Adverse Selection and Targeting
Ex gratia severance payments are often provided as part of the overall severance package. Particularly in countries where the need to reward or placate labor is strong and social safety nets are lacking, as well as in countries where labor legislation prohibits outright layoffs, governments have resorted to promoting voluntary departures by offering severance payments that exceed legally mandated requirements.
Ex gratia payments are at the core of lump-sum severance packages.
Worldwide, in both private firms and in government, the most common approach for defining severance payments is a formula based on a multiple of years of service and salary. Such formulas are easy for managers to use and are widespread in both the public and private sectors. Table 5.2 describes some advantages and disadvantages of the standard formula.
| Advantages | Disadvantages |
|---|---|
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The formula for severance payments has varied widely among countries and, within countries, among enterprises in different sectors, depending on legal and contractual obligations and the strength of labor unions. Examples of formulas used and the resulting payments in a range of infrastructure enterprises in developing countries are presented in table 5.3.
| Economy/ enterprise | Key features of voluntary departure | Other features | Source for further details |
|---|---|---|---|
| Argentina: Buenos Aires Water and Sewerage | Post-PPI voluntary retirement undertaken by the concessionair | Workers who left voluntary retirement received approximately US$10,000 in severance | under Shaikh 1996 |
| Argentina: Electricity | Severance package is approximately 10 percent greater than the statutory termination package | In 1992 workers received approximately US$10,000 in severance. | Shaikh 1996 |
| Argentina: Rail | 1 month per year of service, with no cap | Approximate cost in 1990 of US$10,000 per worker | Ramamurti 1997 |
| Bolivia: Rail | 3 monthly wages plus an equivalent of 1 wage per year of work for those with more than 5 years of service, plus statutory unemployment benefits | The amount offered was the same as statutory payments; Bolivian capitalization program had made a policy decision to implement a uniform scheme for all enterprises; no incentive for workers who voluntarily retired | Valdez 2002 |
| Brazil: São Paulo Railway | Workers with 4 to 10 years of service, 1 month's salary per year of service; workers with 10 to 20 years of service, 2 months' salary; and workers with up to 25 years of service, 2.5 months' salaries; workers also receive 180 percent of the accumulated funds in their FGTS accounts (a compulsory employee severance indemnity fund, to which all employees in Brazil contribute 8 percent of their basic salaries each month) | Those who left voluntarily gained a cash bonus of 33 percent of monthly salary per year of service; average total package received per worker was estimated at R$29,870 | Carneiro and Gill 1997 |
| Brazil: Rio Grande do Sul State Electricity Company | 60 percent of a month's salary per year of service, but capped at 15 months' salary; additional incentive for workers near retirement age is 10 percent of all remaining wages up to the date of retirement; workers also receive 140 percent of the funds in their FGTS accounts | Average package per worker was R$41,900 | Carneiro and Gill 1997 |
| Brazil: São Paulo Electricity Company | 50 percent of a month's salary per year of service for those with less than 10 years' service; 40 percent if more than 10 years of service; no cap; workers also receive 140 percent of the funds in their FGTS accounts | Carneiro and Gill 1997 | |
| Brazil: Federal Railway | 4 to 12 months of salary, depending on years of service, increasing for workers with 6 to 25 years of service and decreasing for older workers with more than 25 years of service; workers who delayed accepting voluntary departure and were made redundant during the period 1 year after privatization received 80 percent of these benefits | Only workers with more than 6 years of service were eligible; workers were allowed to keep their use of housing for up to 12 months and pension payments were continued for 12 months; average payment to workers was about US$8,000, plus US$18,000 of statutory benefits | Estache, Schmitt de Azevedo, and Sydenstricker 2000 |
| Guyana: Telephone and Telegraph Company | Severance package equivalent to 22 months of salary | Hinds 1995 | |
| India: Federal VRS Scheme (1993-95) | 1.5 months of salary per year of service, or 15 days' salary for each year until retirement at age 58, whichever is less, plus statutory benefits | Three times better than statutory termination benefits of 15 days' salary per year of service | Kouamé 1997 |
| India: Orissa State Electricity Board | 1.5 months' salary for each year of service, or 30 days' salary for each year until normal retirement date, whichever is less, plus statutory benefits | Ray 2001 | |
| Mexico: Federal Railway (FNM) | 4 months of salary plus 30 days for each year of service; part-time workers receive 3 months of salary plus 20 days of salary for each year of service | Salary was a daily integrated salary, which included base salary plus 12 other allowance elements; workers typically received between US$10,000 and US$25,000 in severance. An enhanced pension package was also provided, funded in part from privatization proceeds. | López-Calva 2001 |
| Pakistan: Kot Addu Power Plant | Based on plan for industrial plant privatization in Pakistan; voluntary departure package of 4 months' basic salary per year of service, plus gratuity of 1 month's basic salary per year of service (the "4+1" rule); officer cadre staff had a less-generous package of 2 months' salary per year of service plus gratuity (the "2+1 rule") | Evidence of adverse selection (the most productive workers leaving). Average costs in 1990-93 were about US$3,000, but costs at some industrial plants rose to US$10,000 after 1993 | Kouamé 1907 |
| The Philippines: Manila Waterworks and Sewerage System | Severance package based on years of service, using an "adjusted monthly pay" to take into account various allowances (this was around 30 percent higher than basic pay); workers with less than 20 years' service receive 1.5 months per year of service; those with 20to 30 years of service receive 2 months' salary; and those with more than 30 years of service receive 2.5 months of salary. | Typical package for worker with 20 years of service totaled about US$15,400, roughly twice the standard government package of termination benefits | Cruz 2001 |
| Taiwan, China (Privatization Law) | Severance payment of 6 months of salary in addition to statutory payments. | Applicable to all employees retrenched at privatization or laid off within 5 years after privatization | Chang 2002 |
| Vietnam: (Decree 41/2002 on policy for redundant workers in SOEs) | Severance pay of 1 month per year of service (minimum 2 months); additional compensation of 1 month per year of service; lump sum of VND 5 million; continued salary for 6 months searching for job. | Workers can obtain 6 months' training at vocational training centers; workers who are 5 years short of the pension age have the right to continue paying 15 percent of salary to social insurance in order to qualify for pension and death gratuity benefits | Government of Vietnam 2002 |
In some cases an established uniform formula may already be in place, in which case the key decisions already will have been made. Where the formula is not considered sufficient or where there is no formula in place, a new formula may have to be developed.
At the absolute lower limit, workers must receive the statutory minimum set out in the law. In practice, however, earlier precedents might set a de facto floor for negotiations. The absolute upper limit would be to place a worker on permanent administrative leave with full salary. Although that practice is uncommon, more often the practical upper limit is again that set by previously agreed precedents, even if those precedents are in different sectors and under different circumstances.
Spreadsheet tool for analysis of severance options.
In setting a level of severance for voluntary departure programs, the attractiveness of the package to workers has to be balanced with its affordability for the government. If the payment is too low, workers may not volunteer to leave, and that can threaten or delay the overall objective–a successfully completed PPI transaction. Low levels of severance are sometimes combined with a degree of coercion (for example, threats of compulsory redundancy, unit closure, or wage arrears). Such coercion will engender adversarial relationships with workers, unions, and government, and can damage the political credibility of PPI. If the payment is too high–that is, more than workers would actually need as sufficient compensation for the loss of employment–the government may not be able to pay it, and it may lead to excessive numbers of workers leaving the enterprise, including the best workers.
Overpayment is common in publicly financed severance schemes.
In practice, developing severance formulas is more likely to produce overpayment than underpayment for several reasons:
Where generous and unaffordable precedents have been set, choices must be made between using those precedents or negotiating new severance formulas. The choice will depend on the degree of political support for implementation, the costs imposed by the precedents, and the degree of concern for provision of a social safety net for displaced workers. A cost-benefit analysis of the financial and economic effects of the various options (see module 7) can inform this decision.
In designing severance levels there are various ways to achieve a balance between attractiveness and affordability, and those ways are discussed next.
Setting Minimum and Maximum Levels
A minimum severance level, or a floor, can be set at some point above the statutory minimum termination benefit. A floor can be a useful tool for demonstrating that the severance package is fair and benefits everyone, including lower-paid staff.
A maximum severance payment, or a cap, also can be set. One of the main potential criticisms of severance plans, especially generous ones, is that highest- paid workers or managers can obtain exceptionally high payments. A cap is a simple measure to prevent such criticism, and can be expressed in absolute money terms or in months of pay. For example, the government of Madhya Pradesh VRS-98 placed a monetary cap of Rs. (rupees) 500,000 on payments to workers.
Establishing Preretirement Rules
On its own, a simple straight-line formula (salary x years of service) would give maximum payments to the oldest workers in each cadre of employees. Just before retirement they would have the maximum payment. This is clearly a potential source of influence in employees' behavior: it encourages employees to stay on so that they receive higher compensation amounts, and it discourages earlier voluntary departure. Some empirical formulas attempt to offset this by including an element that reduces payments as the retirement age approaches (see, for example, box 5.2).
In Brazil's federal railway privatization, workers with 6 years of service received 4 months of salary, and for every additional year of service that amount was increased by a factor of 1.0595 for each of the 19 increments up to 25 years of service. Workers with 25 years of service therefore received 12 months of salary as an ex gratia voluntary departure payment. For workers with 25 to 30 years of service, payments decreased by a factor of 0.8705, so that a worker with 30 years of service received 6 months of salary as voluntary departure payment.
Source: Estache, Schmitt de Azevedo, and Sydenstricker 2000.
Another approach to the preretirement period is to make workers who are past a specified age and within a few years of normal retirement ineligible for voluntary departure. This can improve efficiency because workers approaching retirement clearly have the least expectation of loss. If, however, there is a sharp cutoff, again distortionary effects can arise. For example, if a plan is introduced in which workers with fewer than five years until retirement are ineligible for voluntary departure, there will be a very high uptake of the option to leave by workers approaching cutoff point as well as a degree of dissatisfaction and inequity for workers who for timing reasons just miss the newly introduced benefits.
Loss-based formulas have a more rational basis and address the major weaknesses of empirical "ruleof- thumb" approaches.
Adopting Loss-Based Formulas
An alternative approach to the standard way of setting severance amounts, based on labor economics and econometric methods, has been pilot-tested by the World Bank in Guinea-Bissau, Madagascar, and Tanzania, and has been described by Chong and Rama (2000). This approach (which is discussed in greater detail in module 7) recognizes that workers' total incomes often will fall following separation or retrenchment (box 5.3), and it attempts to assess the level of severance that should be paid to offset those earnings losses. The following bullet points summarize the key features of this approach:
There are no tracer studies of the long-term impact of retrenchment on workers in developing countries. In industrial countries, however, the evidence is that earnings losses have been both large and persistent. Reviews by Fallick (1996) and Kletzer (1998) on displaced workers in North America indicate persistent earnings losses of between 10 and 25 percent of predisplacement earnings up to 10 years after displacement.
In Turkey earnings after reemployment among petrochemical and cement workers displaced during privatization were 57 percent and 61 percent, respectively, of their earnings prior to layoff. Most workers also lost a range of nonwage benefits (Tansel 1996).
In Ghana follow-up assessments of the earnings of civil servants showed a 48 percent fall after severance, although workers who found wage employment had a much smaller reduction in income. Note, however, that although:
under current economic conditions, many retrenched workers can expect their lifetime earning stream to be appreciably lower.... we are persuaded that the difference in earnings before and after redeployment reflects the loss of a rent associated with civil service employment.... What the employees have lost, then, is a privileged post that, one can argue, they should not have held in the first place. Their gain in getting a civil service job was the Ghanaian taxpayer's loss, and vice-versa for the post-redeployment loss in earnings
(Alderman, Canagarajah, and Younger 1996, p. 285).
Chong and Rama (2000) described the application of a loss-based approach in Guinea-Bissau.
Table 5.4 summarizes the advantages and disadvantages of loss-based formulas. They can deliver the fairest levels of severance payment for individuals. Furthermore, by careful targeting they can reduce the costs of the severance program for government and avoid adverse selection. Estimates of the level of costs savings realized from tailored formula compared with savings realized from an empirical formula are 31 percent for SOEs in Egypt (Assaad 1999) and around 20 percent in the case of the Central Bank of Ecuador (Rama and MacIssac 1996, 1999).
| Advantages over empirical formulas | Disadvantages over empirical formulas |
|---|---|
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But there also can be some difficulties in adopting a loss-based approach:
Like other severance formulas, loss-based formulas will need to be understood by unions and workers and be discussed during the consultation process:
If appropriate compensation is needed to make the workers accept the prospect of downsizing, it is very likely that the package will have to be negotiated with the public sector trade unions. In that case the final compensation package may not be the cheapest one, or the fairest one, but rather a compromise shaped by the bargaining power of all the players involved. From this perspective the [loss-based approach] should not be seen as an example of "mindless social engineering," but rather as a tool to introduce some economic rationality into delicate political negotiations. While the approach could certainly be refined, it represents an improvement compared to the ad hoc way in which these negotiations are usually carried out (Chong and Rama 2000, p. 26).
Whatever approach is selected, severance payments in early retirement, voluntary departure, and compulsory redundancy schemes can be structured to provide time-based incentives for workers to leave early.
More generous packages for voluntary departure than for compulsory redundancy are the norm. During Brazil's railway reforms, workers were clearly informed that any compulsory retirees would receive only 80 percent of the package given to those who took voluntarily departure benefits (Estache, Schmitt de Azevedo, and Sydenstricker 2000). In Turkey the privatization law offered 30 percent more to employees who volunteered for early retirement (Tansel 1996). Early applicant bonuses can be offered. In the 1992 British Telecommunications downsizing plan, early applicants received an incentive payment.
Estache, Schmitt de Azevedo, and Sydenstricker 2000
For government the decision whether to negotiate severance on a case-by-case basis for each enterprise or to adopt a uniform severance plan for all public enterprises is a critical preliminary decision. Table 5.5 presents the advantages and disadvantages of each approach.
A case-by-case approach to severance, where payments are negotiated at the enterprise level, has arisen when there is a cautious, incremental approach to PPI and when, in the absence of any overall labor policy or guidelines, labor restructuring is dealt with at the transaction level. In some cases enterprises are also governed by their own labor rules or labor contracts, thus leading to a case-by-case approach. In others, a case-by-case approach has been adopted to ensure flexibility based on the individual circumstances of the company. Some governments, for example, have treated profitable and unprofitable enterprises differently, allowing profitable ones to pay higher levels of severance out of their own resources. That was the case in India and also in Tanzania when the government opted to concession port services and container terminal operation (box 5.4).
Although a case-by-case approach can provide flexibility, it can also create unwanted precedents. Each new award raises the minimum severance level for the next negotiations, and there is a ratchet effect that ensures increasing levels of severance. Such approaches can also fuel distrust in the process and bring the wider PPI program into disrepute, thereby threatening its sustainability (see box 5.5). Moreover, trade unions often oppose differentiation between enterprises on the grounds that (a) there should be equality of treatment for all workers in SOEs and (b) the financial distress of loss-making enterprises can be attributed to government mismanagement and therefore it is unfair to penalize employees.
Given the potential problems of a case-by-case approach, there are advantages to adopting uniform severance guidelines that, with some measure of flexibility to take into account enterprise circumstances, are applied to all enterprises (table 5.5).
Uniform guidelines can be perceived to provide fair and equal treatment for all workers and help ensure some measure of predictability in the process.
| Approach | Advantages | Disadvantages |
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| Uniform |
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| Case-by-case |
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In 1996 the government of Tanzania decided to invite private sector participation in the delivery of port services in Tanzania. They also invited private sector participation in the container terminal operation of the Tanzania Harbours Authority (THA) in the form of a 10-year operating lease. THA was one of the few SOEs in Tanzania with a history of sustained profits, and these profits resulted from its monopoly position and because fees to shipping companies were set in U.S. dollars. THA as a whole employed 3,500 workers; of that number 500 were directly associated with the container terminal business.
During the privatization of the container terminal the problem of how to handle severance came to the fore. Earlier proposals by the World Bank had suggested that government declare a consistent policy on severance. Government had decided, however, to retain its existing policy, which provided that:
In pursuing a program for severance of surplus staff, THA decided to offer an ex gratia payment in addition to statutory minimum obligations. Three problems immediately surfaced:
The government decided that all 500 container terminal workers would be retrenched and paid the statutory dues and that those workers who were not reemployed would benefit also from the ex gratia payment. Those employees who declined reemployment lost their rights to the ex gratia payment– a policy intended to avoid the problem of employees with critical skills declining employment, benefiting from the ex gratia, and later being rehired by TICTS because their skills were critical. The ex gratia payments amounted to about 12 months' pay in addition to statutory payments.
The outcome is that the government has resolved labor issues in the PPI transaction of the container terminal. It also has avoided potential industrial unrest among other THA workers (who were watching and now expect similar treatment). However, the wider problem of inconsistency in the treatment of some 21,000 workers in other utilities and infrastructure remains.
Source: Parastatal Sector Reform Commission, Tanzania; Adam Smith Institute.
Sri Lanka: Upward Revisions of Ad Hoc Severance Payments
Average ex gratia severance payments in Sri Lanka's privatization program rose from 17.5 months of salary in 1987 to 53 months in 1997. By the time that Lanka Lohan (a steel company) was privatized in 1997, the package was considered so attractive that all workers applied to leave the firm, a clear sign that the package was overcompensating them. The increases took place because of strengthening trade union bargaining power, and the "ad hoc and lackadaisical manner in which labor issues were handled" (p. 190). In Sri Lanka, severance packages customized on a case-by-case basis for each enterprise proved to be downwardly rigid and confusing to the parties involved and they encouraged rent-seeking behavior and hostility to privatization. Another outcome was that government was no longer able to easily afford to restructure labor before privatization.
Source: Salih 2000.
Zambia: Disparity in End-of-Service Benefits Fuels a Distrust of Privatization
The United Bus Company of Zambia was insolvent and was forced into liquidation. Under the applicable bankruptcy law, employees were entitled to 200 kwacha (equivalent to US$0.30) as preferred creditors for the legal minimum end-of-service benefit; for any additional amount they ranked as ordinary creditors in accordance with their contract terms of employment. In contrast, a cleaning worker who left Zambia Telecommunications after working there for only two years reportedly received a payment of 2 million kwacha (US$3,000). Such egregious disparities between the legal and contractual minimums for end-of-service benefits can create opposition to privatization and delay transactions.
Source: World Bank 1996e; quoted in Campbell-White and Bhatia 1998.