Why leaders shouldn’t expect salary increases to decline even in a slowing market
This year’s downward slide back to “the land of 3%” was evidenced in this May article that addresses the average salary increase in the U.S. going from 4.4% in 2023 to 4.0% in 2024 and down to a projection of 3.7% this year.
Now that we’re in Q4, it appears my statements back then will stand, and we will remain firmly in the land of 3% in the coming pay cycle. While we wait for results from WTW’s December Salary Budget Planning Survey, the July edition reported a 3.5% average increase projected for 2026 in the U.S. This also is what most companies appear to have paid this year (down from the earlier 3.7% projection).
As those who are on a fiscal calendar year prepare for your upcoming annual pay cycle, you may already be getting questions from leaders and others about why salary increase budgets are projected to stay where they are from 2025 to 2026 given the state of the U.S. labor market.
In August 2025, the U.S. Department of Labor’s jobs creation report showed that only 22,000 jobs were added to the economy. By comparison, the average job creation from 2021 to 2023 was 350,000 per month — a stark difference that amplifies where the labor market landed in 2025.
With headlines blaring about how dismal the demand for labor has become in the United States, the thought that salary increase budgets should drop seems logical, but for three key factors.
01
We all know that salary increase budgets are a direct reflection of the supply and demand for labor in a given market, such as the U.S. However, the way salary increases shift over time tends to be overlooked.
Salary increases go up or down from one year to the next based on the balance of demand for labor with its supply. So, when the demand for labor skyrocketed in 2021 and 2022 but supply didn’t match that demand (remember the worker shortages?), salary increases went above 4% for the first time in well over a decade. Conversely, when the Great Recession of 2008–2009 dropped the demand for labor, supply was plentiful, and salary budgets dipped below 3% for the first time ever.
Well, in 2025, the labor market is in a period of relative balance and while the demand for labor has declined, worker supply is still an issue. In fact, given U.S. immigration changes, worker shortages may be worse now than during the go-go years of the Great Resignation. We still have worker shortages; we just don’t feel it as acutely because demand is so much lower.
02
Historically, drastic changes to salary increases have only happened during steep U.S. economic downturns. We saw the most extreme example of this when salary budgets went from a 3.9% average increase in 2008 to 2.2% in 2009. Why did this happen? Because a good number of companies (nearly half of the salary budget planning survey participants) determined that they needed to freeze salaries — meaning no increases.
We also learned that the “no increase” move is not sustainable and, as the economy recovered, so did salary budgets. And while it took nearly five years to get back to the land of 3%, most organizations got there simply because they once again began providing annual salary increases to employees.
Without these drastic economic conditions, especially in times of labor market stability, salary increases tend to also stay stable. They just don’t react as quickly (or even at all) to moderate changes in the economy, such as the slower job growth we are experiencing right now.
03
If you study the history of salary increases over time (Figure 1), you will see that, at an average of 3.5%, salary increases already are relatively low. So, how much lower can they drop?
It’s possible that salary increase budgets may go back down, closer to 3% by this time next year (or sooner if economic conditions worsen). But, as described above, going any lower than that has historically meant that some — potentially many — employers are resorting to zero salary budgets which, as history has shown, is a drastic and unsustainable move.
Given this historical analysis, it’s possible that salary increases have reached a point of inelasticity, and we shouldn’t expect them to change much soon — unless a recession hits.
Having said all of this, your leaders may still expect you to manage your salary increase spend more wisely, if not ask you to spend less (despite the rationale provided here).
All the heat and light we give to the year-end salary process tends to drive underground any scrutiny or analysis of the various adjustments and increases we give almost every other time of the year.
While leaders, managers and even compensation committees focus so much on the one-time-a-year event of merit increases, they may forget (and we don’t remind them enough) that they have a fiduciary responsibility to manage labor costs more broadly.
The reality of the annual salary increase process is that it takes months of planning, discussion, analysis and modeling. And it’s happening at the same time the compensation function is bombarded with (almost daily in some cases) requests for promotional increases, market adjustments, equity adjustments, counteroffers and so on.
It may take some intestinal fortitude, but HR and compensation leaders should analyze the overall year-to-date spend on salary changes and present that to decision makers and leaders. This way, everyone understands the fuller picture of total salary spend.
More broadly managing and communicating the overall salary spend decisions for the entire year may not change the year-end process, but at least there can be a greater understanding of where the money is going. This also provides an opportunity for further discussion on how to optimize this investment more fully. Which brings us to our next point.
If you’ve ever looked at a salary budget planning report, whether from WTW or elsewhere, you will notice that salary increase data is displayed for different types of employee groups: executives, managers, salaried employees, hourly employees.
Did you ever wonder why these are shared when the average salary increase numbers for these groups are the same? Well, it’s because they haven’t always been the same. Decades ago, organizations apparently budgeted different salary increases for each employee group. Wow! What a concept!
To get the most from your year-end salary increase spend, why not segment the dollars based on sound reward strategy reasons. This will support the organization in optimizing its investment in people. And it might look something like this:
Does merit pay still have merit? Using salary increases to pay for performance started more than 45 years ago when salary budgets were more than double what they are now.
With the average salary increase now back in the land of 3%, the concept of trying to differentiate based on individual performance using shrinking salary budgets is not only outdated, but also (in many ways) dysfunctional. It’s likely that this has not been effective at your organization for some time, so can we just use the once-again downward trend in salary budgets to finally retire merit pay once and for all?
As with relying on market position to more discriminately triage your salary budget by employee segments that have greater needs, the concept is the same here: Only by individual employee rather than setting different budgets for different groups. In other words, eliminate the salary increase to pay for performance and redeploy it to ensure pay stays competitive for employees below market.
Many organizations use a merit matrix that considers both performance rating and position in range. This concept leaves out the rating and only focuses on the current employee salary level relative to a market point (e.g., midpoint of the range). This (of course) assumes that there is a baseline level of performance or eligibility for increases only for employees in good standing.
While pay often is cited as the number one driver of attraction and retention, there are many other elements that go into the “special sauce” of an organization’s unique employee value proposition. Understanding the strengths of your total rewards offering and making sure those are fit for purpose in these challenging times can also help avoid the trap of the singular salary increase focus, even at year-end.
Focusing on the full rewards offering also helps you avoid the “be happy you have a job” mentality that tends to come up at times of weak job creation, especially if you are faced with particularly low salary budgets this year. The financial crisis of 2008 to 2011 taught us that those messages were particularly disastrous when things turned around and employee retention became an issue again. Employees have very long memories!
While none of these concepts are necessarily new or earth-shattering, the idea is to take a “let’s try something new” approach. In a year when nothing is certain and you may be asked to spend more wisely and/or less, it seems like a good time to get rid of the rubber stamp of the annual increase process and work to strategically make the most of the limited salary increase dollars available to you.
