Strategic compensation planning for 2004 is as complex as it can be. Sectors of the economy are starting to report increased productivity, but unemployment remains stubbornly high. Few companies want to be too optimistic about growth in the near term, but many sense that it is around the corner. They wonder how the impending talent war will differ from the last one and what new strategies they will need to compete in it. Salary levels remain flat, while health care costs are projected to rise at double-digit rates in 2004 for the fifth consecutive year. Executives are concerned about their ability to afford any sort of pay increase for employees while sustaining the total reward costs – pay and benefits – they are paying today.

These converging and complex external events are forcing companies to make incremental responses. How your organization chooses to respond should differ from your peer group’s responses, and should be carefully considered in concert with the full spectrum of human capital decisions. Based on Mercer’s experience with all company types and sizes, and our extensive annual pay data, we offer some paths for you to contemplate that – when considered holistically – will help you chart a course toward growth in these uncertain and challenging times.

Reward ROI: Affordability and sustainability

Companies are finding that they cannot afford to maintain – or sustain beyond 2004 – their current level of pay and benefits spending in light of escalating benefits expenses. Something needs to give, but what? How do you allocate next year’s reward investment to get the best return?

Companies cannot shrink to greatness; they must approach these difficult reward program decisions by thinking more boldly and taking measured risks. Adopting a holistic approach to reward strategy and using tools to connect employee actions to economic outcomes can help employers make such decisions and enhance business results. Reward ROI involves the statistical analysis of a company’s employee, operational, and financial data along with marketplace practices to determine how reward investments affect human capital and business outcomes.

Making human capital investment decisions based on reward ROI, versus solely on market pay practices, involves a careful examination of your workforce. Begin by determining the critical skills it takes to drive business results and then track who within your organization has those skills and where they came from, what career development and training opportunities are available to them, and what the turnover has been in that skill group and why.

This internal labor market perspective helps companies address the issues of affording and sustaining their human capital investments and managing resources to improve future business performance and competitive positioning. Keeping a finger on the pulse of the external market is critical to attracting and retaining the best talent, but competing on pay alone is expensive and most often a losing proposition.

Base pay: Proceed with caution

Employers do not have to look far – internally or externally – to know it will be another cautious year for setting pay increase budgets. Overall average increases are expected to fall below 4% for the third year in a row. The silver lining is the fact that inflation hit a five-year low (1.6%) in 2002. That was fortunate, because overall pay increases, even though less than 4%, have provided real and sustained economic gain.

We may not be so fortunate in 2004. The differential between the Consumer Price Index and employee base pay is expected to decrease slightly next year because of the expected rise in inflation. The Economic Forecasting Center of Georgia State University estimates that the Consumer Price Index will rise to 2.6% and 2.7% in 2003 and 2004, respectively. And, according to Mercer’s 2003/2004 US Compensation Planning Survey (with more than 1,700 participants), pay increases will average 3.3% in 2003 and are estimated to be 3.5% in 2004. So real increases in average pay could be well under 1% from now through 2004.

Another belt-tightening response by employers is to freeze salaries, but the trend for such drastic measures is diminishing. While the prevalence of salary freezes varies by industry, only 12% of employers indicated that they had to do so in 2003. Very few employers indicated that they will freeze employee pay in 2004, largely because they expect the economy to improve before then.

Attracting, differentiating, and retaining top talent

Given finite financial resources, how are employers to position themselves to grow? We encourage employers to think beyond cash and consider the entire work experience from the employees’ perspective. Work explicitly with high performers to enrich their jobs with faster career progression, more interesting assignments, and diverse responsibilities. The most progressive companies look at pay, benefits, and career progression opportunities plus other intrinsic work factors such as employee skills, work processes, work environment, and work-life balance. Although creating a unique total reward mix for your high performers takes more effort, it addresses the limited resources concern and is difficult for your competitors to emulate.

Our second annual web-based survey, Measuring the Return on Reward Investments SnapShot Survey, shows how 184 employers are adjusting their talent management practices in a shifting economic and labor market. One-fifth of respondents currently have formal career planning and another 20% are considering it. In fact, just over 50% of firms are now defining “rewards” as more than just pay and benefits.

A number of the emerging reward practices – current or planned investments in career planning, training, and short- and long-term reward programs – are related to organizations’ shifting talent acquisition strategies. While about half of the SnapShot Survey respondents currently have an even balance between “buying” talent from the outside and “building” talent from the inside, they expect their strategy to change in the future. Thirty-six percent expect to “build” more and 16% expect to “buy” more. Among companies whose current strategy is to buy talent, six in ten said they expect to build more in the future.

Changes to future “build vs. buy” strategies

This shift in strategy requires an organization-wide commitment and a culture that supports leadership development. The good news appears to be that companies are already taking steps in that direction by making investments in career progression activities.

Pay for performance

Executives often agonize: Should we give high performers a 5% merit increase and mid-performers 1-2%? With increased optimism about the economy, it is a risky proposition to demoralize those who are meeting expectations, because that group will be critical for helping the company react quickly to a business up-tick.

We recommend that companies firmly embrace a pay-for-performance strategy and reward their high performers with short-term incentives, equity, and career opportunities. Create a performance framework by linking short- and long-term incentives to what drives business results. Ensure that your employees:

• Understand your vision,
• Know how they can make a difference, and
• Are rewarded when goals are attained.

In summary

As companies consider the remainder of 2003 and the year ahead, optimism prevails – 37% of respondents to the SnapShot Survey are preparing for growth. The challenge for the human resource professional is to balance potentially competing priorities effectively – preparing for top line growth while managing costs. It’s a challenge that you can address by developing a holistic reward strategy that considers more than just pay, differentiates meaningfully between high and low performers, considers critical skills, and ties pay to performance clearly.

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