POSITION PAPER Remedying the Principal-Agent Problem in the Public Sector By Charlie DeWitt, Vice President Business Development, Kronos Incorporated
Since the dawn of civil service, regardless of culture or era, public sector service providers have often been labelled inefficient, wasteful, and even corrupt. Which raises the question, are public sector entities indeed as bad as their historic reputation would indicate? And if they are, why would taxpayers put up with the wasteful expenditure of such a large amount of money? The public sector workforce generally represents the largest component of most municipality, state agency, and school district budgets. 1 When summed over all of the public sector entities in the U.S., the cost represents trillions of dollars. 2 There isn t a city in America today that isn t facing the challenge: Costs are growing faster than the tax base. As a result, cities are being forced to increase taxes while simultaneously reducing services. For the average citizen, this seems like an unfair bargain: They are paying more and getting less. When you add the spotlight provided by the media on examples like overtime abuse that results in high salaries, large sick leave payouts, and pension spiking and padding, it s only natural that the result is a high level of public frustration. The impression left by investigative reports of fraud or abuse is one of poor stewardship or corruption. City employees in Phoenix, Arizona, have increased their pensions by more than $12 million annually by adding payouts for unused sick leave, vacation time, bonuses, and cellphone allowances to their base pay at the end of their careers. As a result, more than 25 retirees earn more in retirement benefits than they did while working. Overall, pension boosting in Phoenix has increased average pension payments by 18 percent. 3 In St. Paul, Minnesota, late-career overtime is leading to charges of pension spiking. While average pay increases of about 4.75 percent are expected in an employee s final years, nearly 90 percent of fire department employees who retired since 2008 had pay increases more than double that rate. 4 1 Contain Personnel Costs, Government Finance Officers Association, accessed April 16, 2014, http://www.gfoa.org/index.php?option=com_content&task=view&id=1281&itemid=511. 2 2012 Public Employment and Payroll Data, 2012 Census of Governments: Employment, accessed April 16, 2014, http:// www2.census.gov/govs/apes/12stus.txt. 3 Pension spiking may cost Phoenix $12 mil per year, AZ Central, October 17, 2013, http://www.azcentral.com/community/phoenix/articles/20131015pension-spiking-may-cost-phoenix-mil-per-year.html. 4 MaryJo Webster, Mara H. Gottfried, Christopher Magan, Public pension spiking : Overtime hours soar for St. Paul fire supervisors, twincities.com, March 5, 2013, http://www.twincities.com/pensions/ci_22148782/public-pension-spiking-overtime-hours-soar-st-paul. 2
DEFINING THE PRINCIPAL-AGENT PROBLEM Economists have been studying this kind of problem for years. It s so pervasive and difficult to resolve that they have a name for it: the principal-agent problem. It typically arises under three conditions. The principal-agent problem is more severe in the public sector in part because public sector workers cost 45 percent more than their counterparts in the private sector. 1. There is an agent who is working on behalf of a principal. In the public sector, the agents are the employees and managers and the principals are the administrators and elected officials who are in turn working for the ultimate principal, the taxpayer. 2. The agent and the principal have conflicting interests. With regard to the workforce in the public sector, the principals are interested in offering a full day s pay for a full day s work, whereas the employees and managers are often incented to maximize their short-term and long-term paychecks. 3. Asymmetric information exists. Asymmetric information is an economic term that essentially states that some parties have better informationthan others. In this case, employees and managers have better information about the day-to-day work, allocation of resources, and amount of money that should be due them than do administrators and taxpayers. Principal-agent problems are pernicious and pervasive. They are not so much about poor stewardship or corruption as they are about human nature. It s safe to assume that a public sector organization of any size will have all of the conditions necessary for a principal-agent problem to exist. The players Conflict of interest? Asymmetric information Principal Taxpayers and city leadership Fair day s pay for a fair day s work Data is overwhelming, if available at all. Reliance on after-the-fact, aggregated reports and trust. Agent Managers and employees Maximize individual paychecks Each agent has detailed information. Agents know if their pay is justified. 3
Problem inflated in the public sector? The principal-agent problem is more severe and more sensitive in the public sector than in other industries. More severe, because a larger percentage of the overall cost of running a public service is related to people and therefore the financial impact can be very significant, with public sector workers costing 45 percent more than private sector workers. 5 More sensitive, because the problem is not isolated to a single entity: it affects every taxpayer. The lack of control and perceived unfairness provokes the ire of the average citizen. Common workplace situations illustrate the nature of the problem: Reducing one hour of overtime today saves $300 in pension obligation. 6 An employee is mistakenly overpaid. He knows his pay is incorrect. Does he report it? Over the years it has become common practice for a particular supervisor to play favorites with overtime or approve overtime that might not be called for. An employee forgets to enter a vacation day. The supervisor misses it. Does the employee ensure that the vacation day is accounted for? A 30-year veteran is approaching retirement. The common, but unpublicized, practice is to reward longtime employees with gratuitous overtime in order to inflate their last few years of earnings (used for pension calculation). A department takes care of its own. If an employee is late for work or needs to leave early, one of his buddies punches him in or out at the scheduled time. While each of these acts taken on their own seems fairly insignificant, the sum of this behavior over long periods of time creates a big financial drag on any public sector entity. It s death by a thousand cuts. Public sector leaders need to ask: Does my organization have one or more of these problems? How would I know? If I do have a problem, can it be solved? It s worth asking whether the problem can simply be attributed to a few bad employees. In most cases that doesn t tell the whole story. The majority of public sector employees are hardworking and have a solid record of achievement. It s simply human nature that, having recognized that certain behaviors are not visible or acted upon by their employers, some employees will take advantage of them. 5 Chriss Street, Government Workers Cost 45% More Than Private Sector, American Thinker, March 13, 2014, http://www. americanthinker.com/blog/2014/03/government_workers_cost_45_more_than_private_sector.html. 6 Assumes 20 years of pension payments, 6% discount rate, 50% of overtime attributed to the pension calculation, paid in annual installments. $1 spent today has an NPV of $1 + $5.73 to a government. If an incremental hour of overtime is given to an employee retiring the following year rather than an employee who isn t. Employee earning paid overtime at $45 an hour where that overtime wage is included in the pension calculation, NPV is $45 + ($45*$5.73) = $302.85. 4
WHEN THE COST OF DOING BUSINESS IS TOO HIGH Economists have devised many potentially clever solutions to the principal-agent problem, several of which involve addressing the conflicting-interest piece of the problem, by using incentives. Historically this made sense because the asymmetric information piece of the problem was considered too costly and difficult to resolve. When administrators have visible access to the same information, in real time, that employees and managers have, instances of time-related fraud and abuse will disappear. The problem is not that the information does not exist. It does. But commonly it s trapped in paper systems, reported in monthly or departmental aggregates, rife with bad data, and highly variable and complex. All of which makes it very difficult to detect, at a glance, if abuse is actually occurring. How can administrators tell the difference between good overtime and bad overtime? Anyone who has a received a FOIA request knows firsthand that it can be incredibly time-consuming and difficult to gather and analyze employee time-related data to locate problems and exponentially more difficult to proactively manage on an ongoing basis. Administrators have traditionally dealt with this challenge by focusing on providing topnotch service to citizens rather than spending valuable time and resources chasing down potential abuse. They consider the problem to be a cost of doing business, similar to shrink in retail or bad debt in the financial industry. Restoring confidence and accountability But what if a city, state agency, or school district could solve the asymmetric information problem in a highly cost-effective and even easy way? What if administrators had visible access to the same information, in real time, that employees and managers have? The answer is obvious. Instances of time-related fraud and abuse would melt away. Advances in business intelligence, integration, databases, visualization, storage, and data warehousing have led to one of the hottest buzzwords in technology today: big data. But realistic big data use cases, ones that can be acted upon today, drive real hard dollar value, and aren t quixotic or futuristic, are hard to come by. Using analytics as part of a workforce management solution allows you to consolidate operational, financial, and workforce data, so big data can deliver the visibility and insight needed to solve the principal-agent problem. With accurate, accessible, and actionable data at their fingertips, the public sector can make progress on the intractable problem of asymmetric information. 5
HOUSTON RESTORES SYMMETRY TO TIME AND LABOR DATA The city of Houston is using Workforce Analytics to find a solution to the principal-agent problem. By changing the way information on time and labor is reported, executives and managers can now understand, in real time, the decisions people are making and how they impact services and pay. With everyone in the city now having the same visibility into how labor dollars are used, three significant benefits have emerged. First, the symmetry of information between city managers and employees prevents employees from operating in gray areas of pay and work policies. Second, alerting managers to costly situations before they have a big impact on the budget means supervisors aren t overloaded with information, but can easily access the details they need to make better decisions. Finally, the transparency and accountability of decisions reduces favoritism and increases fairness to all employees, leading to higher levels of citizenry services and satisfaction. CONCLUSION Workforce management delivers immediate short-term effects in labor budgets and reduces long-term obligations such as pensions. When information about employee time, attendance, and leave can be easily accessed and analyzed by managers at all levels of an organization, incentives and opportunities for workers to break the rules are removed. People tend to behave the way they are supposed to when they know someone is watching. The result? Entities solve the seemingly unsolvable human nature problems associated with time-related fraud and abuse. They eliminate asymmetric information associated with the public sector s largest expense and provide transparency and accountability. And repurpose millions of dollars of waste and inefficiency into better serving the public and garnering their trust. We feel that our workforce management solutions represent a real opportunity to make a meaningful difference and would love the opportunity to discuss this further with public sector executives and managers. www.kronos.com 2017 Kronos Incorporated. Kronos and the Kronos logo are registered trademarks and Workforce Innovation That Works is a trademark of Kronos Incorporated or a related company. For a full list of Kronos trademarks, please visit the trademarks page at www.kronos.com. All other trademarks, if any, are property of their respective owners. All specifications are subject to change. All rights reserved. PS0229-USv2