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Article | Beyond Data

The impact of inflation on pay raises

By Hatti Johansson , Catherine Hartmann and Andy (Andrew) Goldstein | February 2022

It’s hard for compensation professionals to make sense of whether current economic conditions are a result of pent-up, post-pandemic demand and/or of a new, longer-term reality.
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Inflation, labor shortages and wage increases are creating a lot of headlines: US inflation rate is at 7%, the highest since 1982. Droves of people leaving their jobs, an all-time high. Millions of jobs open as labor market tightens. Major mismatch between skills required for available jobs and those of available workers. And so on …

With all this noise, it can be hard for compensation professionals to make sense of whether these economic conditions are a result of a reset of pent-up demand post pandemic and/or of a new, longer-term reality.

While the “how” and “when” of a new steady state is uncertain, one thing is clear: Labor market pressures stemming from the pandemic-altered economy and the need to attract and retain talent have had a significant impact on how organizations finalized their 2021 pay budgets. More than 80% of US organizations held their regular salary review cycle in 2021, with budgets increased over prior years.

Looking at 2022, greater scrutiny on the labor market will continue among both employers and employees. Results from our latest Salary Budget Planning Survey, which reflects responses from 1,004 participants from October and November 2021, suggest that 98% of companies globally will increase salaries. Among US organizations that are planning to grant increases, average salary increases of 3.4% are forecasted (vs. 3.1% actual increases in 2021) – the highest since 2008. Participant demographics for the Salary Budget Planning Survey are available at the end of this article.

Additional key findings:

  • Average 2021 actual total salary increase budgets for those that granted increases rose from 2.9% in the July 2021 survey to 3.1% in the December 2021 survey.
  • Projections for 2022 salary increase budgets jumped 0.3 percentage points from 3.1% in July to 3.4% in December.
  • Salary increase budgets vary significantly by industry:
    • Industries most heavily affected by the pandemic either froze salaries or offered limited increases in 2021, with average salary increases (including zeros) of 1.3% for Leisure and Hospitality, 2.1% for Oil and Gas, and 2.5% for Aerospace and Defense.
    • However, 2022 projections show an extreme bounce back to 3% for Leisure and Hospitality, 3.6% for Oil and Gas and 3.3% for Aerospace and Defense. That is a significant difference compared to one year ago. A key factor in this shift is the number of organizations planning to grant increases compared to zero increases or salary freezes in 2021.
    • The High-Tech industry maintains the strongest average 2022 salary budget projections with above-market increases: Fintech is at 3.9%, Software Products and Services at 3.9%, Semiconductors at 3.7%, and Electronics, and Electrical and Scientific Equipment at 3.7%.
  • Companies continue to reward top performers with significantly larger pay raises than average-performing employees.
  • Employers’ concerns over a tight labor market (74%), anticipated stronger financial results (34%) and inflation or the rising cost of supplies (31%) are the main causes of the jump in salary increase budgets.

As labor markets tighten and inflation rises in certain countries, all eyes are on salary budgets that, so far, seem to be moving above prior years. But increased salary budgets only make it more critical for organizations to have a clear strategy for awarding pay increases as effectively as possible, prioritizing critical employees and hot jobs, and differentiating for performance.

Identifying the economic/salary budget relationship

A lot of words are being thrown around to explain our current situation. To understand the impact of the current economic environment on salary budgets, it is important to understand a few key terms.

  • Salary increase budget: The pool of money an organization pays to increase salaries. The budget focuses on base salary increases, typically including promotions and merit increases. It excludes additional wage components of total rewards (e.g., bonuses, long-term incentives, health and wellness benefits). It also includes cost-of-living adjustments. When comparing against different sources, it is important to be aware of whether the figure includes or excludes freezes, is merit only or includes other components and is an average or median.
  • Inflation: Typically defined as an annual change in prices for a basket of goods and services. As prices are rising at a rate not seen since the 1980s, the question is whether this will become a permanent fixture post pandemic, or if it will ease as organizations identify ways to produce and transport what people want to buy. Wages don’t decrease when inflation lowers, so organizations need to be careful in assuming that if inflation jumps salaries should follow.

    Inflation causes a loss in consumers’ purchasing power as prices go up. And organizations increase wages only to the extent that the value of what employees produce increases – either because employees are producing more or because inflation is leading to an increase in demand for goods and services. Conversely, an increase in wages can drive costs that companies may pass on through higher prices, which can fuel an inflationary spiral like the one that occurred in the 1970s.
  • Labor market shortage: Created when there are more job openings than people with the skills required to fill them. Labor shortages can be general, as when a significant number of people have left the workforce, whether due to retirement, safety concerns, new choices/career changes or simply opting out. This has occurred in the US recently. Or it can be specific to certain positions, as may happen when the demand for certain skills increases faster than the supply of employees with those skills. This can be seen among truck drivers or, over the longer term, employees with digital skills. Regardless of the reasons, salaries are being driven up as organizations are forced to compete for talent – whether that means attracting or retaining the people they need – often against new competitors for that talent.

When setting salary budgets, it is important to consider several factors including current economic conditions (both the labor market and inflation) as well as your organization’s performance, overall compensation, business and financial strategy and goals.

Assessing insights from 2021 salary budgets

In 2020, employers looked to 2021 with optimism and an eye toward recovery, but many U.S. organizations had to adjust to tumultuous business conditions that emerged from the pandemic. When looking at 2021 salary increases (including zeros) and salary freezes, budgets were notably softer than initially expected. Most organizations dialed down their original forecasts to be more in line or slightly below 2020 salary budgets. However, among those organizations that granted increases, 2021 salary budgets of 3.1% were in line with 2020.

Figure 1. Comparing average salary increases for 2019-2021 survey reports

Organizations are differentiating their base salary increases and bonuses. Employees receiving the highest possible performance rating were granted an average increase of 4.5% in 2021, 61% higher than the 2.8% increases granted to those receiving average ratings. About 10% of incumbents were rated at the highest rating level. This trend is consistent across employees who received the highest ratings in the groups of management and professional, support staff and hourly workers.

The survey also revealed that 89% of companies awarded annual performance bonuses in 2021 based on 2020 performance, significantly higher than 71% of companies that awarded them in 2020. Bonuses, which are generally tied to company and employee performance goals, averaged 16% of salary for management and professional employees for those that paid bonuses. Bonuses for support staff and production and manual labor employees averaged 6.1% and 4.3%, respectively.

Looking ahead to 2022 salary increases

Organizations have adjusted their 2022 projections as labor market challenges have unfolded. While almost half of organizations reported not changing their projections from earlier in the year, 32% reported that their 2022 projections are higher now than anticipated earlier in 2021. Of the organizations that reported higher 2022 projections at the end of the year, the average total increase forecasted was about 3.8% (compared to 2.9% for 2021 for the same group of companies). The upper twenty-fifth percentile of organizations that changed their budgets reported total overall salary increases of 4.0%. There are no significant differences forecasted by employee category, however, salary increase budgets do vary by industry depending on how they were impacted by the pandemic.

Figure 2. Comparison across industries (including zeros)

Cautious optimism will be the 2022 focus for employers, with many looking to increase salaries and provide bonuses for employees – particularly for critical or high-performing talent. Being adaptable to ongoing market-condition changes is never easy, but indications are that employers are intending to return to a more-normal salary review cycle in 2022. They also are looking at how to focus their salary budgets for the greatest impact, with 2022 projections showing that 98% of companies will increase salaries and far fewer will implement salary freezes than in 2021 or 2020.

Figure 3. 2022 Projected total increase (including zeros)

2022 will likely be a better year for salary increases. The tight labor market and challenges related to filling positions – especially for hourly and digital/tech talent – will continue to put pressure on salary budgets. Given how 2022 salary increase budget projections are trending, it is possible that later this year the actual 2022 amounts could exceed the currently forecasted 3.4%. However, it is questionable whether they will hit the 3.8% level last seen in 2008. Regardless, prioritizing and segmenting increases will be vital to ensure an appropriate return on investment.

Setting a clear salary increase strategy is critical

What are you trying to achieve with salary increases? It sounds like a simple question, but a clear answer isn’t always easy. After all, the actual total cost of salaries goes well beyond the annual merit budget. When the complete spend for off-cycle increases, counteroffers, promotional adjustments and the like are taken into considerations, companies are actually spending well in excess of the 3.4% base salary increase budget.

To set a clear salary increase strategy, you need to begin by identifying your compensation plan’s strategic goals (remembering that every organization will have its own set of goals and unique priorities). Then, after establishing your increase budget based on market data intelligence, you must align your priorities to those goals. For example, if one of your goals is to retain critical roles and resolve any possible inequity issues, then your priorities are to adjust any major diversity, equity and inclusion issues using salary budgets – and even some fair pay analytics – and consider in-demand and business-critical talent and what new competitors for that talent may emerge.

And even with an increased budget, it is important to segment your workforce as you consider your goals. Consider segmenting by employee level (e.g., hourly, professional, executive), performance level or even by areas in which you’re having trouble attracting and retaining (e.g., digital talent).

Also, make sure you take a Total Rewards perspective. Look beyond base salary adjustments and consider other important components of your Total Rewards package like bonuses, long-term incentives, health and wellness benefits — even career progression and learning and development opportunities. There are also many other tools that can be utilized for attraction and retention from a total rewards perspective, which is why addressing elements beyond base salary – to sign-on bonuses, cash retention, equity or even non-monetary rewards – makes sense. Consider other payments you may have made during the year, like retention bonuses or recognition awards.

Taking a holistic view will ensure your salary increase process is transparent and emphasizes the connection between salary increases and business performance. Greater transparency with your employees about how pay decisions are made will improve the employee experience as you respect them as your business partners. It’s easy to forget that salary increase budgets are driven by several factors and, as such, should be viewed as one piece of a larger picture.

When it comes to salary budgets, be ready for anything

2021 was another year of change, with tightening labor markets pushing salary increases around the world. 2022 will see salaries and other aspects of life return to some sense of normality and more companies implementing regular salary reviews and higher increases than in 2021. Workers now have some (small) power due to labor shortages and they are deciding to exercise it.

Yet, salary increases still will need to be allocated in line with market conditions and influenced by clear business priorities. Keeping an eye on the market with the latest rewards data intelligence is the best start for navigating the year ahead.

Authors

Global Innovation and Product Development Leader, Rewards Data Intelligence
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Managing Director, global work,
Rewards and careers practice leader
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Managing Director, Executive Compensation and Board Advisory
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