Compensation: Is it time to Switch from Cost-Cutting Back to Compensation Strategy?

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1 Compensation: Is it time to Switch from Cost-Cutting Back to Compensation Strategy? By, Marie Brinkman and David Knopping Radford An Aon Consulting Company As we are almost mid-way into 2009, is it time to switch gears from survival mode to planning for an eventual upturn with our compensation strategies? Maybe it s time to look ahead. While the global recession grinds on, there are now glimmers of hope and signs of an uptick. At least, in many cases, the downward pace has decreased: the rate of decline in orders, profits and job losses is slowing. Although this recession is deemed to be the most severe since World War II with the global economy now expected to shrink by 1.3% in 2009 a slow recovery is still anticipated to take hold next year. While GDP is forecasted to decline in all the advanced economies, it is still expected to grow by 4.8% in developing Asia as a group - with China (at 6.5% GDP) and India (at 4.5%) in the lead. (International Monetary Fund, World Economic Outlook, April 2009). Table 1 6.0% World Advanced Economies Developing Asia 4.8% GDP Forecast 6.1% Annual Percent Change 2.0% -2.0% -1.3% 1.9% % -6.0% Source: IMF World Economic Outlook Projections, April 2009

2 Green shoots have been sighted! According to recent reports, consumer confidence in the US shot up in April compared to March, showing some encouraging signs of growth. Additionally, inventory levels are bottoming out signaling an upcoming need for new orders and new production. In the US, the Institute for Supply Management (ISM) manufacturing index edged up in April with the highest level of new orders since August China s manufacturing index, the PMI, also picked up in April adding to signs of improvement in its economy. Even in Japan, hard hit by falling exports, industrial production rose 1.6% in March, compared with a fall of 9.4% in February. (Wall Street Journal, May 1, 2009; The Economist, May 2, 2009) Stimulus funds in many countries are being disbursed with wide ranging impact. For example, China s rapid deployment of funds for infrastructure projects are having a positive impact not only on local employment and production, but on international markets for commodities and other raw materials, as well as multinational firms in the US and elsewhere providing capital equipment and technical and managerial expertise to China, once again illustrating the interrelatedness of the global economy. The month of April saw a global stock rally with the Dow Jones World Index up 12% - its largest monthly jump since its inception in Stock markets in the US, Europe, Japan and Shanghai all showed gains. The markets are still far from their pre-november 2008 levels and it is likely there will be continued volatility in stock prices in the coming months, but given that the stock market is considered a leading indicator, April s stock market performance is cause for optimism. In light of recent indicators, how are companies coping with the current economic environment, and just as importantly, preparing for the future and eventual turnaround? HR/Compensation Strategies Reacting to the Downturn Navigating the downturn has produced a variety of HR survival strategies. These range from financial triage, with rapid and dramatic across-the-board cost reductions that include pay cuts, significant reductions in work schedules and/or major layoffs by companies hardest hit and least able to withstand a sharp decline in business. For companies less severely affected by a drop off in business or those with the financial ability to endure the decline, surgical, or selective strategies to pare back have been adopted. These may include a hiring or salary freeze, limited bonuses, and/or a reduced work schedule. For the fortunate companies with a more recession-proof business model and a strong balance sheet, it may be an opportune time for acquisitions and the selective hiring of key talent. Additionally, by pausing from the hiring frenzy of recent years, it means the opportunity to enhance employee selection processes and career development and performance management programs. For many companies, particularly in the fast growth markets, it s the chance for a resetting of employee expectations to be more attuned with a more realistic growth mode.

3 Employment Outlook In grappling with compensation strategy in this economy, the first question to answer may be: how stable is the employment picture for 2009? Radford s Quarterly Summary of Industry Trends (QSIT) report shows that about 40% of high-technology companies anticipate workforce reductions in 2009 overall, with about half of those reducing staff levels by less than 5% and the other half by more than 5%. Another 40% of companies expect to maintain current staffing levels, while about 20% actually anticipate growth in the workforce, even if only selectively. Most of the global hiring will occur in China and India with 20%- 25% of surveyed companies anticipating adding staff in these locations, even if only modestly. Only a small percentage of companies (9%-11%) anticipate increasing the size of their workforce in Japan and Singapore economies harder hit by the downturn. Table 2 Planned Changes to Size of Workforce 2009 Percent of Global Companies Changing Staffing Levels in these Countries Country Decreasing No Change Increasing China 29% 51% 20% India 26% 49% 25% Japan 32% 59% 9% Singapore 32% 58% 11% Salary Trends More Variation in the Market Unlike recent years, when virtually every high-technology multinational company provided salary increases to employees globally and double digit increase percentages were common in rapid growth markets, the picture now is quite different. There is more variation in practice because the economy is not affecting every company in the same way. Typically, in the past, companies would rely almost exclusively on general market pay data, narrowly benchmarking against the median of market salary increase forecasts to develop their pay strategy. Now, however, given so much economic turmoil, there is a great deal more variation in market practices. Trends in market pay levels will range from decreases in pay (due to pay cuts), to no movement in pay levels (due to a pay freeze), to modest increases, and finally, to relatively generous salary increases for key positions or key sectors by those fewer companies that can still compete aggressively for talent. Table 3 (China) and Table 4 (Hong Kong) illustrate the mid-market range of annual overall salary increase percentages for 2007, 2008 and The mid-market range is defined as the middle 50% of the market (i.e., salary increases falling between the 25 th and 75 th percentile of the market). As charts demonstrate, there is significantly more variation in the mid-market range in 2009 compared to prior years.

4 Table 3 Annual Salary Increase Percentage % 1 6.0% 2.0% 8.5% 6.3% Overall Annual Salary Increase - China 9.5% 7.0% % 4.3% 25th Percentile 50th Percentile 75th Percentile Table 4 Annual Salary Increase Percentage 1 6.0% 2.0% Overall Annual Salary Increase - Hong Kong 5.0% 3.7% 5.0% 4.2% 4.3% 2.8% th Percentile 50th Percentile 75th Percentile

5 Table 5 shows the spread in salary budgets for 2009, compared to 2008, for several APAC countries. Table 5 Overall Salary Increase Budgets for 2009 Market Percentiles Middle 50% of Overall Market Country 25th 50th 75th Mid-Market Range Spread 2009 Mid-Market Range Spread 2008 China 4.3% 8.2% 8.2% 2.5% Hong Kong 2.8% 4.3% 4.3% 1% India 10% 14% 14% 3.5% Japan 2.5% 3.5% 3.5% 1% Singapore 3% 4.5% 4.5% 1% South Korea 3% 6% 6.5% 2% Taiwan 2% 4.2% 4.2% 1.5% US 3% 4% 4% 1.5% This means that HR and compensation professionals need to carefully evaluate their company s growth prospects and cost constraints, as well as opportunity costs, when determining what level of salary increase, if any, is right for their company for the remainder of 2009 and in planning for Careful selection of peer companies and industry sectors helps in interpreting the variance in the market, providing a more nuanced view of compensation trends. Balancing market trends with what your company can afford and its long-term viability is essential.. For HR and compensation professionals involved in workforce planning with a need to forecast relative labor costs across countries, it is helpful to determine the cross over point (i.e., when market pay levels will be the same for a given job in different countries based on current salary increase trends). For example, Table 6 shows the pay level for a senior finance management position in China compared to that in Hong Kong (both translated to US dollars) and the number of years until their pay would be the same, given certain assumptions about market trends. Together with information about the supply and demand for talent in each labor market and other economic and business metrics, this may be helpful in forecasting staffing requirements and associated costs across countries.

6 Table 6 Senior Finance Position When is Pay the Same? Calculator Current Salary Market 50th Percentile China Annual Salary Growth Number of Years Future Salary Current Salary Market 50th Percentile Hong Kong Annual Salary Growth Number of Years Future Salary USD 100,000 8% 9.25 USD 203,700 USD 155,000 3% 9.25 USD 203,700 Source: Radford International Survey, October 2008 Incentive Plans Acting as an Automatic Stabilizer In times of economic turmoil, a properly designed incentive plan acts as an automatic cost stabilizer, paying out when company performance meets expectations, and not paying out when performance (and financial ability) is lacking. According to a recent Radford flash survey Managing Compensation in a Downturn Economy, most incentive plans are doing just what they were designed to do, with approximately 70% of multinational high-technology and life sciences companies expecting to pay either no bonuses or lower bonuses in 2009 than in 2008, reflecting this year s extremely challenging business climate. Although this is beneficial from an overall company cost standpoint, it presents a difficult message to many employees who are working harder than ever and have been used to earning good bonuses in recent years. Many companies are taking advantage of the current environment, when rapid hiring and other HR initiatives are not the top priorities, to reset expectations and clearly communicate the goals and structure of their incentive program. This helps employees to better understand the concept of variable pay, which in good times, many had come to see as a guarantee. It also helps them understand how their contribution, performance and bonus payout is connected to the overall company performance. Additionally, it is important, particularly in a multinational company, that employees clearly understand what portion of their incentive is tied to the performance of their company as a whole versus their geographic region, country and/or business unit, and/or their own individual performance. Recognizing that forecasting performance and setting incentive plan goals are particularly challenging this year, some companies have made modifications to their incentive plan design, although these changes are in the minority: some have changed the performance measurement period to be more frequent, while other companies have re-oriented their goals to compare performance relative to peer companies. However, a more likely scenario is that companies are making highly selective awards, such as project team bonuses or special incentives, for top performers to recognize and reward superior efforts, and outcomes that rise above the challenges of today s economy.

7 Stock Plans Increasingly Selective At the same time that stock values have declined, bringing down the value to employees from employee stock options and restricted stock plans, there is continued pressure by shareholders and investors to reduce the amount of overall company dilution (a measure of annual stock spend) such that companies cannot simply grant more shares to make up for the shortfall to employees. Here, too, there is marked variability in the strategies companies are undertaking. For the last couple of years, the trend has been steadily away from broad-based equity plans. Most multinational hightechnology companies in the Radford survey have been moving toward granting equity more selectively to critical talent and high performers. However, a counter trend in the current market is to use the current downturn as an opportunity to put stock in the hands of all employees when prices are at the lowest that they have been in years, resulting in significant upside potential. Because many companies have reduced staff and expect limited hiring, there is an opportunity to extend equity more broadly in the organization without overextending the equity pool. In addition, many companies are considering allowing employees the opportunity to exchange their underwater stock options for new at-the-money stock options or restricted stock based on exchange ratios that are fair to employees and shareholders alike. This serves two purposes: it helps to retain employees by taking their value-less underwater options and making them more retentive while also reducing unproductive stock dilution which benefits the shareholders. Conclusion In terms of the work of HR and compensation professionals, this year has been marked less by compensation strategy and more by dramatic and necessary cost cutting reactions. As we look toward the latter part of the year, and beyond to 2010, it may be time to take measure of where the market has landed, and plan your best strategy accordingly.