The Annual Salary Increase Process is Broken and It’s Time to Fix It

By all measures, we’re entering a new era with increased competition for talent. US unemployment is down to 3.9% (Bureau of Labor Statistics), and more than 97% of executives are expecting an increase in competition for talent in the coming year, according to Mercer's 2019 Global Talent Trend study.

That said, one might think it should be a “golden age” for American workers. Yet, employers are not budging on salary budgets. Based on the results of Mercer’s 2018/2019 US Compensation Planning Survey, salary increase budgets for 2018 are flat at 2.8% and projected to be only 2.9% for 2019. Even an influx of cash from December’s Tax Cuts and Jobs Act hasn’t had an impact – only 4% of employers plan to redirect tax savings to salary increase budgets in 2019, of which 53% project the increase to be less than 1% of payroll. Something seems broken, yet our research shows that most organizations (89%) are not making any changes to their salary increase program for 2019.

It is well documented that talent is critical to business transformation, and how talent is rewarded impacts an organization’s ability to retain and build the workforce needed to deliver on future business objectives. Current compensation systems are struggling from 10 years of small salary increase budgets, which has made differentiation difficult, if not impossible. Pay increases have largely been distributed through organizations sparingly (0% to 5% on average), and not based on business needs, performance and current competitiveness.

Employees understood tight budgets in a weak economy, but as the economy continues to improve they are becoming increasingly unhappy with pay. Employee perception of fair pay has declined from 57% to 52% over the last five years, and perception of pay for performance has dropped from 55% to 47%, according to an analysis by Mercer | Sirota of employee satisfaction data from across approximately 100 companies and 1 million employees.

Since many organizations continue to “follow the pack” when it comes to salary increase budgets, a major shift in budgets is not expected. In fact, US salary increase budgets will likely remain flat through 2021 based on a Mercer Select Intelligence study of current economic projections and 20 years of historical data. Many factors are contributing to this, but three stand out:

  1. Cost containment: As organizations have placed more focus on maximizing shareholder value, they’ve focused on reducing costs – for many industries employee salaries represent one of the most significant operating costs.
  2. Economic uncertainty: Due to the current political climate, financial leaders continue to be conservative and limit increases in fixed costs. Salary increases are not easily reversible, so there’s likely a hesitation to pull the trigger on these longer-term fixed costs.
  3. Globalization of labor forces: Wage stagnation is not just a US market-driven issue, but a global phenomenon. Employers are increasingly able to tap into a global talent pools, which drives wages towards a global equilibrium over the long term.

Given these dynamics, how do employers stand out in a crowded marketplace? Perhaps they have an opportunity to do something different that may involve disrupting historical norms and deviating from the pack when it comes to how they budget for annual salary increases.

Here are some recommended actions for organizations rethinking their compensation plan and total rewards strategy:

Be Fair and Transparent and Focus on Pay Equity

Pay equity should be top of mind given the increase in public scrutiny from activist investors and regulation in this space. As labor markets have tightened, employers have held on budgets for salary increases to current employees, but have “loosened their belts” when it comes to hiring rates out of necessity given the competition for talent. Often, new hires are being brought in at a premium over their peers.

Furthermore, new research shows the “squeaky wheel gets the grease” as over 70% of employees who asked for a raise received one, according to PayScale’s recent Raise Anatomy report. Of concern, however, is that people of color were significantly less likely to receive a raise when they asked for one relative to white men.

These dynamics are creating an environment where employees are demanding greater pay transparency – as are many regulators – but to get there companies must create the foundation for fair and equitable pay delivery, which often starts with the annual salary increase.

Rethink Pay for Performance

Does your annual salary increase process reflect the new reality of salary increase budgets? If not, it’s a good time to rethink traditional notions of pay for performance. Historically, salary increases were advertised as “merit budgets” to highlight pay for performance. Market pressures have driven the need to balance pay for performance with maintaining market competitiveness.  The reality is that the common practice of slicing a budget of 3% by these two dimensions is falling short on both fronts: internal pay is falling behind market in many pockets and performance differentiation is limited.

Many organizations are considering other levers as they redefine pay for performance. The reality is that in an era of tight merit budgets, real pay growth may only be achievable through career progression. Organizations that focus on career progression not only as a means to professional advancement, but also as a means to rewarding performance have an opportunity to make greater impact with limited resources. Mercer’s 2018/2019 US Compensation Planning survey shows that the average promotional increase offered to employees in 2018 was 7.8%, up from 7.5% in 2017. To keep pace with the external labor market, organizations may need to provide more aggressive promotional increases – as much as 10% to 20% – to move to a competitive market rate and effectively compete with the premium competitors are offering new hires.

Consider Salary Increase Budgets as a Strategic Investment in the Business

In today’s environment, every company has a unique mix of workforce needs that requires building or repurposing talent for the future. This may call for an investment in base pay that is different than the competitor or the company next door. Like any investment, how salary increases are allocated should be based on a sound business case. Yet, many companies continue to budget salary increases based on what everyone else is doing.

Recasting the salary budget as a strategic investment might change the perspective on the budget needed in any given year. Through the lens of the future direction of business and workforce needs as well as current pay equity and market competitiveness, budgets may need to be more or less than the average in the market. With typical salary increase budgets being a multi-million-dollar long-term investment in human capital, both an annual and long-term strategic plan for salary increase budgets is essential.

Differentiate with Experiential and Emotional Rewards

Pay isn’t the only way for organizations to invest in their workforce and prepare for the future. Once compensation is right, consider expanding the view of rewards to include elements that can differentiate the employee experience in a way that other employers can’t easily replicate:

  • Enhance visibility into career opportunities by developing a career framework that makes it easier for employees to seek opportunities within the company and targets development and training to build critical skills.
  • Demonstrate a focus on total well-being for employees that goes beyond the physical health and includes their financial, emotional and social well-being.
  • Harness the power of the company’s purpose to create an emotional connection to the company and help employees discover more meaning in their work.

Is It Time to Make a Radical Shift in the Annual Compensation Planning Process?

Given the state of the labor market, the external scrutiny on pay equity and the continued trend of tight merit budgets, employee rewards is on the top of the agenda. Employee patience with the current state is being tested. As the economy improves, they have more options for where to work and competitors are willing to pay a premium to get them in the door. Employers that do not embrace a new model may not be able to leverage one of their greatest assets – their people – to compete in the future of work.

Lauren Mason
by Lauren Mason

Principal, Career