The Turnover Myth

June 2, 2005

Jeff Chambers, vice president for human resources at SAS Institute, based in Cary, North Carolina, will tell you quite frankly that measuring turnover costs is a waste of time. In another equally heretical moment, he will tell you that he doesn’t care if SAS is sued for wrongful termination. But he cares a great deal about performance management and is willing to tolerate turnover costs and the risk of a lawsuit to drive financial results.

    The overall turnover rate for the software company’s 9,300 employees is low by industry standards, but the overall rate masks the sharp truth that appears when the number is segmented. Voluntary turnover at this legendary employer of choice is minimal, but involuntary turnover is quite high.

    Total turnover at SAS for 2004 was 6.34 percent, up from 5.06 percent in 2003. What is remarkable, however, is that two out of three separations at SAS are involuntary, roughly double the common proportion. The involuntary rate jumped from 3.28 percent in 2003 to 4.15 percent in 2004.

    "Involuntary turnover is rising because we are being more aggressive," Chambers says. "We’ve removed the institutional impediments and let managers know that we want to get the right people on the bus. If employees can’t do the job, we cut them loose." Chambers believes that his performance-driven approach to turnover at SAS is clearly reflected in the company’s 15 percent revenue growth for 2004.

    Chambers’ thinking is apparently untouched by the volumes of material produced by self-proclaimed turnover experts and human resources executives who fixate on minimizing turnover in all cases and measure its costs down to the last dime. The single-minded focus on turnover reduction sold well during the "war for talent" in the 1990s and spawned a mini-industry of consultancies, conferences and cost calculators that reinforced the perception of turnover as a money-sucking evil. Turnover reduction became an end in itself, disconnected from business outcomes.

    The current economic environment requires a far different approach, however. Like many workforce trends, turnover rates track employment growth. In this new era of ongoing soft labor markets and unusually low quit rates, the pressing issue at many companies is not whether voluntary turnover is too high, but whether it is too low to provide opportunities for introducing new talent and resetting salaries. And with a heightened fear of wrongful termination lawsuits emanating from the general counsel’s office and increasing managerial reluctance to discharge poor performers, involuntary turnover may be too low to ensure the high-performance workforce needed to meet global competition.

    Achieving optimal turnover means understanding both the financial costs and gains incurred as well as controlling who stays and who goes. Although many workforce management executives are satisfied with simply minimizing turnover and measuring it against broad industry benchmarks, others have mastered turnover as a tool for achieving a maximum return on the investment in human capital.

Aggressive approach
SAS’ aggressive stance took shape after a massive infusion of new talent during the dot-com crash, when the company snapped up talent by hiring 600 highly qualified employees who had been laid off at other firms. Adding these new people raised the performance bar in some areas. The recent increase in involuntary turnover reflects the terminations of new hires who were not a fit and of existing employees who could not meet the higher standards.

    "We considered a forced ranking and other techniques, but decided to leave it up to the managers to get rid of poor performers," Chambers notes. "But we did remove the institutional shackles that keep managers from acting. The biggest shackle was related to budgets. We typically slow down hiring toward the end of the summer, and managers were afraid they would lose the position if they terminated an employee." Human resources solved the problem by making it clear to managers that the positions would be preserved.

    Chambers was general counsel at SAS before he was appointed to head up human resources in 1999, so he understands the risk of litigation. When terminations are necessary, "human resources has to commit to doing what’s right and help managers deal with it," he says. "I don’t care if we get sued; I care if we win. We give employees with performance problems a chance to correct the problem, and we do that in a way that any third-party fact-finder or agency can understand." In 80 percent of the cases, the low performer corrects the problem, but in the remaining 20 percent, the company acts decisively.

    James Hatch, partner at PricewaterhouseCoopers-Saratoga, believes that most human resources executives make it far too difficult for managers to terminate low performers. He also believes that human resources overestimates the potential for employee lawsuits. "High-performance companies look at the bottom of the deck every year and take out the bottom 2 percent to 5 percent," he says. "Most companies terminate only 1 percent of employees on an annual basis. It’s difficult to deal with performance-related terminations, so companies wait for a downturn and sweep employees with performance problems into the layoffs."

Optimal turnover is not the lowest turnover you can achieve. Optimal turnover produces the highest long-term levels of productivity and business improvement." --Jamie Hale, senior consultant and leader of the workforce management practice for Watson Wyatt

    This practice undercuts the message that the organization is performance-driven. At SAS, Chambers uses turnover to reinforce the company’s performance culture.

The financial threshold
    While low overall turnover rates suit SAS’ purposes, high overall rates generate the greatest financial returns at IndyMac Bank. Overall turnover rates at the Pasadena, California-based bank have averaged nearly 30 percent for the past three years, ranging from highs well above 40 percent for sales and operations staff to the low teens for professionals and management. The bank’s overall rate is five to 10 points above industry benchmarks. According to traditional turnover analysis, IndyMac should be hemorrhaging money. Instead, it outperforms its competitors by substantial margins and reported 23 percent earnings growth in 2004.

    Jeffry Higgins, vice president for performance management, accountability and compensation at IndyMac, can tell you the average turnover rate for a bank teller with a "meets expectations" performance rating, or a programmer with an "above expectations" rating. In fact, he can tell you the turnover rate for every position at every performance level for the bank’s 5,000 employees.

    Most important, he knows the exact point at which the costs of turnover for any position are canceled out by savings that are rarely documented in turnover analyses. With this knowledge, Higgins runs a performance-driven culture with extraordinarily low turnover rates for top performers, high turnover rates for low performers and superb financial results for the company.

    Higgins did not reach this point through a careful reading of turnover studies. His initial research on turnover turned up little of value. "At IndyMac, we searched for wisdom on turnover for three years," he recalls. "After reading the literature, we were not only unsatisfied, but frustrated. Most of the numbers and approaches we have seen don’t hold up under financial scrutiny. There are financial benefits to turnover, but none of them are reflected in any organizational or analytic tool." Financial analysis stands at the core of Higgins’ work; he was a CFO before he signed on at IndyMac.

    Higgins’ quest is to identify the true costs and benefits of turnover and use that data to drive performance management. He is building workforce segmentation tools, beginning with the top seven job categories and then digging deeper to create turnover profiles for 30 job families.

    "Based on three years of company data, we know that there is a break point where the financial benefits of turnover outweigh the costs," he says. "It’s different for each job category and for performance levels within each category, but it can be calculated and documented for any position in the company."

    Optimal turnover rates for any position lie within a range that Higgins describes as green-yellow-red. The green band covers the rates at which turnover is financially beneficial for the firm. Within the yellow band, turnover is cost-neutral and has minimal impact on the organization. This is the broadest band. Beyond this, as turnover climbs to higher levels and into the red band, it begins to significantly hurt the organization.

    Turnover in low-impact, nonexempt positions within operations, for example, generally falls into the green and yellow bands, where high turnover is acceptable. When an employee leaves one of these jobs, other employees pick up the workload for the 30 to 60 days that the average position is open, and the bank pockets the savings--plus additional savings when an annual bonus is not paid out or when a replacement is brought in at a slightly lower salary level.

    But at the opposite end of the spectrum, turnover among high-impact professional and managerial employees can cause a six-month delay in a multimillion-dollar project. "For high performers in key roles, the cost of turnover is larger than any estimate I’ve seen," Higgins says. "It could run into the millions."

    Finding the financial threshold for each position hinges on two factors: the performance level and the compensation level, including how the position is paid relative to market. The performance level is weighted by specific productivity measures that may include sales, volume or projects completed on time and within budget. The bank uses steep performance-based pay differentials to maintain low turnover among its high performers and high turnover among its low performers.

As Unemployment Rises, Turnover Falls

Turnover generally rises during economic expansions and falls during recession, in an inverse relationship to the unemployment rate.

Source: Turnover rates from the Bureau of National Affairs Inc.; unemployment rates from the Bureau of Labor Statistics

Resetting pay
    One of the largest financial benefits of turnover is that it provides a rare opportunity to reset salaries.

    "Driving turnover among employees who have reached the high end of the pay structure generates substantial cost savings because the company can typically bring in a replacement at a lower rate or promote from within and lower the rate for that employee’s replacement," says Jamie Hale, senior consultant and leader of the workforce management practice for Watson Wyatt in Dallas.

    In addition, employers who are able to negotiate two-tier pay systems or reduce benefits for new hires can boost turnover with buyouts or bonuses to move more employees into the lower cost structure. When Safeway Inc., the giant grocery retailer, installs a two-tier wage plan in one of its locations, for example, it often offers buyouts to workers at the higher wage level and brings in new employees at the lower scale. Employers must ensure that their two-tier pay and benefits systems and buyout programs do not create a pattern of discrimination, but the substantial savings generated justify the cost of a careful review.

    An extraordinarily effective program for using turnover to reset salaries stemmed from a detailed analysis of turnover by the Texas State Auditor’s Office. At the request of the Legislature, the auditor’s office conducts an annual analysis of turnover among the state’s 143,000 employees. The state’s overall turnover rate of 14.8 percent for the 2004 fiscal year is not far out of line with the relevant benchmarks, but the state suffers from two common problems: Turnover among young employees is too high and turnover among retirement-eligible employees is too low for maximum cost-effectiveness.

    "The audit found that on an annual basis, an average of only 3,000 employees retire out of a pool of 12,000 to 14,000 retirement-eligible employees," says Floyd Quinn, a human resources consultant in the auditor’s office who heads up the turnover analysis team. Faced with large budget deficits and high salary costs, the state launched an incentive program to encourage retirements. Employees who retire within one month of eligibility receive a bonus equal to 25 percent of their annual salary.

    When the employee retires, the state cuts the salary for the position by 35 percent, so the long-term cost savings generated by retirements are huge. When an employee retires from a position with an annual salary of $76,000, for example, the salary is reset at $49,400. The state saves $7,600 in the first year after paying the bonus and $26,600 for each year after, plus any benefits savings related to the lower salary. In the first full year of the incentive program, the state paid out $68 million in incentives and the number of retirements doubled. The cost of the incentives was easily offset by the salary reductions for the first year alone.

    Apart from realizing financial gains through open-position savings, driving performance management with higher turnover or using turnover to reset salaries, companies may benefit from higher turnover in any number of situations created by today’s fast-moving business environment. "Optimal turnover is not the lowest turnover you can achieve," Hale says. "Optimal turnover produces the highest long-term levels of productivity and business improvement."

Up or out
    In other cases, employers must replace old skill sets with new ones as technology or the customer base changes. And in some situations, companies must reshape the workforce for a different demographic mix or for a better distribution of age groups. "Or a company may simply need to move out low performers and upgrade talent," Hale says. When the typical annual performance review process is too slow to create significant organizational change, she advises companies to adopt semiannual or even quarterly reviews to speed up the process of terminating low performers, including employees who cannot step up to meet new needs.

    Law firms are famous for churning talent to reduce labor costs and generate high performance. In the industry’s up-or-out model of workforce management, four out of every five associates hired never make it into permanent partner positions. "Healthy turnover benefits a firm," says Karen MacKay, partner at Edge International, a global consulting firm for professional services. "It means that the firm is actively evaluating employees and making decisions. Low turnover means that the firm is working around existing people instead of constantly pulling in new people with new ideas to build the organization. At successful firms, turnover becomes a business advantage."

    At the law firm of Bowman and Brooke, based in Gardena, California, associates work in a 7½-year up-or-out career path that feeds the firm’s need for high-powered trial lawyers. "Associates who do not belong on the partner track are counseled out of the firm within their first three years on the job," managing partner Robert Miller says. Outright terminations are rare. With associate billing rates averaging roughly half of partner rates, the up-or-out model allows the firm to control labor costs and skim the best talent from a pool of qualified and closely watched candidates.

    The up-or-out model is not suited to every workplace, but the broader strategy of creating churn to meet specific needs is applicable across industry sectors. In an economy marked by negligible job growth and turnover well below normal recovery-phase levels, many workforce management executives are looking out over a dead pond. And unless their performance and salary management systems are extraordinarily effective, they are living with bloated labor costs.

    Excessive recruitment and training cost money, but so does a workforce filled with stale managers and somnambulant employees--all at or near the top of their pay range, covered by costly legacy benefit packages and protected by an overblown fear of litigation. Despite the recent flurry of warnings about the return of the "war for talent," labor markets will likely remain soft for the foreseeable future, and conditions are ripe for managing turnover for positive financial results.

Workforce Management, June 2005, pp. 34-40 --Subscribe Now!