LESSON 11

Compensation structure and Differentials

Chapter 5: Introduction To Basic kinds of Wage Plans

Learning Objective

• To know concept of Wage Plans

• To understand the different Types of Wage Plans

Interaction:

There are two major kinds of wage and salary payment plans: those under which
remuneration does not vary with output or the quality of output, but depends on the time
unit consumed in performing work. These are known as time wage plans. The time unit
may be the day, week, fortnight or month. Time plans are non-incentive in the sense that
earnings during a given time period do not vary with the productivity of an employee
during that period.

The second kind is concerned with the output or some other measure of productivity
during a given period of time. To earn more, an employee is required to put in more
labour and produce more. This Kind is known as the piece or output wage plan. It is a
direct financial incentive plan,

Thus, the "time" and the "output" wage plan are the two basic systems. All the other
plans are simply variations of these two.

Types of Wage Plans

After understanding above the concept of wage plans no let us understand in details
below the different types of wage plans:

(1) Time Rate

This is the oldest and the most common method of fixing wages. Under this system,
workers are paid according to the work done during a certain period of time, at the rate of
so much per hour, per day, per week, per fortnight or per month or any other fixed period
of time.

The essential point is that the production of a worker is not taken into consideration in
fixing the wages; he is paid at the settled rate as soon as the time contracted for is spent.

Merits:

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The merits of the system are:

(1) It is simple, for the amount earned by a worker can be easily calculated;

(2) As there is no time limit for the execution of a job, workmen are not in a hurry to
finish it and this may mean that they will pay attention to the quality of their work;

(3) As all the workmen employed for doing a particular kind of work receive the same
wages, ill will and jealousy among them are avoided;
(4) Due to the slow and steady pace of the worker, there is no rough handling of
machinery, which is a distinct advantage for the employer;

(5) It is the only system that can be used profitably where the output of an individual
workman or groups of employees cannot be readily measured. The day or time wage
provides a regular and stable income to the worker and he can, therefore, adjust his
budget accordingly.

This system is favored by organized labour, for it makes for solidarity among the workers
of a particular class. It requires less administrative attention than others because the very
basis of the time wage contract is good faith and mutual confidence between the parties.

Demerits:

The main drawbacks of this system are:

(i) It does not take into account the fact that men are of different abilities and that if all
the persons are paid equally, better workmen will have no incentive to work harder and
better. They will therefore be drawn down to the level of the least efficient workman.

Halsey observes: "Matters naturally settle down to an easy-going pace in which the
workmen have little interest in their work and the employer pays extravagantly for his
product." Taylor says: "The men are paid according to the position which they fill and not
according to their character, energy, skill and reliability."

(ii) The labour charges for a particular job do not remain constant. This puts the
authorities in a difficult position in the matter of quoting rates for a particular piece of
work.

(iii) As there is not specific demand on the worker that a piece of work needs to be
completed in a given period of time, there is always the possibility of a systematic
evasion of work by workmen.

(iv) This system permits many a man to work at a task for which he has neither taste nor
ability, when he might make his mark in some other job.

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(v) As the employer does not know the amount of work that will be put in by each
worker, the total expenditure on wages for turning out a certain piece of work cannot be
adequately assessed.

As no record of an individual worker's output is maintained, it becomes difficult for the

employer to determine his relative efficiency for purposes of promotion.

(2) Piece Rate:

Under this system, workers are paid according to the amount of work done or the number
of units completed, the rate of each unit being settled in advance, irrespective of the time
taken to do the task. This does not mean that a worker can take any time to complete a
job because if his performance far exceeds the time, which his employer expects he
would take, the overhead charge for each unit of article will increase.

There is indirect implication that a worker should not take more than the average time. ' If
he consistently takes more time than the average time, he does it at the risk of losing his
job.

Under this plan, a worker, working in given conditions and with given machinery, is paid
exactly in proportion to his physical output. He is paid in direct promotion to his output,
the actual amount of pay per unit of service being approximately equal to the marginal
value of his service in assisting to produce that output.

This system is adopted generally in jobs of a repetitive nature, where tasks can be readily
measured, inspected and counted. It is particularly suitable for standardized processes,
and it appeals to skilled and efficient workers who can increase their earnings by working
to their full capacity. I

In weaving and spinning in the textile industry, the raising of local in the mines, the
plucking of leaves in plantations, and in the shoe industry, this system can be very useful.
But its application is difficult where different shifts are employed on the same work or
where a great variety of different grades of workers are employed on different and
immeasurable services, as in the gas and electricity industries.

A worker's earnings can be calculated on the basis of the following formula: WE=NR,
where WE is the worker's earning, N stands for the number of pieces produced and R for
the rate per piece.

Merits:

This system has many advantages:

(i) It pays the workman according to his efficiency as reflected in the amount of work
turned out by him. It satisfies an industrious and efficient worker, for he finds that his

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efficiency is adequately rewarded. This gives him a direct stimulus to increase his
production.

(ii) Supervision charges are not so heavy, for workers are not likely to while away their
time since they know that their wages are dependent upon the amount of work turned out
by them.

(iii) Being interested in the continuity of his work, a workman is likely to take greater
care to prevent a breakdown in the machine or in the workshop. This is a point of
considerable gain to the management, for it reduces plant maintenance charges:

(iv) As the direct labour cost per unit of production remains fixed and constant,
calculation of costs while filling tenders and estimates becomes easier.

(v) Not only are output and wages increased, but the methods of production too are
improved, for the worker demands materials free from defects and machinery in perfect
running conditions.

(vi) The total unit cost of production comes down with a larger output because the
fixed overhead burden can be distributed over a greater number of units.

Demerits:

The demerits of the system are:

(i) In spite of the advantages accruing to the management as well as to the workmen, the
system is not particularly favoured by workers. The main reason for this is that the
fixation piece rate by the employer is not done on a scientific basis.

In most cases, he determines the rate by the rule-of-thumb method, and when he finds
that the workers, on an average, get higher wages compared to the wages of workers
doing the same task on a day-rate basis, pressure is brought to bear upon the workers for
a cut in the piece rate. Halsey observes: "cutting the piece price is simply killing the
goose that lays the golden eggs. Nevertheless, the goose must be killed. Without it, the
employer will continue to pay extravagantly for his work; with it he will stifle the rising
ambition of his men."

(ii) As the workers wish to perform their work at breakneck speed, they generally
consume more power, overwork the machines, and do not try to avoid wastage of
materials. This results in a high cost of production and lower profits.

(iii) There is a greater chance of deterioration in the quality of work owing to over
zealousness on -the part of workers to increase production. This over-zealousness may
tell upon their health, resulting in a loss of efficiency.

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(iv) It encourages soldiering; and there "arises a system of hypocrisy and deceit, because
to escape further cuts they begin to produce less and also regard their employers and their
enemies, to be opposed in everything they want.

(v) Excessive speeding of work may result in frequent wear and tear of plant and
machinery and frequent replacement. Trade unions are often opposed to this system, for it
encourages rivalry among workers and endangers their solidarity in labour disputes.

(3) Balance or Debt Method:

This method is a combination of time and piece rates. The worker is guaranteed an hourly
or a day-rate with an alternative piece rate.

If the earnings of a worker calculated at the piece rate exceed the amount which he would
have earned if paid on time basis, he gets credit for the balance, i.e., the excess piece rate
earnings over the time rate earnings.

If his piece rate earnings are equal to his time rate earnings, the question of excess
payment does not arise. Where piece rate earnings if less than time rate earnings, he is
paid on the basis of the time rate; but the excess which he is paid is carried forward as a
debt against him to be recovered from any future balance of piece work earnings over
time work earnings. This system presupposes the fixation of time and piece rates on a
scientific basis.

Let us suppose that the piece rate for a unit of work is Re. 1.00 and the time rate Rs.
0.37V2 an hour, the weekly work hours are 40 and the number of units to be completed
during these 40 hours is 16.

It will be seen that the debit during the second week completely eliminated the edit of Re.
1.00 obtained during the first week. The worker will be paid his guaranteed time rate, in
this case Rs.15.00, in the first week and the same amount in the second eek, although his
earnings during the first week are Rs.16.00 and during the second eek they are Rs.14.00.

An adjustment will be made periodically to find out the balance be paid to him.
The obvious merit of this system is that an efficient worker has an opportunity to increase
his wages. At the same time, workers of ordinary ability, by getting the guaranteed time
wage, are given a sufficient incentive to attain the same standard, even though the excess
paid to them is later deducted from their future credit balance.

Table 16

Balance Method of Wage Payment

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 Total Total Debit Balance
Name of Units of Earnings Earnings
Credit
Worker Completed Under Piece Under
Rate Rate
Nil Rest. 1/
Sohan
16 Rest. 16/- Rest. 15/- Rest. 1/-
first week)
Sohan Nil Rest. 1/
Second 14 Rest. 14/- Rest. 15/- Rest. Nil
week)

Questions:

1. What do you understand by the term wage plan?

2. What are the basic kinds of wage plans?

3. What proper administration of wage plans is required in compensation

management?

Tutorial Activity 1.1

Let us understand what is a Pension Equity Plan?

To meet the needs of workers who hold a number of jobs throughout their lives,
employers continue to seek new kinds of retirement income plans; pension equity plans,
like cash balance plans, let employees know the lump-sum value of their pension while
they are still working.

Traditional defined benefit pension plans have been described as "golden handcuffs,"
providing generous ("golden") retirement income to workers who remain with the same
employer (the "handcuffs") throughout their work life. Such plans, which often base
benefits on earnings in a worker’s last years with the company, may provide lower
benefits for those employees who work in multiple jobs throughout their lifetimes. In
January 2002, employees had worked for their current employer for an average of 3.7
years; those aged 45 to 54 had worked for their current employer an average of 7.6
years.1 These data suggest workers may be accumulating retirement benefits from several
jobs; employers have attempted to deal with these changing needs by seeking alternative
approaches to providing retirement income.

The different career plans of the younger generations have led many employers to
conclude that their retirement plans were not beneficial to these younger, more mobile
workers. This was not conducive to attracting potentially valuable employees that could
help increase efficiency.

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One new approach is the pension equity plan, which is a defined benefit plan that builds
cash value throughout a person’s working life. Much like cash balance pension plans,3
which have received considerable attention in recent years, pension equity plans offer the
guaranteed benefits of a defined benefit plan while expressing benefits in terms of a
current lump sum, which mobile employees can access when they leave their employer.
(See the appendix for a comparison of cash balance plans and pension equity plans.)

When designing retirement benefits, today’s employers may face different issues than
were faced in the past. Consider some of the needs of today’s employers.

The ability to recruit new employees that are well into their careers

The ability to provide predictable retirement benefits

The ability to accommodate early retirement

The ability to provide portable benefits upon employment termination or

retirement

The ability to provide benefits that keep up with inflation

To meet these needs, new, hybrid forms of pension plans--including pension equity plans
and cash balance plans--have been developed. Such plans are referred to as "hybrids"
because, even though they are defined benefit plans, they combine the features of both
defined benefit and defined contribution plans. A defined benefit plan typically includes a
formula for computing benefits at retirement. Benefits are often based on salary and
length of service; employers are required by law to place sufficient funds in the plan to
pay for future benefits.

The Federal government guarantees benefit payments, within limits. In contrast, a defined
contribution plan specifies contributions, or ranges of contributions, from employers and
employees. The contribution is often stated as a percentage of the employee’s salary; all
funds go into an individual account designated for the employee. The fund balance,
including investment earnings, is paid to the employee at retirement. Unlike a defined
benefit plan, the risk of investment loss in a defined contribution plan is borne by the
employee.

Hybrid plans began to emerge in the late 1980s with the introduction of cash balance
plans. Hybrid plans generally specify contributions to an account (or balance) like a
defined contribution plan, but guarantee final benefits like a defined benefit plan. Such
plans grow throughout an employee’s career and allow employees to see that growth
through an account balance.

The key difference between defined contribution plans and hybrid plans is that defined
contribution plans establish an actual account for each participant while hybrid plans use
a theoretical account that does not actually accrue funds.

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A defined contribution account accumulates the actual funds contributed by the employee
and employer, and the account changes with investment earnings and losses. The account
in a hybrid plan is theoretical and is not actually funded by employer contributions. The
employee receives credits each year and the account balance grows, but the employer
contributes to the plan as a whole (covering all workers in the plan) to ensure that
sufficient funds will be available to pay all benefits. The employer’s contribution in a
given year may be more or less than what is credited to an individual employee’s
account.

Among the first pension equity plans was the plan designed for RJR Nabisco and
introduced in 1993. BLS data indicate that, of the 22 percent of full-time private industry
workers with a defined benefit pension plan in 2000, 3 percent participated in pension
equity plans. In 1997, about 1 percent of full-time workers in larger private companies
with a defined benefit pension plan were in a pension equity plan. While the incidence of
pension equity plans remains very low, other hybrid plans have grown rapidly, perhaps
suggesting that more pension equity plans will be seen in the future. In 2000, for
example, 1 in 4 full-time private industry workers with a defined benefit pension plan
was in a cash balance plan, up from 1 percent in 1988 and 6 percent in 1997.7

Plan design

A pension equity plan is a defined benefit plan that provides an annuity or lump-sum
benefit at the termination of a participant’s employment. Pension equity plans define
benefits in terms of a current lump-sum value. Annual credits can be based on age,
service, or a combination of both. The plan determines the total benefits by providing a
"schedule of percents" that are accumulated throughout the work life of the employee.

When an employee leaves the employer, either at retirement or at any time once vested,
the accumulated percentage is applied to final earnings (defined by the plan) to determine
a lump-sum benefit.

Appendix: The following tabulation shows an example of how a pension equity plan
might accumulate percents of earnings strictly on the basis of age:

Percent of earnings
Age
accumulated

29 and younger 2.5

30 to 35 3.0

36 to 40 4.0

41 to 45 5.0

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 46 to 50 6.5

51 to 55 8.5

56 to 60 10.5

61 and older 13.5

Employees receive a percent of earnings credits for each year of service, which are
accumulated throughout the employee’s career with the employer. The total percent
(shown as a credit in some plans) is multiplied by the employee’s final average earnings.
Final average earnings generally are defined as an annual average of the highest earnings
over a specific number of years--for example the average of the highest 3 years of
earnings.

Table 1. Illustrates how three different workers would accumulate benefits under a
pension equity plan. Each employee leaves the company with the same final average
earnings (as defined by the plan), but the amount of their actual lump-sum benefit--and
consequently their annuity value--differs considerably because of differences in their ages
and lengths of service. Because the benefit credits accumulate more quickly for older
workers, employee 1 with 15 years of service at age 40 has a smaller lump-sum benefit
than does employee 3, who has 15 years of service at age 65. The employee with 30 years
of service who retires at age 65 has the greatest accumulation, reflecting both long
service and nearness to retirement age.

Employers may use alternative approaches to determining credits under a pension equity
plan. For example, an employer with multiple lines of business can adjust the percents to
accommodate many different types of workers. Table 2 shows an example of this
flexibility. In this example, the plan includes three different schedules of percents for
three different occupational groups within the same company.

Pension equity plans can vary their accrual rate based on both age and service, and they
can provide different accruals for those earning more than the Social Security taxable
wage base. For example, an employer can provide a standard age-based accrual and add
to that a smaller accrual based on service. Employees with 10 to 20 years of service
might receive an additional service accrual of 2 percent per year, while those with more
than 20 years of service might receive an additional 3 percent per year.

Defined benefit pension plans are also allowed to "integrate" benefits with Social
Security; such a provision takes into account the employer funding of Social Security
benefits up to an annual threshold (the Social Security taxable wage base). A pension
equity plan might vary its accruals for those earning less than or more than the wage
base. For example, a plan that accrued 3 percent of earnings per year for those aged 31 to

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40 might increase that accrual to 5 percent per year for those earnings that exceed the
wage base.

Distributions

While pension equity plans identify their benefits in terms of a lump sum (a percent
multiplied by final earnings), as a defined benefit plan they must make benefits available
in the form of an annuity. In practice, this annuity requirement is typically only
applicable to workers who are nearing retirement age. By law, defined benefit plans with
a value of $5,000 or less can, without the consent of the covered employee, pay the
employee a lump sum and not offer an annuity option. In a traditional defined benefit
plan, such value is determined by the present value of future benefits. In a hybrid plan,
the value is the actual account balance.

Workers whose account value is greater than $5,000 must be offered the option of an
annuity; in fact, the standard form of benefit for a married employee must be a joint-and-
survivor annuity. Only if both the employee and spouse waive the right to a joint-and-
survivor annuity can the benefit be paid out in another way, such as a lump sum.
While hybrid plans are designed to allow workers to know the value of their retirement
benefits at any time, and to have easy access to the lump-sum value of those benefits
should they leave their employer, receipt of retirement benefits prior to retirement age
can have adverse tax consequences. Such distributions are considered taxable income in
the year they are received. The distribution may also be subject to a 10-percent Federal
tax penalty for early receipt of retirement benefits, depending upon the employee’s age.
To avoid such taxes, the employee terminating employment and moving on to another job
can roll over the lump-sum benefit into an Individual Retirement Account (IRA) or a
retirement plan sponsored by a future employer.

Pension equity plan advantages

The ability of employees to know the current value of their plans at any time is one of the
advantages of pension equity plans. Another perceived advantage is that there is no
reduction in benefits due to early retirement. This means that if a worker terminates his or
her employment before normal retirement age, but has fulfilled the vesting requirements,
the benefit will reflect the length of time worked. In contrast, a traditional defined benefit
pension plan specifies periodic pension distributions as the amount available at normal
retirement age. Employees receiving benefits before that age typically receive lower
benefits to account for receiving benefits over a longer expected lifetime.

While this early retirement "reduction" is considered a penalty by some, it is in fact

merely an adjustment based on life expectancy. (Some employers subsidize that
adjustment by making the reduction less than a true actuarial reduction.) No such
adjustment occurs in a pension equity plan. Because benefit accruals typically rise with
age, however, the pension equity plan formula already has adjustment for age built into
the accrual formula.

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While pension equity plans and cash balance plans share methods of accumulating value,
a major difference is the earnings used to determine the benefit. Cash balance plans
specify a credit each year, based on that year’s earnings. By contrast, in a pension equity
plan, the credits are applied to final earnings. This feature provides built-in inflation
protection. Regardless of whether an employee has just a few years of service required
for vesting or has worked under the plan an entire career, benefits are based on earnings
at the end of the employee’s career.

Through its annual benefits survey, BLS has tracked the change in retirement plans over
time, from traditional defined benefit to defined contribution to hybrid plans. BLS will
continue to monitor and report on the incidence of pension equity plans.

Comparison of features of Pension Equity Plans and Cash Balance Plans

Feature Pension Equity Plan Cash Balance Plan

Benefit formula Percent of earnings, may vary Percent of earnings, may vary
by age, service, or earnings by age, service, or earnings

How benefits are Percent of earnings, as Dollar amount (benefit

accumulated determined by the benefit
formula, are accumulated each
year, but the final benefit is not
determined until employee
leaves the plan
formula times earnings)
placed in hypothetical account
each year; interest on account
balance also credited each
year

Definition of Total accumulated benefit Percent applied to each year’s

earnings applied to final earnings, as earnings
defined by the plan; final
earnings typically those in last
3-5 years before retirement

How to determine Employees can multiply their Account balance is the current
value of benefits accumulated percent of earnings benefit
for current times their final earnings as
employees defined by the plan to determine
their current benefit

Distribution Specified as a lump sum, but Specified as a lump sum, but

can be converted to an annuity can be converted to an
annuity

By L. Bernard Green

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He is a graduate student in economics at Florida State University. During 2001 and 2002,
he worked as an intern in the Division of Compensation Data Analysis and Planning,
Bureau of Labor Statistics.

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