Controlling the cost of severance. (Human Resources).

You've made the tough but financially necessary decision to reduce headcount. And you've set the numbers for each department or division. Now all you need to do is let human resources take it from there, right? Wrong.

First, you may be overdue for a review of the design of your severance benefits.

Second, even if you're satisfied with the structure of those benefits, how you handle the basic administration of severance pay arrangements can make a big difference--up to 20 percent--of your annual severance cost. That's due to the idiosyncrasies of state unemployment benefits, payroll tax regulations and new outsourcing opportunities.

Moreover, you can share some of those savings with departing employees in the form of more generous severance benefits.

Given the massive layoffs initiated during the current economic slump, and the prospect of more to come, the potential financial impact of changes in severance arrangements is nothing to sneeze at.

Moreover, the dollar value of severance benefits--at least for average workers--is trending downward. "Packages today for rank-and-file are less rich than you might have seen several years ago, particularly if you're getting into a second or third round of layoffs," observes Doug Tormey, senior vice president at The Segal Co. in New York.

Back to Basics

As a result, any approaches that help employers save would appear worth investigating. Any such review should begin with the most basic question: Why offer severance benefits? Since severance is not required by law, the question isn't academic. Analyzing the traditional rationale for severance pay provides a basic foundation to build from.

In a recent report on severance pay policies, Buck Consultants laid it out this way: The use of severance benefits "allows a company to maintain a positive public image by demonstrating fairness and concern for its employees, while also managing the risk of future adverse litigation. By offering severance benefits to terminated employees, companies also help to maintain positive morale and motivation for the active ongoing organization."

In a broader economic context, the availability of severance benefits facilitates a more flexible employment environment that benefits all employers, says John Challenger of Challenger, Gray & Christmas, a Chicago-based outplacement firm. "Today, we have 'no-fault job loss,' and people need a bridge to their next job."

A snapshot of the corporate severance policy landscape can be derived from a recent survey by another outplacement firm, Lee Hecht Harrison. The following data is based on 925 companies' responses:

* Just under 80 percent of employers have formal severance pay policies, which typically cover employees at all levels.

* Years of service generally is the basis for determining severance payment for all but the most senior employees.

* One week's salary per year of service is the most common tenure-based severance benefit for exempt and non-exempt employees, while two weeks is the median for officers and other executives.

* "Most" organizations offer outplacement benefits to "some employees at all levels."

Payout options

Employers participating in a different survey, sponsored by Human Resource Executive magazine, reveal the popularity of different severance payout options. The 839 employers participating were essentially evenly divided between those making lump-sum severance payments and those who distribute severance pay on a weekly or some other regularly scheduled basis.

The traditional rationale for lump-sum payment is that it enables an employer to sever ties with former employees promptly and cleanly. When ex-employees are still receiving checks, some employers express concern "about people coming back and worrying the people who are still there," says Heidi Toppel, a senior compensation consultant for Watson Wyatt Worldwide in Boston.

The lump-sum payment, in contrast, provides "finality," and may communicate that the company is demonstrably sharing in laid-off employees' financial pain by immediately surrendering a significant amount of cash.

Duration Management

But lump-sum payments deny employers the chance to control severance costs through "duration management." In particular, severance pay distributed periodically affords employers the chance to curtail payments once a laid-off employee finds a new job through the use of a "mitigation clause." Employers can give employees a financial incentive (to add to the strong emotional one) to find a new job promptly by giving them a share -- perhaps 25 percent -- of the savings in the form of a bonus.

Managing the length of former employees' unemployment is the basis of duration management. Mitigation clauses can be problematic for employers, however, when they administer severance payments themselves. "It takes time and effort to monitor mitigation," notes Segal's Tormey.

However, that task -- along with all other services related to managing a severance pay program -- can be outsourced, giving employers the savings opportunity of duration management without requiring them to monitor ex-employees' activities.

If the outsourcing company has fee incentives to maximize savings for employers via duration management. it will, of course, be motivated to help laid-off workers find new jobs. This aligns the interests of all parties: former employees seeking new jobs; the human resources department, focusing on the human side; the finance department; and the outsourcing vendor.

Following are additional features of a new severance administration outsourcing business model (see table below for savings illustration):

Payroll tax savings. Structured properly, severance benefits are exempt from FICA, FUTA (Federal Unemployment Tax Act) and, in most regions, state unemployment insurance (SUI) taxes. This can generate an 8 percent savings for employers and somewhat less for the former employee.

State benefit tie-ins. Coordinating a severance pay plan with state unemployment insurance allows employers to present a combined package that may be superior to what they would otherwise have offered.

Administrative enhancement. As with other outsourced services, companies can receive sophisticated administrative features, including database management, benefit check processing, re-employment status monitoring and responsiveness to beneficiary inquiries.

Reemployment support. As noted, duration management is an essential ingredient for savings. Thus, the outsourced service provider should offer research and administrative support to displaced employees to accelerate their reemployment. This may include traditional outplacement services.

As the numbers in the table suggest, the outsourcing model offers significant savings potential. Here, the former employee has a maximum severance benefit that could be 20 weeks or longer, yet the employer's cost is reduced by 30.1 percent.

An outsourced solution cannot do anything to eliminate the need to make staff reductions. But to the extent that it makes the best of a distasteful situation, outsourcing allows employers to concentrate on managing the fundamentals of their business -- perhaps with the ultimate result of a return to a growth mode.

Outsourced Severance Administration Savings Illustration

Company Cost & Savings                  Traditional  Outsourced
Based on 100 employees @ $1,000/week    Plan         Model

Maximum severance period (weeks)        12           20
Severance payments funded by employer   1,200,000    1,200,000
Federal employment taxes (FICA, FUTA)   91,800       0
Durational savings
(early re-employment at the 15th week)
                      (5 week savings)  0            (297,500)
Total net cost to the employer          1,291,800    902,500
Total cost as a % of traditional plan   100%         69.9%
Employer savings as % of traditional    0%           30.1%
plan

                  Employer  State         Gross   Federal     Net of Fed
Participant       Funded    Unemployment  Salary  Employment  Employment
Benefit                     Benefit               Tax         Taxes

Pre-displacement  1,000     0             1,000   77          924
 weekly salary
Weekly payment    595       405           1,000   0           1,000
 under outsource
model

Douglas H. May and Tom Brandenburger are CEO and Executive Vice President, respectively, of Stamford, Conn.-based Transition Services Inc., (www.tsisolution.com). A subsidiary of R.V.I. Guaranty Co., Ltd., TSI focuses on severance management and administrative services.