Compensation in Inflationary and Recessionary Years

Inflationary and Recessionary times are all part of the normal business and economic cycle. As compensation professionals, we need to know what to expect during these times and how to respond to them.

Inflationary Environment

In an inflationary period, while salary budgets are rising with the other costs to the company, the relative value of the dollar decreases (the dollar doesn't buy as much). Moreover, company profits (while seeming to rise) may not be keeping pace with inflation, thereby making the profits over-inflated, which makes profits seem like they are rising — when in fact they are not. This is where compensation analysis and financial analysis converge.

As well, the value of a salary increase (while quite considerable) could be in fact, not keeping pace with the economic pressures of rising prices. In inflationary times, it is important to track the cost of living and assure that salaries are maintaining the projected target level (perhaps the 50th or 75th percentile). It is also more likely that employees will move around during inflationary times, hoping to attain higher pay by in effect catching a mid-year increase which puts them closer to the market. In extreme times, inflation can reach the double digits and midterm/semiannual adjustments to salary structures and pay may be needed to retain critical staff. Still, to be on the safe side, it is wise to allocate some of the compensation funds to incentive pay that can be lowered when the inflationary market takes a turn to the downside, which it eventually will. Often, base salaries are not reduced even when salary market data warrants it. To be competitive with other companies (on a regional or national scale) allocating funds to incentive awards can allow the company the flexibility of decreasing compensation later (by removing the incentive pay) when the market data shows the decreased values of jobs, monetarily, during a recessionary period.

Recessionary Period

In a recessionary period, money gets tighter and the impact to the bottom line is more critical. As a result, we may find our workforce shrinking to accommodate the contraction in the business. At those times, in particular, it is crucial to allocate our compensation funds to the maximum benefit. Concordantly, within a recessionary period, we may also find that job sharing or job expansion is occurring — which affects our need to keep our job descriptions and job evaluations updated. More importantly, though, is the need to leverage our compensation funds to deliver the maximum return on investment. One of the strategies for doing that is to make sure that the pool of funds allocated to the company's compensation budget is applied to reward job families that advance the company's goals of reaching the bottom line. In these instances, more of an emphasis on incentive pay can be appropriate.

As well, individuals that exceed performance standards should be paid above the median salary increase, while those at average or below may receive little or no increase. That is called leveraging your salary plan. Use of a performance/pay increase matrix can be helpful. Another consideration is the tendency for salary levels to remain static and not to decrease as one might expect. Companies are reluctant to lower base salary levels, even when the market data warrants it because of the fear that it would decrease employee satisfaction and performance. In summary, given those circumstances, it is critical to thoughtfully allocate compensation funds in a manner that will yield higher performance for the company, thereby increasing the chances of a higher performing return on equity which can benefit all employees. In other words, in hard times, job families and individuals within those job families that don't have a crucial affect on the bottom line could be reallocated or given smaller increases. Still, even in the less critical jobs, employees that exhibit higher levels of performance should be rewarded well. One method of managing the compensation plan to pay for performance is to utilize a merit pay/performance guide, like the example below.

Example of a performance-quartile guide which yields merit pay increases:

Performance RatingFirst Quartile*

25th Percentile

Second Quartile

50th Percentile

Third Quartile*

75th Percentile

Fourth Quartile

100th Percentile

Outstanding 8 %7 %6 %5 %
Exceeds Requirements 5 % 4 % 3 % 0 %
Meets Requirements 3 % 2 % 0 % 0 %
Does not meet requirements 0 % 0 % 0 % 0 %

* 75th Percentile means that 75% of the salary structure lies below this point

* 25th Percentile means that 25% of the salary structure lies below this point

Therefore, if two employees with the same performance rating, outstanding, resided in two different percentiles, 25th and 75th, the employee in the 25th percentile would receive an increase of 8%, while the one in the 75th percentile would receive 6%, because he is already being paid more highly on a relative scale.

By spending most of the salary budget on those that are outstanding performers, (as you'll see within the first row) you will hopefully retain them.

In summary during recessionary periods, employees that play a key role in contributing to the bottom line should be rewarded — perhaps with incentive increases that can be altered later when the circumstances change. For the merit increase budget, allocate most of the compensation pay out to the highest performers — make those increases significant. One way of paying for performance is to use a pay/performance guide like the one shown above.

Since both cycles (inflationary and recessionary) are a necessary phase of business expansion and contraction, respectively, it is advisable for the compensation professional to know how to deal with these business cycles ahead of time.