The effect of separation bonuses on voluntary quits: evidence from the military's downsizing.

• Author: Mehay, Stephen L.

1. Introduction

   Despite widespread downsizing of both private firms and government agencies during the last decade, little research has been conducted on the various financial incentives used to encourage voluntary separation. Several studies have analyzed the influences of early retirement programs on an individual's retirement decision and on the optimal age at retirement (Burkhauser 1979, 1980; Fields and Mitchell 1984). Hogarth (1988) analyzed a state government's early retirement bonus program and Lumsdaine, Stock, and Wise (1990) analyzed an early retirement option offered to employees of a private firm. Other studies have developed a general method of analyzing the decision to separate voluntarily (Black, Moffitt, and Warner 1990; Daula and Moffitt 1995). But no study has linked the decision to resign by nonretirement-eligible personnel in response to separation incentives, especially when the incentives are offered during an organizational downsizing. Thus, little is known about the overall effectiveness of buyout programs in inducing voluntary separations of nonretirement-eligible personnel.

   During the post-Cold War downsizing that began in the late 1980s, the U.S. military needed to eliminate mid-career personnel, but wanted to avoid involuntary separations. Historically, military personnel have considered the military retirement system an implicit contract. Though the military pension is not vested until 20 years of service, prior to the drawdown, personnel had come to expect that after six to eight years of service they would be allowed to serve 20 years and qualify for a retirement annuity. However, the scale and speed of the military downsizing meant that some nonvested careerists, who in other times would have served until retirement, faced involuntary separation.

   To avoid imposing these pension losses on mid-career personnel and creating negative incentive effects for junior personnel, the Department of Defense offered a separation bonus to selected careerists in 1992. Two options were offered. The first, called the Special Separation Benefit (SSB), provided a lump sum payment equal to 15% of annual base pay multiplied by years of service. Unlike private firms, the military also offered an annuity option, called the Voluntary Separation Incentive (VSI), which provided an annual payment equal to 2.5% of annual base pay multiplied by years of service. The annuity would continue for twice the number of years of service. These programs replaced the equivalent of between 29% and 36% (depending on years of service) of the present value of the expected military pension for a person who would have retired after 20 years.

   This article examines the decisions of uniformed personnel to leave voluntarily under the military's separation incentive program. It focuses on the effects of the VSI/SSB bonus program on Navy and Air Force enlisted personnel in 1992, the first year of the program. In particular, we estimate the net effect on retention - the reduction in the retention rate that was induced by the program.(1)

   Two methods are used to estimate the effect of the VSI/SSB program on retention. The first method approaches the estimation problem from a "program evaluation" perspective in that we use a difference-in-differences design to isolate the program effect. That is, we use a selected period before implementation of the VSI/SSB program and the period during the program and include occupations eligible for the program and a comparison group of occupations that were not eligible. The program effect is estimated using a dummy variable, and the difference-in-differences design controls for occupation and time period fixed effects.(2) The second approach estimates a structural model of retention. The separation bonus is incorporated as a component of the financial incentives influencing the individual's stay-leave decision. We estimate the effect of the separation bonus on Navy enlisted personnel in 1992 within the framework of the annualized cost of leaving (ACOL) model, which has been applied extensively in modeling the effect of pay on separation decisions (Warner and Goldberg 1984; Black, Moffitt, and Warner 1990).

   Heckman and Smith (1995) argue that so-called "black box" program evaluation methods - estimation of mean effects using nonstructural models - are inferior to estimation of program effects using structural models, in part because the results provide little general information on fundamental economic behavior. We use both techniques here because an unbiased, relatively precise estimate of the program effect using black box estimation can provide corroborating evidence regarding the estimate from a structural model and provide a useful test of the structural model itself.

   The ACOL results provide an estimate of the effect of the financial incentive on the individual's voluntary retention decision. But there is the potential problem that individuals may have believed that if they rejected the buyout they would be involuntarily separated under less favorable financial terms. The Navy announced that involuntary layoffs would not be used. At the other extreme, the Air Force announced that layoffs would be necessary if response to the buyout program was not adequate. Air Force personnel, prior to being offered the bonus, were grouped by occupation into "tiers" based on the probability of future layoff in each occupation. We use the Air Force data to test for the effect of the threat of layoff on the individual's decision to accept the "voluntary" separation incentive. Not surprisingly, acceptance rates for the exit bonus increase with the threat of layoff.

2. Annualized Cost of Leaving Framework

   The theory underlying the ACOL model has been developed extensively in the literature (Warner and Goldberg 1984; Hogan and Black 1991; Daula and Moffitt 1995). Here, we briefly summarize the basic form of the model. In the ACOL model of retention, the individual is assumed to compare the utility of leaving the military immediately with the utility of remaining for each possible future period of service. In general, one searches over all possible lengths of stay to determine the optimal length of stay at a given decision point. The financial returns associated with the optimal length of stay are then compared with the financial incentive of leaving immediately. The ACOL value is the net financial incentive to stay. It is calculated as the annualized difference in the financial rewards from staying to the optimal leaving point relative to leaving immediately. Depending upon rank, all personnel are forced into mandatory retirement at various points between 20 and 30 years of service. The utility from staying or leaving depends on both the present value of the income stream and the present value of the monetary equivalent of any nonpecuniary aspects. The latter component is unobserved.

   In our analysis, we assume that individuals choose between leaving immediately or leaving after 20 years of service, which is the vesting point for retirement. The exit bonus is incorporated into the ACOL model by including the value of the bonus in the income stream associated with leaving immediately. This assumes (correctly as it turns out) that the separation bonus was perceived as a one-time offer.

   The ACOL value is the net financial incentive to stay. We assume that an unobserved component of the decision the net difference between the value of nonpecuniary factors associated with civilian and military life - is distributed normally with mean [Mu] and variance [[Sigma].sup.2]. Then, if the net taste for civilian life for...