private sector workers doing jobs requiring comparable skills and comparable risks. Obviously some public sector jobs should pay a premium – but the question is how much of a premium is too much.

The reality today is this – a mid level bureaucrat in the public sector probably will make about $65K per year, which with benefits of 58% (on the low side) will normalize to $102K per year. A white collar worker or skilled technician in the private sector, doing work requiring equivalent skills will probably earn $50K per year if they’re lucky, with an overhead benefit of 30%, which equates to $65K per year. Public employees now make about twice as much as private sector employees make.

When one does an in-depth analysis of the real rates of employee compensation in the public sector vs. the private sector, the solution to government deficits is clear. The solution is not “furloughs” or even layoffs. The solution is to cut their pay and their benefits to levels equivalent to what people make in the private sector. This step would not only restore equity to the workforce, but would immediately eliminate the structural deficits endured by state and local governments.

7 Responses to “Calculating Employee Compensation”
  1. Bill Tufts says:

    Excellent analysis.
    Recent reports have confirmed this.
    CFIB Pdf –
    Las Vegas chamber reports –

  2. marcia says:

    Wages and benefits increased because tax revenue went up during rapid economic growth. We now know the growth was a sham caused by outrageous mortgage underwriting policies.

    Now that the bubble has busted, the only sensible solution is to adjust wages and benefits lower. It’s happening in the private sector, and it should also happen in the public sector. Unions who cling to the notion that “we can’t give up what we’ve fought so hard to get” will destroy themselves faster than anyone else can. They’ve never seen a WAGE cut. But until recently, we’ve rarely seen house values go down, either. Things are not the same today, and until unions realize this, they will be part of the problem, and not part of the solution.

  3. Bull says:

    Quoting …”When one does an in-depth analysis of the real rates of employee compensation in the public sector vs. the private sector, the solution to government deficits is clear. The solution is not “furloughs” or even layoffs. The solution is to cut their pay and their benefits to levels equivalent to what people make in the private sector.”

    AMEN ! AMEN ! AMEN !

    It is wrong to tax people (Private Sector workers) who make market wages in order to subsidize people (Civil Servants) who, by virtue of their union clout, have been able to negotiate wages and benefits well above the prevailing market.

    Civil Servants are the energizer bunny’s of greed and the self-serving, vote-selling, contribution-soliciting, politicians are their enablers.

  4. TD says:

    Ha Ha, lots of fuzzy math here, you are really skewing the number to make your case. And counting vacation days as overhead pay? Ridiculous.

    And what hat did you grab some of these statistics out of; $50K pay vs $65, private to public sector for a technician? Your analysis is about as scientific as the math in a Bugs Bunny cartoon. Show your references please (but you can’t because these are fictitious statements), otherwise thanks for the laugh.

  5. Ed Ring says:

    TD: Thank you for your comment. It is difficult to do apples to apples comparisons because many jobs in the public sector don’t have obvious counterparts in the private sector. But the fact that public sector employee base pay and benefits have increased much more swiftly than private sector packages over the past 10-20 years is well documented.

    As for counting vacation days as overhead, in the context in which we are discussing overhead, that is completely valid. This exercise is using as a baseline 2080 hours per year, and simply shows the cost to the employer according to a 2080 hour year baseline, using as the numerator the number of hours actually worked each year. The fact is, again, public sector workers get significantly more paid days off than private sector workers, and there is a cost for this. If you want to do an apples to apples comparison, the methodology I’ve used is as good as any.

  6. Johnny Vegas says:

    Public sector employees never want to count vacation pay, sick leave pay, medical and dental and certainly not pension and retiree ehalthcare costs in their compensation package.

    And one must remember that the pay scale for many of the 100K+ cash compensation jobs, such as FF, cop and prison guard requires nothing more than a GED education level and no prior work experience. In the private sector those types of jobs pay minimum wage with no benefits (with illegal immigration even driving those wages down because they pay off the books).

  7. Neal says:

    I think it really is one of the more difficult things to deal with is calculating employee benefits. Not only is tough to come up with a fair value for everyone, it can be a very touchy subject. I am just glad my firm recently decided to use a PEO to handle this. It saves so much hassle and time.


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