Labor markets have been destabilized by events that have created a turbulent environment.
For example, data shows 1.7 job vacancies for each unemployed person in the U.S., which places upward pressure on pay rates. Inflation has also created employee expectations that their employers will maintain their real income. Minimum wage regulations have been modified significantly in many areas, mandating pay increases for employees paid below the new minimums. These mandates have also created pay compression, with other employees paid in the lower parts of their assigned pay ranges. The interaction of these factors has made pay management more complex.
In the decade before the pandemic arrived employers in the private sector were seemingly on autopilot. Budgets for pay adjustments were around 3% and pay structures were moved 1% to 2% on average. Inflation varied between 3% and 0% year to year for more than two decades. Unemployment was not a major problem, and most organizations were able to attract and retain staff. Although shortages existed in some occupations, increasing pay rates for some was often a manageable remedy, since the increased costs were generally limited to a small portion of the workforce. But that was then, and organizations must deal with what’s happening right now.
A Host of Challenges
Pay management practices in public sector entities have evolved in a manner that makes them more similar to those in the private sector. The use of automatic, time-based pay rate progression declined dramatically in much of the sector.
Although the federal government still uses the general schedule (GS) system, which mandates automatic step-based progression, many federal agencies have changed to basing pay actions on competence and performance by gaining approval to adopt “excepted service” approaches.
The primary reason for the change is that automatic pay rate progression does not provide motivation to perform, and it is viewed negatively by those who perform at higher levels, who question why lesser contributors are receiving the same adjustments.
For example, the Office of Personnel Management (OPM) is now faced with deciding how much to adjust the GS structures at a time when there is pressure to match inflation rates. Adjustments to the GS structure are on top of the cost of the automatic step progressions and the combination of the two adjustments creates a permanent fixed cost increase to be supported by taxpayers.
Collective bargaining agreements also present a challenge. Multi-year contracts can result in adjustments that are higher than prevailing competitive averages in some years and lower in other years. The predictability offered by a three-year contract might have made the approach attractive when negotiated, but the current year adjustment may seem inadequate when inflation is at the current level.
Private sector organizations that have not made it clear they manage pay based on cost of labor, and not cost of living, are also experiencing the pressure to fix the damage done by inflation. It is not viable to adjust pay each year based on whichever of the two rates is greater, but a visit to a gas station or paying an electric bill can override intellectual understanding of these economic realities.
Wage levels in the U.S. have gone up about 50% faster than inflation over the last five decades. Rational analysis would suggest it is better to have one’s pay increased by the cost of labor rather than the cost of living, at least over the long run. From an employee perspective, the best option is to receive the higher of the two rates each year. But that would lead to insolvency for most organizations.
Even if a public sector entity dependent on taxation revenues could somehow afford this form of largesse it would escalate pay rates to much higher levels that exist in the private sector. That would at some point be likely to generate considerable citizen opposition.
Today’s environment creates challenges that have not been confronted for several decades. An inflation rate that exceeds an organization’s pay increase budget by two to three times presents a daunting challenge. Even if employees realize their pay is administered based on the cost of labor rather than inflation, the short-term impact on their ability to sustain their quality of life shocks their sensibilities. Each time someone fills the gas tank or visits a grocery store, the impact of increasing living costs is felt.
Alternative Approaches
No matter what compensation strategies an organization adopts, it must be based on a recognition that an increase to someone’s base pay is a permanent addition to fixed costs. Pay reductions are not expected, and when they occur, those affected are likely to believe a contract was violated. If an employee’s base pay is increased, they are likely to adjust their standard of living based on the expectation that future increases are uncertain. But there is a strong belief that reductions will not occur.
Organizations that have a high percentage of their controllable operating costs in the form of workforce costs will be impacted by pay increases much more than one with a smaller percentage related to people costs. For example, a refinery is capital-intensive and has less than 5% of its costs in workforce costs, which makes it feasible to pay much more than a public sector entity with well over half of its costs related to maintaining its workforce.
This reality raises real issues for public sector entities when recruiting people in occupations that are mobile across sectors. Consequently, when measuring competitive pay levels, it is necessary to use data that encompasses employers from all sectors for those mobile occupations.
One of the potential limitations facing public sector agencies is that they cannot use devices like equity-based programs as a part of their total rewards package when competing for talent. Variable pay programs also present challenges, although it is possible to use incentive pay programs in the public sector. However, it is necessary to carefully consider the context prior to considering programs that may appear to be inappropriate to the primary constituencies, including taxpayers and regulators. It may also be difficult for employees to accept the contingent nature of variable pay if they have been used to a different approach.
One of the most common types of variable-pay plans used in the private sector is the profit-sharing plan. Since profit is a tangible metric, it is possible to include all employees in a plan that creates a pool when profits exceed a threshold that gives investors a reasonable return.
No such clear metric exists in the public sector. Although actual performance relative to the operating budget could be used as a performance measure, management could be motivated to cut back services to ensure the budget was not exceeded, which may constitute dysfunctional motivation.
There is an option, however, since increasing base pay levels by a large amount to offset temporary spikes in the inflation rate would create costs that will be fixed into the future. If an entity has budgeted 3% for pay increases but inflation is currently at 6% management could decide to limit pay increases to the budget but create a 3% of payroll “inflation offset adjustment” pool that would be paid in cash.
This approach should be accompanied by clear communication that the employer recognizes the toll on employee spending power and that this payment is a one-time offset to address a short-term condition.
It should also be made clear that economic realities demand that the entity manage pay based on cost of labor, not cost of living. Cash awards out of a 3% pool could be 3% of current pay for everyone. A further refinement could be to give everyone the same amount, calculated by dividing the pool by the number of employees. This recognizes that the spending power of lower- paid employees is being impacted more significantly than those at higher pay levels.
Strategies For the Future
The most important reality employers must communicate is that it is not economically feasible to adjust base pay levels each year that match the higher of the cost of labor or the cost-of-living increase rates. Organizations that attempt to do so can perhaps satisfy employees currently but may see compounded increases in fixed costs that are not sustainable.
Public sector entities must answer to those who fund them, and if taxation rates must be increased, they must provide justification for the practices that escalated costs. Private sector entities are subject to a similar accountability, since their investors are free to withdraw their support.
Base pay programs that link pay actions to performance can be refined to use both base pay increases and cash awards. For example, if there is a 4% budget, 1% of that could be reserved for cash awards tied to performance, leaving 3% for base pay increases.
Although 1% does not seem like a large budget for cash awards, those in the top 10% could receive a 5% cash award and those in the next 25% (such as those receiving a ”Significantly Exceeds Expectations” rating) could receive a 2% cash award. This would result in cash awards amounting to 1% of payroll. Base pay increases could be used to position individual pay rates in the appropriate part of the pay range, which should reflect individual competence. The cash awards do not inflate payroll cost and do not result in future compounding.
Convincing employees that the pay system is economically sound, equitable and competitive is one of the most daunting challenges faced by any employer. Cognitive bias causes a widespread feeling of being underpaid, since people believe they are better than they are. When the pandemic struck, it cost some their jobs and forced others into alternative working conditions that resulted in frustration.
Human nature causes employees to expect the employer to somehow undo the damage, even for things that were not under the control of organizations. Someone experiencing high levels of frustration may note that employers are having trouble staffing their workforces and that there are a lot of jobs readily available. If that person does not feel the organization understands their plight or that it is doing too little to address the causes, it can lessen the attachment one feels. Decisions made while frustrated, angry or feeling mistreated are often poor ones. Yet once an employee begins to examine alternative employment, inertia can ease departure.
If recruiting is difficult, as it is now for many employers, it is wise to invest in minimizing unwanted turnover. Reviewing pay systems is a necessary, but not sufficient, step to take to address employee concerns. It is also necessary to minimize the risk that short-term actions taken in haste do not have a negative impact on future viability.
01 January 2023
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February 2023 Issue • HR News Article