The Great Pay Freeze

Misery is relative, and effective workforce management relies on that relativity in a downturn. As the first quarter of 2009 unfolded, a new one-two program for cost reductions emerged, with companies announcing mass layoffs for thousands of workers in one breath and a wage freeze for all remaining employees in the next.

This pattern is now playing out across all industries. On January 15, Saks Inc. announced that it would cut 9 percent of its workforce, freeze salaries and eliminate its 401(k) match. On January 22, Microsoft announced that it would terminate 5,000 employees and cancel all merit increases. On January 26, Sprint Nextel announced that it would cut 8,000 jobs, freeze salaries, cancel its 401(k) match and end tuition reimbursement.

A mid-January survey by Towers Perrin found salary freezes in place at four out of 10 companies. The proportion is likely to rise to 60 to 70 percent by the end of the first half of 2009, according to Ravin Jesuthasan, managing principal and global practice leader of Towers Perrin’s rewards and performance management practice.

Where freezes are not in place, actual wage cuts have occurred or are on the table. A December survey by Watson Wyatt found that 5 percent of firms instituted wage cuts in 2008; an additional 6 percent said they might cut wages in 2009. In its January Beige Book report, the Federal Reserve found a place in its long litany of deteriorating conditions to note that employers are introducing wage cuts.

On January 8, trucking firm YRC Worldwide announced that it had negotiated a 10 percent pay cut with its Teamster drivers and would institute pay cuts for nonunion employees. Advanced Micro Devices Inc. announced on January 16 that it would eliminate 1,100 jobs and cut pay between 5 and 20 percent for workers and executives.

Salary freezes and wage cuts quickly sweep across whole sectors because they fundamentally reset the cost base that companies must meet to remain competitive. “If a company sees a peer freeze salaries, it will be motivated to do the same,” Jesuthasan says. “It is in the same market for talent and under the same financial pressures.”

Salaries may be frozen, but labor markets are not. Even in the most desperate environments, the small numbers of employees who can create competitive advantage retain their mobility. Employers may be prepared to starve the many, but they must feed these few.

Retaining pivotal employees
While companies continue to look for ways to reduce costs, 62 percent remain concerned about the potential impact on their ability to retain high-performing talent or those in pivotal roles, according to the Towers Perrin survey. To address this concern, many companies are turning to cash awards and targeted salary increases even as they cut these expenses for the rest of their workforce.

“It is absolutely crucial to identify pivotal employees when an organization is looking to take out costs,” Jesuthasan says. “Rewards for pivotal employees are a very real consideration for most companies that are freezing salaries. Pivotal talent may have options in competitor companies or even other industries.”

Employers are slashing training budgets designed to keep pivotal employees on board, but maintaining cash incentives for this select group. “We now see a meshing of employer and employee concerns,” Jesuthasan reports. “For the first time in many years, pivotal employees are now focused on money rather than career development and training, which has always been their primary concern.”

Pivotal employees are defined by their strategic and financial impact and their direct contribution to competitive advantage. Other employees may be high-level, high-performing or high-potential, but not pivotal.

“Pivotal employees form a vertical slice of the workforce that may reach all the way down to the people touching customers,” Jesuthasan says. In an airline focused on growing its business traveler segment, for example, the people who manage that segment may be pivotal, while the pilots are not.

“The key distinction is between ‘pivotal’ and ‘important,’” Jesuthasan says. “In some organizations, the CFO may be important but not pivotal.” Leaders are always important, and some core and support jobs may be important, but they may not be pivotal or strategic. The pivotal group may constitute as little as 5 percent of the total workforce.

Pivotal employees are not immune from cost-cutting measures, however. Some organizations are conducting performance-based layoffs that target all lowest-rated workers—the “1s”—even if they are pivotal employees.

“Organizations need to look at the vertical slice and then look at performance within that vertical slice,” Jesuthasan notes. “Don’t hang on to 1s regardless of where or who they are in the organization. But in this environment, many organizations will have to go up to 2s when they make cuts, and then you must be mindful of where they sit. It is at these margins that the decisions become really challenging.”

Redesigning incentives
The critical labor-cost reductions that many companies must make to survive the downturn now hinge on effective workforce management practices that compensation experts have advocated for more than a decade.

“Segmenting the workforce is the most critical development we’re seeing because it is forcing companies to redeploy their investment in pay, literally taking away from some and giving to others,” Jesuthasan says. “We’ve been talking about this for years, but apparently we needed a depression to force companies to do this.”

To retain their pivotal employees, three out of 10 employers are using cash retention awards and four out of 10 are using targeted salary increases, according to Towers Perrin. “We are seeing a pulling apart of the organization and a multiclass situation emerging, where some employees will see salary cuts and others will see meaningful increases,” Jesuthasan says.

Many of the companies that are freezing salaries are using spot cash awards for pivotal employees. “In fact, these awards are being granted simultaneously with the announcement that a salary freeze is in effect,” Jesuthasan reports.

Most of the awards include a retention tool of some kind. For example, the award may be structured over two years so that the employee receives 50 percent at the end of the first year and 50 percent at the end of the second year. These retention awards often involve significant dollars, with amounts equal to what would have been a year’s bonus payment or 20 to 50 percent of salary.

Some organizations are using stock rewards or discretionary bonuses. “Also, with profits and earnings down at many companies, organizations are going back and redesigning their bonus plans to emphasize what individuals can control,” Jesuthasan reports. “If they used a profit-sharing plan that is now less effective because of the financial position of the company, they may shift to team-based rewards or project-based incentives.”

The practice of using variable pay as a key retention tool while slashing salary budgets is confirmed by Hewitt’s December 2008 survey, which reports that most companies are not making drastic cuts to their 2009 variable-pay budgets. For salaried exempt employees, spending on variable pay as a percentage of payroll is expected to be 11.1 percent in 2009, slightly lower than the projected increase of 12.1 percent in July.

Beyond 2009
The salary freezes implemented in 2009 may well carry over into 2010, but retention risks will remain low. A Towers Perrin survey conducted in August 2008 and again in December 2008 found a significant rise in the number of workers who value job security far more than pay levels, promotions or career development.

The declines in employee expectations and mobility that occur in downturns create the conditions for resetting wages to the levels that existed at the end of the previous trough. On an aggregate level, the great salary freeze of 2009 will put a quick end to the very short-lived rise in real wages that marked the final quarter of 2008. Without the widespread salary budget cuts that unfolded in the first quarter of 2009, real wages might have reached 2003 levels, reversing a 30-year trend toward lower real wage costs.

The salary freezes now in effect align with forecasts that call for zero inflation in 2009. But if pricing power picks up in 2010 and inflation rises to a projected 1.5 to 2 percent, ongoing wage freezes will cut into living standards. The array of health care and retirement benefit reductions ushered in along with the salary budget cuts will further the downshift in total labor costs.

The long-term effect will accelerate the equalization of wage levels at the global level.

“In the United States, it has been rare that anyone would leave to go work in another market, but there are more people now who will find it more attractive to work in Europe or India,” Jesuthasan notes. “Also, we saw a lot of work leave the United States because of labor costs, but now the wage differential has eased, and some of that work may come back. Whether we want it back is another issue.”