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Valuing Employee Benefits

The four principal approaches for valuing benefits are:

• Actual cost
• Perceived value by the employee
• Employee's cost to provide the same benefit
• Standardised cost for the employer.

Follow the links to each link for a summary of the approach, the advantages and disadvantages. The Hay Group Benefit Valuation Methodology (BVC) uses the Standardised Cost approach, as this best enables us to compare the benefits provided by different organisations. For more information, contact Peter Boreham at Hay Group, on 020 7856 7146.

1. Actual Cost

The 'actual cost' is the hard cost incurred by the employer to provide each benefit. It therefore reflects

• employee demographics
• employer's purchasing power for different benefits
• funding patterns (e.g. in a pension fund with surplus assets the actual cost in any one year may be zero - as no further funds need to be injected)
• tax payable by the employer on the provision of benefits and, if net cost is looked at,
• corporation tax deductions allowed on benefit expense.

Advantages of using a methodology based on actual cost are:

• exchange of one benefit for another or for cash can be determined on a cost-neutral basis for the specific employer (marginal cost may need to be investigated to ensure full cost-neutrality)
• the saving obtained by abolishing (or the cost of adding) benefits can be accurately determined.

Disadvantages are

• the same benefit will be valued at a different cost for two different employers
• the current cost-structure can be complex - and may be affected by changes in the packages offered thus defeating the cost-neutrality feature shown above.

This methodology is therefore best suitable to decide the impact of flexible benefit provision or changes in benefits on a particular employer's cost given the current employee population. Another application would be the comparison of operating costs between different organisations. It can also be used for a single organisation to compare competitiveness of benefits provided. In this case the sponsoring employer's cost structure should be used to value not only the benefits provided by the sponsoring employer, but also those provided by all comparators. 'Competitiveness' in this case is assessed in terms of equivalent employer cost, not in terms of the employee's actual replacement cost or the value - in terms of 'what would I pay for this benefit?' in the eyes of the employee.

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2. Perceived value by the Employee

This is the value of the benefit in the opinion of the employee. It is not the money needed to replace a particular benefit, but the amount of money that the employee would be willing to give up in order to receive the benefit. It therefore reflects the subjective judgement of each employee.

Advantage

• the resulting value for each benefit gives the amount of money that an employee is willing to give up for this benefit, so gives an accurate indication whether money is spent to the best effect

Disadvantages

• the value is highly subjective so does not lend itself for comparison purposes between employees or organisations
• there is no guaranteed connection between the cost of providing a benefit or replacing it with this perceived value
• the perceived value may depend on current circumstances which can change rapidly (e.g. private medical insurance mayhave no value for an employee who believes him/herself to be in excellent health until problems occur)

The best application of this methodology is as a supporting measure to decide on which benefits to offer or suitable cash alternatives for a benefit which an organisation wants to phase out.

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3. Replacement cost for the Employee

This is the value received by the employee in benefits measured in terms of the (typically, gross) cash that would need to be paid to enable the employee to buy an equivalent benefit in the open market. It is normally based on a 'typical employee' situation to allow employee tax and funding costs to be determined in a single model.

Advantages

• the resulting total benefit value gives a measure of the alternative cash allowance that is sufficient to replace all benefits, so can be used for comparisons between different packages
• it gives a positive value to benefits which are not subsidised by the employer but where the employer can obtainbetter terms than a single employee (e.g. group discount schemes for private medical insurance)

Disadvantages

• the methodology yields a higher value for tax-efficient benefits than those which are tax-neutral or not tax-efficient. This can yield to an additional unit of benefit to be valued higher than the base unit (e.g. for UK pensions which are only tax-effective up to a certain amount) and could give different values for the same benefit depending on how the benefit is delivered
• incorporating tax in the value can yield to less transparency of the results as a different mix in benefits willbe both reflected in tax and benefit value itself
• replacement of the benefit may not be possible for any particular employee because of personal circumstances (e.g state of health) so the underlying assumption of cash equivalence to replace benefit may not hold in practice
• the total value is likely to be higher than the employer cost of delivering the package - it is therefore unlikely that the employer would be willing to offer a pure cash package of the same amount
• whilst the value reflects tax in the situation of 'each benefit or cash', it does not reflect the correct balance between benefits for the purposes of interchange between benefits.

The methodology is particularly suitable to determine whether it is better to introduce a certain benefit or to pay in cash.

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4. Standardised Employer Cost of the Benefit received by the Employee

This is the cost a typical employer would incur through the provision of each benefit. It can be calculated net or gross of employer taxes payable on the benefits.

Advantages

• this methodology gives the same value to benefit packages that are different in design but can be provided by the employer for the same cost. It therefore reflects realistic options for the employer to change the benefits mix
• the value can be used for a group of employers with different cost structures to compare the values of their respective benefit packages on a like-for-like basis without having to replicate each employer's cost-structure and doing multiple comparisons
• when added to cash payments, the total value is the employer cost for cash and benefits together exclusive of employee contributions and gives a measure of a realistic alternative total cash package on offer.

Disadvantage

• the value does not reflect the amount of money a typical employee would need to replicate the benefit package on offer

This methodology lends itself particularly well to competitiveness comparisons - based on a typical employer cost which reflects a realistic framework within an organisation could address mix and level of packages offered. The tax-efficiency for the employee of having certain benefits provided can be addressed separately through fairly straightforward commentary.

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Hay Group Benefit Valuation Calculation

Interest in benefit values, and the associated concept of Total Remuneration (cash pay plus benefit value), comes from those wanting to apply professional management tools to benefits and total remuneration policies. Managers are looking for a way of managing benefits similar to that used for pay i.e. answering the question of how much to provide relative to other organisations for the same job or job size.

Two categories of organisation are most concerned. First, those who now provide more valuable benefits than average. They may want to show management and employees the financial impact of these in order to justify a total remuneration package. Second, those who now provide less valuable benefits than average, who often want to keep those low benefits but need to be able to defend their lower value against criticism by ensuring that employees get sufficient cash remuneration to compensate.

The purpose of the Benefit Value Comparison is therefore to enable compensation managers and general managers to compare on an objective basis the package of employee benefits their organisation provides with benefits packages provided by other organisations, and similarly to compare the total remuneration package, cash plus benefits, with other organisations. Comparisons between organisations are based on the employer's stated basic policy, but the same methods can be used to compare the remuneration packages of individuals within an organisation, or in different organisations. Benefit Value Comparison also enables compensation managers to assess the effects of changes in the pay and benefits package on the competitive position.

The Valuation Process

In order to compare the different complex benefit packages provided for different jobs we need to find a way to add life cover to pensions to cars and so on to produce a single index for the whole package. The Hay Benefit Value Comparison, or BVC, is a process of calculating a money equivalent for each benefit, building up to a total value for the whole benefits package.

A common set of assumptions is used for valuing the benefits provided by all employers in the comparison, eliminating factors such as bulk buying power or pension funding history. All benefit features of any significant value are taken into account - over 60 features in all.

The approach used is to calculate a theoretical or standardised cost of providing each benefit. BVC measures the benefit that gets through to the employee, not the actual amount the employer is spending to provide the benefit. This is particular important in the case of pensions:

• the pensions schemes in two organisations may provide identical benefits from the point of view of employees, but havegreatly different employer contribution rates because one fund has a surplus and the other a deficit for historical reasons. BVC assigns the same value to both schemes;

• National Insurance pension benefits are identical for all those earning over the upper earnings limit who are contracted out, and for all those who are contracted in. BVC values the benefits, not the National Insurance contributions which are now paid by the employer on all earnings.

Using standardised costs means the BVC can be used by employers to help assess the cost of changes to their benefits policy - if Benefit Value is £500 below Median then a new benefit costing about £500 should bring Benefit Value up to around Median. For this reason no account is taken of tax advantages to the employee (e.g., with company cars) and no value is attached to benefits that generate no cost to the employer (e.g., the option to contribute for better benefits, flexitime).

Some benefits are particularly controversial in their value - some pensions aspects such as pensions increases after retirement have been valued very differently by different actuaries in the context of comparing inflation-proofed public sector pensions with private sector pensions, and cars with their valuable tax advantage can be valued on a wide variety of assumptions. The BVC uses assumptions that are close to the middle of the range of reasonable possibilities. Where a practice is very different from other organisations, e.g. no job status cars, then this should be taken into account when reviewing the value of the total package.