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Bombarded by questions about pay and inflation? We have answers

Part I of a compensation primer

By Lori Wisper and John M. Bremen | June 24, 2022

Recent history has led to tricky salary-related questions from both employees and executives. Here are the answers you need.
Health and Benefits|Employee Experience

Compensation and HR professionals entered a career “twilight zone” beginning in early 2020. From a global pandemic through a fundamental shift in how jobs are structured and work is accomplished, to some of the highest inflation rates and tightest labor markets, numerous unexpected challenges have raised unexpected questions. And the demand for answers by business leaders and employees has only escalated.

Through this short series, we are supporting compensation and HR professionals in their efforts to answer the tricky questions being asked at all levels of the organization.

From the CEO: ‘Should we be giving bigger base salary increases to respond to inflation?’

The simple and ideal answer is, “No, base salaries should not be increased or adjusted based on higher inflation” (in fact doing so leads to higher inflation!). However, the reality is not this simple. Helping executives understand both the employee and employer perspective provides the most effective way to guide discussions about potential solutions.

Employee perspective: Inflation represents the increase in the cost of a market basket of goods and services, including housing, energy and other items in a specific geography. Like the cost of living, inflation varies greatly from region to region, country to country and city to city. Inflation basically reflects the supply and demand for goods and services in those locations, and employees have choices about where they live and what they buy – and that determines how inflation affects them.

Employer’s perspective: From an organizational perspective, an employer’s base salary program (and total compensation philosophy) is grounded in the cost of labor, not the cost of living. What employees earn is driven by changes to the supply and demand for labor, and that can be impacted by demographic trends, labor participation rates, technological advances, availability of educational and training programs, and growth in productivity. This means employers assess the supply and demand of labor in each defined market and pay competitively based on that definition not on the cost of a basket of goods specific to what employees may choose in those defined markets. For example, if an employer defines the competitive labor market for certain jobs based on a specific location (and not a specific industry or company size which might be more meaningful for higher level roles), then pay rates are determined by the local competitive compensation data, reflecting the supply and demand for labor in that location.

The confusion between what employers pay in base salaries and inflation is understandable. After all, base salaries represent employees’ buying power, and they use that buying power to purchase from that market basket of goods. When prices go up, employees’ buying power goes down.

While this is a reality for everyone, it’s important to remember that moderate inflation (i.e., 2% to 3% range) means an economy is growing. However, when the demand for goods and services exceeds supply that means costs go up, and when costs go up, there is an expectation that base salary increases will follow. While inflation and salary increases generally move in the same direction, they are driven by different inputs and are not the same.

For example, in 1979 – the year of the highest peacetime inflation on record – U.S. inflation was 13.3% but salary increases were a much lower 8.7% Conversely, U.S. inflation was 1.9% in 2001, but salary increase budgets were much higher – near 4% – in 2001 and 2002. In 2020, inflation was a low 1.4% but salary increase budgets in 2020 and 2021 were higher (between 2.5% and 2.8%). This reality tends to provide employees an advantage in terms of real spending during low-inflation years (e.g., 2001, 2020) and work against them in high-inflation years (e.g., 1979, 2022).

Follow-up question: ‘But inflation is at one of the highest rates in recent history. Shouldn’t that matter?’

In the United States, inflation hit 8.6% at the end of May 2022 – the highest it’s been since 1981 (two years after the 1979 peak). However, employers in 1981 weren’t as concerned about this inflation level because, at the time, unemployment was also high at more than 8%. Today, U.S. employers are grappling with the double whammy of high inflation and low unemployment. The last time we were in this circumstance was 1969. Before that? 1946!

The point is, we have not experienced these economic conditions in some time, and we also haven’t seen them together very often (very few of today’s business leaders were working in 1969 or even 1981). Figure 1 illustrates this unique set of circumstances that is testing compensation and HR professionals in ways we never imagined. The bottom line is, if workers care about inflation and employers are experiencing worker shortages, then that means employers must care about inflation as well.

For unemployment rate, the percent change in 1946 was 3.9%. In 1969, it was 3.5% and in 2021 it was 3.9%. - description below

For inflation, the percent change in 1946 was 18.1%. In 1969, it was at 6.2% and in 2021 it was 7%.

Figure 1. Unemployment and inflation change (1929-2021)

Source: Unemployment Rate by Year Since 1929 Compared to Inflation and GDP

To understand how inflation can be addressed in compensation programs and processes as well as provide guidance to senior leaders, here are some points to consider:

  • Get grounded in philosophy. Refresh your compensation and Total Rewards philosophies. If you’ve always had a cost-of-labor philosophy as described, is that still working for all jobs and all employees? Are you still able to attract and retain employees with this philosophy? If the answer is “no,” that doesn’t mean a fundamental shift away from the cost of labor-driven pay philosophy, but you may need to deploy it differently for different jobs (especially scarce or critical skill roles), and that leads to the next point.
  • Segmentation is key. Analyze how the cost of living affects different employee groups as well as which jobs have the greatest challenges in attracting and retaining talent. Overlay those analyses to understand which jobs are the most critical to your business, and now you have the start of an effectively segmented compensation strategy.
  • Think both short- and long-term. Many analysts believe inflation already is peaking; others believe it will have a longer tail. If you’re being asked to address it now, be sure to build in actions that will fit this (hopefully) short-term period of high inflation. What actions will you take as inflation recedes?

    Labor economists know salaries are sticky, meaning that business leaders are reluctant to raise salaries because they know they cannot decrease them under different conditions without layoffs. Essentially, this means that you should not build inflation-type salary adjustments into your salary budget because once inflation goes down, you won’t get those budget dollars back. Unlike inflation, also consider that low unemployment may last for some time, especially for certain jobs or skill sets. Analyze which actions will work to stem attrition in both the short and long run (i.e., retention bonuses vs. paying a living wage) and that will give your organization a sustainable recruiting advantage.

  • Deploy rewards and consider employee experience beyond base salary. Base salary represents one of the largest fixed labor costs for employers, and base salary increases have a compounding effect on fixed costs over time that must be managed intelligently. This calculus has driven a conservative approach to salary increase budgets and has resulted in less elasticity and slowed the rate of salary increases over time. This makes it important for employers to look at their full arsenal of rewards to address the unique nature of the 2022 labor market.

    This could mean a focus on how you use both short- and long-term incentives, or an increase in the use of temporary allowances. It also should include an honest assessment of your organization’s overall employee experience. While a great culture alone doesn’t pay the bills or attract and retain employees in a hot labor market, it can make a difference when all other things are equal or close.

From employees: ‘If I don’t get an 8% salary increase to match inflation, then you’ve cut my pay!’

If you are hearing this from employees, it comes back to buying power. For example, if an employee paid $1 for a loaf of bread in 2021 and then paid $1.08 in 2022, the logical thinking is that they need to earn more money to buy that more expensive loaf of bread. Adding up 2022’s price increases, employees may see that their annual salary increase prevented them from spending the same amounts they did in 2021 to get the same goods and services.

While it's true that employees’ buying power is diminished when salary increases are lower than inflation, a response to that point is, “Pay NEVER goes down.” As mentioned, most (if not all) employees receive some level of salary increase every year, and those increases compound over time. It is important to help them understand that for many years, salary increases were HIGHER than inflation (and few employees complained).

The perception that salary increases have not kept up with the cost of living is not helped by the fact that, over time, the rate of increase has steadily gone down, as shown in Figure 2. But even as salary increase budgets have dropped at each economic downturn in the U.S. and never fully recovered, salary levels have consistently risen every year.

In 1981, the rate of increase was 10.4%. In 1990, it was 5.5%, in 2008 it was 3.9% and in 2021 it was 3%.
Figure 2. Salary budgets (1980-2021)

Source: WorldatWork Salary Budget Survey

However, as Figure 3 shows, it is equally important for employees to understand that U.S. salary increases have been larger than inflation since 2008, as is common during times of low inflation. Employees are now seeing what happens during times of higher inflation, again reinforcing the reality that low-inflation years benefit employees in terms of real spending and high-inflation years inhibit them.

For CPI in 2007: 4.1%, 2008: 0.1%, 2009: 2.7%, 2010: 1.5%, 2011: 3%, 2012: 1.7%, 2013: 1.5%, 2014: 0.8%, 2015: 0.7%, 2016: 2.1%, 2017: 2.1%, . - description below

2018: 1.9%, 2019: 2.3%, 2020: 1.4%, 2021: 7%: 2022 estimate: 8.5%.

Total salary budget increase in 2007: 3.9%, 2008: 3.8%, 2009: 3.1%, 2010: 2.9%, 2011: 3.1%, 2012: 3%, 2013: 3%, 2014: 3%, 2015: 3%, 2016: 3%, 2017: 3%, 2018: 3.1%, 2019: 3.1%, 2020: 3.1%, 2021: 2.8%: 2022 estimate: 3.4%.

Figure 3. Inflation vs. salary budget increases

Source: 2007-2021 Salary Budget Planning Reports, BLS CIP index, 2021 year-end

In 1981 – the year everyone likes to compare to because it’s the last time the U.S. experienced high inflation – salary budgets were 10.5%, which is significantly higher than today’s 3.0% range. However, there are three important factors to consider:

  1. In 1981, variable pay (i.e., bonuses) were largely the purview of only a small number of executives. Since then, eligibility for annual incentives has broadened significantly, with most large and mid-size organizations providing both base salary and bonuses to most salaried employees (and some hourly employees).
  2. According to the U.S. Bureau of Labor Statistics, average pay in the U.S. in 1981 was $12,531 (which would translate to approximately $36,000 in inflation-adjusted 2020 dollars). In 2020, average pay in the U.S. was $62,797. Even using inflation-adjusted salary increases, the significantly larger current payroll that most employers carry today would likely be unaffordable and impractical for more significant increases and would trigger mass layoffs if recession ensued.
  3. Many economists predict that inflation will drop below 3% by the end of 2022. If employees expect salary increases to match inflation, they will need to prepare for real pay cuts (and/or layoffs) as inflation recedes.

When thinking about how to respond to employees on this point, remember:

  • Once again, pay philosophy! Remind employees of your overarching pay philosophy, which is grounded in paying competitively based on the supply and demand of labor in each market in which you compete for talent.

    If you take the advice in this article to revisit and refresh that philosophy, you also will be able to describe what that means for each of your pay elements (i.e., base salary, short- and long-term incentives, wellbeing, career movement and advancement) and how these programs impact the employee experience.

  • Focus on retention. Develop a retention strategy that is as sharp as the strategy you use for customers: Understand how inflation affects your employees, how the experience and culture of working for your organization helps them manage their cost of living and use that intelligence to review all your reward programs – not just pay programs – to ensure you are addressing their needs in ways that also work to retain them. Winning the war for talent starts with retention.
  • Educate and communicate. The bottom line: If employees are referencing “real-time data” they find online and believe they are getting a pay cut because your salary increases don’t match inflation, you have some work to do to educate them about basic economics and labor markets. Don’t underestimate the importance of this education effort.

The world is in a period of rapid change, and the world of work and rewards is not immune. Compensation and HR professionals are under pressure from employees at all levels of the organization to provide insight and guidance in unusual times. Understanding how it all fits together, considering all perspectives and ensuring you have a solid compensation philosophy to back you up will be your best tools for responding.

WTW Associate Vismay Pandia also contributed to the development of this article.


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