The New Way to Pay

In high-energy silicon valley, Kate DCamp, vice president for human resources at Cisco Systems, is busy reworking the company’s compensation system. She is reinstating the merit budget, pulling money out of incentives and putting it back into base salaries, and bracing for the smaller pool of employee stock options that shareholders are likely to approve at their November meeting.

    Across the country in sleepy Columbus, Georgia, Casey Graves, 2nd vice president for human resources at Aflac Inc., is also reshaping his company’s compensation system. He is holding down base salaries and merit increases but pumping money into bonus payments and launching new short-term incentive plans.

    Both DCamp and Graves are working toward highly aggressive growth goals. At Cisco, revenue per employee jumped 27 percent to $690,000 last year, and the company is now pushing for $1 million per employee, unprecedented in the industry. Aflac plans to double its revenue within five years, with a minimal increase in headcount.

    To achieve these goals, DCamp and Graves are shifting the balance between fixed and variable pay, but in opposite directions.

    Compensation design is in flux. Cisco and Aflac represent the new focus on achieving extraordinary growth and productivity while controlling labor costs, but they also demonstrate that companies are forging very different approaches to this common goal. Standard practices have splintered into highly customized and constantly changing compensation programs, designed to boost output within the confines of flat salary budgets.

Room to move
    The context for this experimentation is the flexibility provided by relatively soft labor markets and diminished employee expectations. Cisco’s 27,000 U.S. employees haven’t seen a merit increase since 2001, but the company still receives 70,000 applications a year for relatively few positions and maintains a low voluntary turnover rate of 4.6 percent.

    Aflac keeps base salaries for most of its employees at or below market and sets its annual salary budget close to the national average, which has barely covered inflation since the 2001 recession. But it still attracts almost 100 candidates for every job opening and sports a 30 percent increase in policies in effect per employee over the past four years.

    “Softer labor markets have played a role in our recent thinking,” DCamp says. “We’ve found that we’ve been very competitive without a broad merit budget. We had small amounts of money for promotions and adjustments for specific skill groups that were in short supply, but that was all based on the market, and we’re not seeing market wages moving.”

    DCamp’s perceptions are accurate. Real wages remain below their pre-recession levels across almost all industries, and salary-increase budgets are almost a full percentage point below the 4.4 percent average recorded for 2001 despite the full-blown recovery in profits.

    When Cisco reinstates its merit budget to raise base pay in the second half of 2006, it will fall within the modest projected average increases reported by the major surveys. Employers are planning increases averaging 3.6 percent for 2006, barely topping the forecasts for inflation, according to a recent survey by Mercer Human Resource Consulting of 1,350 employers with 13 million workers.

    “Flat salary budgets will continue as long as the markets are weak,” says Peter Cappelli, director of the Center for Human Resources at the University of Pennsylvania’s Wharton School. “We are nowhere near full employment. In addition, there is a relentless drive to push costs out of the system.”

    The slight decline in unemployment this year has not stimulated wage growth. “Labor markets are picking up, so we would naturally expect to see budgets that reflect this change in supply and demand, but salary budgets are not reflecting it,” notes Steven Gross, leader of the rewards practice at Mercer.

    Mercer found that 22 percent of employers increased incentive pay eligibility and opportunity over the past three years, while 7 percent decreased them. “Companies are reticent about increasing fixed costs, so they’re shifting money to a variable basis,” Gross says. “But it’s moving into less formal programs such as spot awards and sign-on bonuses and into pockets of the workforce instead of across whole populations.”

    For short-term incentives such as spot cash and project awards, less than 20 percent of the employees receive some payout, he notes.

Rebalancing base pay
    Although the standard practice for companies looking for lower fixed labor costs and higher productivity is to move more money into variable pay, Cisco has discovered that it may have too much pay at risk.

    “We just shifted about 5 percent out of incentive pay and put it into base salaries at most levels in the company,” DCamp says. “Our hiring experience and employee surveys over the past few years indicate that we have more pay at risk relative to the market than we want to. Also, employees have expressed that base pay is a principal concern.”

    DCamp continues to remake compensation to fit the growth goals of a company where labor represents 64 percent of total costs and competitive pressures keep pushing against profits. The Internet networking leader reported net sales of $24.8 billion for fiscal year 2005, up 12.5 percent from 2004, but issued subdued guidance for the current quarter.

    Cisco monitors compensation at large, successful firms in its industry and across industries where it shares a labor pool for executives, sales and technical talent. “We position ourselves to be at the 65th percentile for base pay in that market and at the 75th percentile for total cash,” DCamp says. “For total compensation, including stock, we are the top payer if the company performs well, and we have no problem with that.”

    But with software engineer salaries at Cisco running $102,000 a year and administrative assistants earning $51,000, Cisco keeps a tight rein on headcount. DCamp controls labor costs by closely monitoring value added per employee and staffing levels relative to competitor companies.

    “Cisco tends to have fewer employees than some competitors in our revenue category, partly because we’re selective about the businesses we serve in and don’t try to do everything ourselves,” she says. “We focus on the areas where we can truly add value, which gives us good profitability and a smaller employee population than firms that try to do too much.”

    Cisco also diligently maintains the intangible portion of its rewards package. “We know that people stay at Cisco because of the culture,” DCamp says. “Pay is important in attracting people–there’s no doubt about that–and if you let your pay slip off market, you will have unwanted turnover. But at Cisco, you get to work with smart people on interesting projects, and in every function you get to be closer to the customer than you do in almost any other company.”

Boosting variable pay
    Like Cisco, Aflac is redesigning compensation to pursue aggressive growth at lower costs, but the similarities between the two companies end there. While Cisco scrambles under close shareholder scrutiny in the highly volatile tech industry, Aflac is calmly issuing guidance for 2007. And while Cisco is shifting its pay mix to increase the fixed portion, Aflac is keeping fixed costs well down and adding more variable pay.

    Aflac draws from national markets for critical IT talent but staffs most positions in Columbus from the local area, where unemployment is well above 6 percent, and rising. Still, Aflac’s rapid growth exerts some pressure to maintain competitive compensation levels. The insurance giant collects $14 billion a year in revenue, with an enviable 10 percent growth rate.

    The company takes a very conservative approach to base salaries. The most common position, call center customer service specialist II, earns $24,755 in annual base pay. “You won’t see us coming in at above market,” says Graves, who oversees compensation for Aflac’s 4,100 U.S. employees. Instead, the company ensures high retention with lush benefits and drives performance by moving money into incentive plans that leave fixed costs low.

    The cornerstone of its variable pay is a year-end profit-sharing bonus for all employees that has paid out at or above target for each of the past 14 years and creates a clear hiring advantage. The company increased its profit-sharing targets for nonmanagerial employees and supervisors in 2004 and for managers in 2005. In February, while other employers were ditching their equity-based incentive plans, Aflac added stock option grants for all employees, tiered by job position, with three-year cliff vesting for greater retention.

    The firm buttresses these substantial performance incentives with short-term programs that include spot cash awards of $500 to $750 for a significant project. The company is now exploring new short-term incentives for meeting project milestones and productivity goals.

    “We are discussing additional incentives based on productivity measures such as the number of claims processed,” Graves says. “We want performance pay vehicles that are business-driven and reward specific behaviors on an immediate basis, perhaps once a month, as a variable additive. The discussion of new performance-based pay plans is taking place in the context of our revenue growth goals. Any areas of pain we may have, such as lagging behind on claims, are woven into the discussions of performance pay improvements.”

    Aflac’s retention-oriented benefits plan includes all basic benefits plus a defined-benefit pension and retiree health benefits for the entire employee population, an employee stock purchase plan, college tuition for employees’ children and grandchildren, and on-site child care and health clinics. For the most common nonexempt jobs paying in the mid-$20,000 range, the value of the benefits package contributes 26 percent of total compensation.

Stirring the mix
    While Aflac’s merit increases range up to 7 percent, with incentives adding to the meaningful differentiation between high and low performers, most companies are still operating without substantial amounts of performance-based pay. Mercer found that employers are using average increases of 4.9 percent for their strongest performers, 3.2 percent for average performers and 1 percent for the lowest performers.

    “Pay for performance is not being executed on a sustained basis,” Gross says. “Especially when budgets are flat, it’s too hard for managers to push the differential higher. So instead they are turning to one-off programs such as spot cash awards, with small base pay increases.”

    With the new short-term incentives producing relatively small awards, long-term incentives declining and salary-increase budgets losing ground against inflation, there’s not much money on the table for recruitment, retention and performance gains. Across the board, companies are holding labor costs down. Within this setting of lower budgets, the most successful companies are shifting the pay mix to create the optimal balance of fixed and variable compensation for retaining specific employee groups and meeting growth goals.

    At Cisco, this means reducing incentives to fund base pay increases. At Aflac, it means suppressing fixed costs and channeling the money into productivity-based incentives. In both cases, workforce management executives are tapping the flexibility offered by slack labor markets to experiment with the right compensation mix, and working in a far more nuanced reality than standard practices allow.

Workforce Management, October 24, 2005, pp. 33-40 — Subscribe Now!