Managerial Economics & Organizational Architecture 6th Edition by James Brickley , Clifford Smith ,Jerold Zimmerman

Exercise 13

The University of Rochester used to pay all faculty a 10 percent bonus as a substitute for a retirement plan. Individuals could either place this money in a retirement fund or keep the cash. Placing money in the fund deferred taxes on the income until the point of withdrawal. Changes in the United States tax code forced the university to change this policy. In particular, employees cannot be given options of this type but must either be covered or not covered as a group. The university now has the following policy. All new faculty members without prior service at another university are given a 10 percent bonus in cash. This payment is treated as ordinary income for tax purposes. Most new faculty are young people fresh out of graduate school. All faculty members with more than 2 years of service must place the bonus in a retirement account. Taxes are deferred until withdrawal from the account. Explain why it might make economic sense for the university to have such a two-group plan, rather than treat all employees (old and new) the same.