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Reducing Compensation Costs and Why Wages Don’t Fall During a Recession

Reducing compensation costs is on the minds of a lot of organizations right now. We are in the middle of a pandemic and the U.S. unemployment rate is the highest it’s been since the Great Depression. Although there was some speculation in 2019 that a recession might be coming after ten years of a booming economy, the outlook at the beginning of 2020 was all roses. That’s all changed in the wake of the coronavirus, with economists now saying that the economic forecast has worsened since April and that when the economy recovers, it will do so in turbulent fits and starts.

HR must plan accordingly.

Why Wages Don’t Fall During a Recession…Usually

Compensation is a critical component of strategic workforce planning. We’ve said elsewhere that during an economic downturn, compensation planning matters more than ever. A company is made up of employees and employees work for the company in return for compensation. This is always true no matter the economic conditions of the time, and the primary reason why wages don’t fall during a recession — at least not across the board.

Economists call this phenomenon “downward nominal wage rigidity” or DNWR. The question that economists ask is why wages don’t decline along with prices and demand. The answer is that they do, but only for a select number of organizations facing tougher circumstances. Statistically, wages rise over time. Although wages can stagnate when the economy is in a slump, wages rarely fall. This is because employers are reluctant to reduce pay to workers because they believe it will have an adverse effect on morale. Instead, when times are tough, most companies choose to retain the most critical portion of their workforce and pay them competitively to keep them satisfied and productive while reducing payroll by issuing layoffs.

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This is true even during a global recession. For example, the Federal Reserve Bank found no evidence that the high degree of labor market distress during the Great Recession of 2007-2009 reduced downward nominal wage rigidity and some evidence that operative rigidity may have increased. In other words, wages don’t go down when the economy goes down. Although there are many theories as to why this is, the Federal Reserve cited that the most compelling reason is that organizations tend to take a multi-year view on labor costs when implementing their compensation practices.

Most recessions only last a year or two, so it would generally cost organizations more to lower wages and lose productivity than to keep core employees satisfied and operate in a lean manner until economic conditions improve. However, this does depend on the type of workforce the organization employs. The more highly skilled and specifically trained the workforce, the more incentive the organization has to retain its people.

Will Wages Fall with Covid-19?

While reducing staff and maintaining competitive pay is standard in a typical economic downturn, we are living in unprecedented times.

While it is too early to say whether the coronavirus and the impending recession will upend DNWR, we are seeing news reports that some organizations are choosing pay cuts over layoffs this time around, at least temporarily, and depending on how bad things get, some organizations may need to do both. However, the percentage of organizations that take drastic measures that include cutting pay will likely still be in the minority. According to PayScale’s online survey, only 6 percent of employees say that their pay has decreased since Covid-19 so far.

Have you seen an increase or reduction in your pay? Fill out an online salary profile with PayScale.

We have also taken a look at wage growth from our Crowdsourced Data. While we have certainly seen wage growth slow in 2020 compared to growth in better years, we are not seeing wages decline. When looking at wages by industry and occupation, we have seen some fluctuation month over month, but wages continue to grow year over year for the most part. The one exception is Retail and Sales, where we are seeing a trend of negative wage growth during the coronavirus pandemic month over month. However, it is too early to say what the long-term effect might be.  Falling wages in Retail and Sales may be indicative of Covid-19 upending DNWR or they may bounce back.

Download our Whitepaper: The Impact of the Current Economy on Wage Growth

So what can organizations do when it comes to how to reduce compensation costs? Are there guidelines for what cost-cutting measures for compensation are most and least effective? What are the Dos and what are the Don’ts?

As always, it’s going to be up to each individual employer, but here’s our perspective.

The Don’ts of How to Reduce Compensation Costs

While your business is likely trying to find ways to cut costs and survive on lower profits, it’s important not to get so fixated on cost-cutting that you strangle the ability of your business to perform or create an environment that employees can’t wait to leave. When it comes to how to reduce compensation costs, including total rewards costs, some options deserve careful consideration of the impact before pulling the trigger. If it can be avoided, we suggest not cutting the following:

Don’t Cut Pay If You Can Avoid It

As we’ve already discussed, cutting compensation isn’t a standard practice, even in an economic downturn. It does still happen. Sometimes cutting pay is necessary or unavoidable for a business to stay afloat. It might be a strategic choice that a business makes to avoid layoffs, or it might make good business sense for a particular industry, workforce, and vision for the future of the company. But it isn’t what the majority of organizations do and cutting pay indiscriminately, especially without strong communications around why and for how long, can backfire and ultimately hurt the business more than it helps.

The reason that cutting pay is not recommended is that it has a demoralizing effect on employees. People tie their value and self-worth in part to their compensation. They also look to their compensation for how their employer values them and the work they do. They also depend on their compensation for their livelihood. Cutting pay can therefore have an egregious effect on the workforce that can result in more turbulence for the business.

If you have to look at cutting pay, make sure you do it judiciously, fairly, and strategically, with decisions backed by good data, and make sure you have a robust pay communication plan in place to explain your decisions to employees, including being transparent about the state of the business, why pay cuts are necessary and whether and when you expect pay levels can return to normal.

Don’t Cut Healthcare Benefits

Compensation is about more than wages. In an economic downturn, many businesses leave wages alone and look to cut benefits instead. This can be a solid strategy, but you should be careful about which benefits you cut and how deep. Healthcare is often the highest expense a business has in its benefits package but cutting healthcare benefits, especially in the midst of a pandemic, isn’t a good idea.

If you cut healthcare during a global health crisis, it will be remembered. Healthcare coverage is a vital part of your employees’ benefits package. For many, health insurance is not a luxury; it’s a necessity, even if there wasn’t a pandemic. Companies are going to be remembered for whatever choices they make right now but cutting healthcare benefits during a pandemic is likely to be viewed as particularly cruel. Your brand may get a bad reputation that can take years or even decades to reverse. With social media, employees have plenty of ways to vent their fears and frustrations publicly. They can also go to the press.

If your situation allows for no alternative, it is recommended that you at least do a benefits analysis and offer minimum or catastrophic healthcare packages to employees if at all possible. If you really can’t afford anything, at least provide resources to help employees buy health insurance coverage from market vendors. Make sure you explain the reasons for your decisions thoroughly.

Don’t Cut Inexpensive Perks That Boost Morale or Productivity

So far, we’ve covered why you should be cautious about cutting your largest expenses, but you should also be careful when it comes to your smallest. Some expenses might seem frivolous, but if they are small and tied to employee morale or productivity, you should think twice about taking them away. These types of expenses might include perks like donuts on Fridays (if you’re still even working in an office), employee awards and recognition, interoffice competitions, yoga classes (they can be done virtually!), and so on. These perks make your business special and demonstrate your company values and commitment to building a positive work environment.

If you have numerous perks and have to do away with a few, you can send out a survey to employees asking them to weigh in on what they would most like to keep and which they wouldn’t mind seeing suspended for the time being. If you are currently working remotely, many office environment-type benefits have probably already been suspended anyway.

The Dos of Reducing Compensation Costs

There are a lot of things you can do to reduce compensation costs that don’t impact employees as deeply as the items above. Here are just a few ideas.

Do Freeze Pay if Warranted

It’s common for organizations to freeze pay in an economic downturn, which means canceling raises for current employees.

When deciding to freeze pay, it is still recommended to do so thoughtfully, fairly and judiciously. Freezing pay will hurt some employees more than others. For example, employees who are newly graduated from college are likely starting out at the low end of their pay range with the intention of learning rapidly and — correspondingly — being compensated more as their value increases. Likewise, new hires may still be candidates for raises if you placed them lower on their pay range with the intention of reevaluating their compensation in light of their performance after six months or so. You also may want to reward top performers who have distinguished themselves in extraordinary ways.

However, you likely also have employees who are performing adequately but not extraordinarily or are simply very highly compensated. This is especially true for employees who are already highly paid, such as executives, and for employees that are currently at the top of their pay range (red-circled), especially if they are long-tenured employees with jobs that haven’t changed much and aren’t likely to. It would be appropriate to freeze pay for some or all employees who meet this criteria, though you should still provide clear and thorough communications around why these employees don’t qualify for raises this year and what the process will be to re-institute raises when the situation changes.

Do Suspend Benefits Other than Healthcare

Most companies offer a variety of benefits as part of their total compensation package. When reducing compensation costs, focus on the things that are costly and not vital, like tuition reimbursement. You might also eliminate fringe benefits like a company car, a paid phone plan, a free gym membership, and other perks, especially ones that employees can’t use right now due to the pandemic. For example, if you were previously budgeting dollars to send employees to conferences for education, you may be able to cut that benefit since so many conferences have been cancelled for 2020 or reallocate those dollars to less expensive education online or through virtual events.

If you’re still needing to cut expenses, you can consider suspending 401K matching. Although offering a 401K match is an expected benefit and a competitive differentiator for many organizations, most employees would probably prefer to see this benefit suspended over something more drastic like eliminating healthcare insurance or cutting pay. As always, different situations will apply to different companies and you can always conduct an employee survey to verify your hunches.

Do Consider Reduced Hours

If you are forced to reduce payroll and layoffs are not an option or aren’t sufficient to reduce spend, you can consider reducing work hours. For hourly employees, this will automatically reduce expenses. For salaried employees, cutting even a single day’s pay out of the month for all employees can provide substantial financial relief. If matters are more serious, you can consider instituting a four-day workweek with reductions in salaries by one fifth.  With this strategy, employees at least get something in return for the reduction in wages (time) and it may be well tolerated, especially if it is temporary.

In addition, if you do not already have unlimited PTO you might consider instituting it on a trial basis. Unlimited PTO can save your organization time as well as money. You will no longer have the expense of tracking accrued hours and can instead just rely on managers to make sure employees aren’t abusing time off. If you must track PTO, you can reduce expenses by instituting a “use it or lose it” policy for vacation hours so that you won’t be paying out cash to employees who leave your organization. You can also do a combination, with a set number of accrued PTO hours as well as manager discretion to allow additional paid or unpaid time off.

Conclusion

When it comes to reducing compensation costs, the most important thing is to approach decisions strategically and communicate rigorously. The more data you have going into these decisions, the easier it will be to communicate them to employees and the more confident you will feel that you made the right decisions.

Obviously, at PayScale, we believe that compensation strategy is important. We also believe that pay transparency is important. In setting or adjusting employee pay, we believe it is critical to use the freshest market data available. We also believe that a strong compensation structure and leveraging the power of compensation management software will reveal to employers where they are overpaying, where they are underpaying, and how to make the most out of their payroll dollars.


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Amy Stewart
Sr. Content Marketing Manager at PayScale
Read more from Amy

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