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Deflating Compensation

October 1, 2004
Related Topics: Variable Pay, Compensation Design and Communication, Featured Article, Benefits

If your salary-increase budget for 2005 is much higher than 3 percent, you’re probably overspending. New survey data indicate that increases at large companies will average 3.5 percent next year, marking the fourth consecutive year of increases below the 4 percent average that characterized budgets before the economic downturn. Projected budgets commonly overshoot actual increases by 10 to 20 basis points, so actual 2005 increases will come in at 3.3 percent to 3.4 percent. For employers beyond the reach of the salary surveys, wage growth will be lower. Broader data show pay increases closer to 2 percent for the first half of 2004 and still headed down.

    Salary budgets at Pitney Bowes, the mail and document giant based in Stamford, Connecticut, reflect the broader trend. The company’s pre-recession annual salary-budget increases were 3 percent to 4 percent, but increases dropped to 2 percent to 3 percent during the economic downturn and remain there for its 24,000 U.S. employees. Although Pitney Bowes has restored profitability, concern about labor costs lingers, and the company has explicitly tied salary increases to top-line revenue growth rather than bottom-line profitability.

    "Pitney Bowes is moving forward in an aggressive growth strategy, but growth is not flying off the charts," notes David Hom, vice president, employment brand and total rewards. "Our revenues tend to be fairly consistent, so we must manage total expenses against moderate revenue growth." Adds Johnna Torsone, chief human resources officer, "Our management has communicated to our employees that our future success would not be well served if compensation were to grow at a rate faster than the rate of growth for our company." Although Pitney Bowes is holding salary-budget increases below the already weak national average, turnover has not increased.

    Across all sectors, wages followed productivity and profits down into the trough of the 2001 recession, but have not joined them in recovery. As the economic expansion now enters its fourth year, flat wages can no longer be explained entirely by lags in the labor market. The uncoupling of wages from productivity and profits in this business cycle now raises the question of whether the downward shift in pay marks the beginning of a permanent trend. Given the extraordinarily rapid growth of automation and information technologies and the globalization of production, the answer may well be yes, with far-reaching implications for compensation planning and workforce management.

    Lower pay levels also carry consequences for the economy as a whole. Workforce-management executives may view their annual salary-budget meetings as tedious events in the life of the company, but the aggregate impact of the decisions they make is profound. The flat budgets and falling real wages of the past few years have now surfaced in low national savings rates, high personal debt and the 3.4 percent decline in median household income since 2000. Labor’s share of the profits generated in this recovery is the lowest on record. With corporate expectations for revenue growth and profitability now drifting down from the peaks reported earlier this year, pay levels and living standards may be stuck where they are for some time to come.

    Like Pitney Bowes, CUNA Mutual Group, a credit union financial services provider, took a pounding in the recession. The company reported a net income loss in 2002. It imposed a wage freeze in 2003, trimmed the workforce and adjusted benefits. "We set our salary budgets according to national and industry projected salary-increase budgets and affordability based on business performance," says Connie Kielty, senior manager for corporate compensation. "We communicated to employees that if we couldn’t get the cost reductions that we needed, the workforce reduction would be much higher." The labor-cost reductions helped the company achieve its best business year ever in 2003, with revenues up 6 percent to $2.4 billion and record profits.

    In 2004 CUNA Mutual adopted a 4.5 percent salary-increase budget for its nonunion employees and proposed a 4 percent increase for its unionized workers, below the inflation rate when averaged over 2003 and 2004. "We communicated that salary budgets were projected to be 3.5 percent nationally and regionally for 2004, and that a 4.5 percent budget is above the competitive level," Kielty says. "We believe that we now have market-competitive pay levels." Although a majority of the company’s 6,000 employees are based at headquarters in Madison, Wisconsin, where unemployment is extremely low, turnover has not increased.

Uncoupling wages
    In the aftermath of the recession, inflation-adjusted average wages moved through a period of disinflation, or a slowing of the rate of increase, until July 2003, when rising consumer prices pushed real-wage changes into negative numbers and actual deflation began, according to data from the Bureau of Labor Statistics. Salary budgets for 2005 foreshadow ongoing disinflation in some industries and outright deflation in others. Surveys from Mercer Human Resource Consulting and WorldatWork show projected salary-increase budgets averaging 3.5 percent for 2005, roughly duplicating the budgets for 2004. These two surveys represent a combined total of 4,374 companies with 27 million U.S. employees, or one-fourth of the private-sector workforce.

"We communicated to employees that if we couldn’t get the cost reductions that we needed, the workforce reduction would be much higher."

    Salary-budget surveys are generally skewed toward large employers and now understate the broader deflation trend documented by data from the Bureau of Labor Statistics. For the year ending June 2004, private-sector wages and salaries rose by an average of 2.6 percent, below the CPI increase of 2.8 percent for the same period. Additional data from the BLS and industry-specific surveys point to extraordinarily severe deflation in hard-hit industries such as information technology. Salaries for many IT jobs fell 20 percent to 30 percent as the industry shed 775,000 jobs in the two years following the recession. With a substantial portion of IT jobs marked to move offshore within the next few years, IT salaries are still falling and will not recover, according to Foote Partners. Most employers covered by the salary-budget surveys have maintained inflation-adjusted pay levels but jettisoned wage improvements—the traditional increase above inflation that reflects labor’s share of rising productivity and fuels a rising standard of living. "Historically, salary-increase budgets average 1 to 1.5 points more than inflation," notes Steven Gross, leader of the U.S. compensation consulting practice for Mercer Human Resource Consulting. "In the late 1990s, budgets averaged 2 points above inflation, so we had real wage and salary growth of 2 points." In 2004, the wage improvements documented in the budget surveys will be less than 1 point. Given the forecasts for 2.5 percent to 3 percent inflation in 2005, improvements will remain below 1 point next year.

Behind the low budgets
    Salary budgets for 2004 and 2005 more closely reflect lasting structural changes in the competitive landscape than the cyclical factors that largely determined wage levels in the past. The most powerful and obvious force behind flat salary budgets is the unprecedented and seemingly noncyclical softness of labor markets through the recovery period. Soft markets will continue into 2005 and well beyond in many sectors, according to forecasters and projections from the BLS. Forecasts for next year put unemployment at 5.2 percent to 5.6 percent, just below the 5.7 percent projected for 2004. Annual pay increases designed for optimal hiring and retention are no longer needed. "There is no war for talent," Gross says. "And there are still concerns about profits among employers."

    Substantial downward pressure on wages also derives from changes in the industrial and occupational mix of jobs in the United States and the gravitation toward a low-wage nation of retailing and unskilled service jobs. This structural change will continue to hold wages down even if labor markets tighten. In addition, rapid deunionization has eroded the traditional role of unions in pushing up the wage ceiling for all workers, while the dramatic decline in the value of the federal minimum wage has dropped the historic floor set by law. Also, the relentless rise in benefit costs continues to suck money out of salary budgets. The 2.6 percent increase in wage costs for the year ending in June 2004 was dwarfed by the 7.3 percent rise in benefit costs for the same period.

    "In the meetings where salary budgets are decided, the first question is ‘What is everybody else doing?’ " Gross notes. "Most companies don’t want to lose their relative position. The second question is ‘What can we afford?’ Even if a company’s neighbors are going to 3.5 percent to 4 percent, the company doesn’t want to be locked into an increase it can’t sustain. The third question, which is related to affordability, is whether the company can raise productivity or prices to offset the wage cost. If you can’t raise productivity or prices, any increase comes out of profits."

"In the meetings where salary budgets are decided, the first question is
‘What is everybody else doing?’
The second question is
‘What can we afford?’ The third question is whether the company
can raise productivity or prices to
offset the wage cost.

    Productivity has jumped 11.1 percent since the recovery began in the fourth quarter of 2001, and corporate profits are up 20 percent in the past year, but few executives expect productivity and profitability to continue to grow at the same rapid rate going forward. In many industries, global competition has permanently reduced pricing power. Although many companies have adopted variable-pay programs in an attempt to exercise greater control over wage costs, the portion of payroll devoted to these programs remains low.

    The new trend toward lower base salaries indicates that employers are more focused on introducing greater flexibility into what used to be the fixed portion of wage costs and less concerned about expanding existing variable-pay programs. It also indicates that compensation programs will be simplified as less money sits on the table and various incentives fall away. Hiring, sign-on and retention bonuses have already disappeared; stock options and complex long-term incentives are vanishing for broad employee groups.

Propping up the package
Soft labor markets have enabled companies to transition to lower pay levels without higher turnover, but markets for some positions will eventually tighten, and employee morale remains an issue. The most forward-thinking employers are reshaping employee communication and the compensation package to support hiring and retention in the absence of meaningful pay increases. "You have to weigh all your investments and let employees know why you are doing what you are doing," Hom explains. At Pitney Bowes, low turnover "is a function of employees’ valuing the full range of compensation and benefits," he says. "It’s not just about pay. It’s about the work environment, the hours, the proximity of our locations to employees’ homes and our benefit programs. Our focus is on total rewards, which includes development and training and compensation and benefits as a total package. Promotional increases and career development keep retention up."

    Pitney Bowes’ focus on career development as a third component of total compensation is an important trend. "From an employee’s perspective, the company provides pay and benefits plus career opportunities, which come in the form of training and development, promotions and lateral transfers," Gross says. "There’s an economic value to being allowed to grow in the organization, so a person may take or keep a job because the company promotes from within." Recasting career development as a noncash part of the total compensation package has a limited demographic reach, however. Older workers may not value development opportunities; nonexempt employees may not have as many opportunities.

    Marc Baranski, senior vice president at Sibson Consulting, says, "Career development is part of the value proposition, and some companies are trying to quantify the value of the training and education they provide." Although he has not encountered companies that have quantified the value of the entire career-development program, he reports that the best companies are communicating career development to employees as part of total rewards.

    More companies are also getting serious about long-discussed efforts to communicate the full value of the compensation package. In February 2004, CUNA Mutual rolled out an online total-compensation statement that provides employees with a complete picture of rewards, updated every pay period. The statements include salary, bonuses, and employer and employee contributions to health-care, retirement and other benefits. "Employees can see benefit costs, so they can see the full value of the package," Kielty says.

    To the extent that employers are able to maintain salary budgets set at or near inflation rates and to hold on to those lower budgets through all phases of the business cycle, employee expectations for annual wage improvements will diminish and the traditional upward march of base salaries will end. This result is more closely aligned with the slow-growth business environment and minimal pricing power that companies now face in the advanced economies. Lower household income and weak consumer spending may come back to bite businesses as wages drift down, but that risk seems preferable to a repetition of the beating that companies with high labor costs suffered during the last downturn. Claims that the United States is becoming a low-wage nation may be exaggerated, but the move toward lower wages is already upon us.

Workforce Management, October 2004, pp. 65-68 -- Subscribe Now!

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