The recession has forced many employers to rethink, and sometimes restructure, their pay and benefits arrangements, says Tom Washington
It may be a tough time for reward, but never has there been a better opportunity for the function to prove its worth. To produce results within tight parameters, reward professionals must adapt to the economic climate by containing costs and ensuring long-term stability, while continuing to motivate staff. All elements of remuneration have come under review and, in many cases, these have been restructured.
According to a survey published by the Keep Britain Working Campaign in June, more than half of all UK workers (54%) have experienced a cut in pay or hours, or a loss of benefits since the recession began. Chantal Fre, practice leader in Watson Wyatt’s human capital group, says: “We are seeing our clients are trying to restructure cleverly, in a way that does not harm the business, and there are a lot of projects to govern pay and reward.”
In fact, unless you are a Premier League footballer, a pay rise this year looks about as likely as Peter Andre winning an Ivor Novello award. Nearly all sectors have seen pay freezes, or even cuts, as employers try to make quick, decisive savings, often to avoid redundancies. Some deals have been put to staff in blunt terms: take a pay cut or jobs will go. Other employers have proposed measures such as sabbaticals on reduced pay, or, as in KPMG’s case, asking for volunteers to work four-day weeks on reduced pay.
Jon Terry, leader of Pricewaterhouse-Cooper’s reward practice, says moves to reduce salary costs are often short-term. “”It has tended to be for a fixed period of time, say about six months, with the typical reduction level between 10% and 20%,”” he says. “Broadly speaking, these have gone through with a good level of agreement from employees. Where employers have increased salaries, it has been at very low levels of 2% or 3%. Employers are looking at people who have performed exceptionally well, not just well, and therefore at a much smaller number of people than before. I would say three-quarters less.”
But employers are working hard to ensure any permanent changes are transparent and fair. “In the past, pay levels have very much been dictated by the supply in the market,” says Fre. “Employers would pay anything to get a certain person in, and we were starting to get internal inequality and inequities. Many clients have asked us to implement a grading structure, so they have an idea of the value of the jobs in their organisation. From that, they can make reasonable pay decisions in the future.”
While most workers have experienced a year of static income, executive remuneration models have come under intense scrutiny for not fulfilling prudent objectives, for example Sir Fred Goodwin’s £16 million pension pot after his departure from the nationalised Royal Bank of Scotland Group earlier this year. More recently, investors in Royal Dutch Shell voiced their disapproval of the hefty reward its directors were planning to award themselves. More than 59% of shareholders voted against the executive pay proposals.
Many people view the huge reward packages received by some directors as a mockery of the financial restrictions facing most workers, and as a far cry from ensuring that the actions of the business are aligned with shareholders’ interests. In an online seminar on the future of executive pay in Europe, held in May, HR consultancy Mercer asked 500 employers if they thought the recession had resulted in a fundamental change in executive compensation. More than half of them said it had. Piia Pilv, manager of Mercer’s centre of excellence for executive remuneration, says: “In other downturns, you have always had short-term measures. We have never seen a trend of fundamental change until now.”
Some employers have already taken steps to re-shape executive reward. In its 2008 annual report, Barclays announced its executive directors would not receive an annual performance bonus for 2008 or a salary increase this year. It also detailed plans to increase executives’ shareholding requirements, and stated those who had long-term performance shares should agree for them to be deferred for two further years, subject to financial performance over that period.
The Financial Services Authority’s (FSA) draft code on remuneration practices, which is set to be finalised this month, is intended to promote such effective risk management. Pilv says: “Although the FSA’s code is only for the big financial institutions, I think it is likely to be perceived as the way to do business for the rest of the financial community and other sectors alike.”
Risk and reward
The key driving factor for performance-based remuneration at any level is the correlation between risk and reward. Typically, as risk increases, so does the potential reward. Employers that compensate staff in this way must avoid basing too much pay on short-term performance and just one performance measure. A one-dimensional approach, such as evaluating a certain set of profit figures, can lead to a skewed assessment of an individual’s achievements.
For example, an uncapped bonus plan can encourage actions that are not in shareholders’ long-term interests because, put crudely, the employee wants the cash. When redesigning bonus plans, employers can ensure they avoid any extreme outcomes by factoring in stringent performance measures, as well as deferral and clawback policies. Also, by tying any deferred part of a bonus to future performance, an organisation can retain more control over the process.
Where bonus arrangements are restructured to include a deferred element, the deferrals must be proportionate to the type of risks taken. For example, a firm trading stocks and shares might link bonuses to its position at the end of a day’s trading because it can be assumed that the risk has passed at that point, but in other circumstances, the risk period might stretch into months or even years.
The recession has not so much moved the goalposts, as ripped them out and tossed them aside, so bonus targets may need to be reset. Targets set even a year ago, when expectations of revenue and profitability were far higher, may no longer be achievable. “It is a question of whether employers still expect people to achieve these targets,” explains Fre. “If they find they cannot earn any bonus, they will become demotivated.”
She adds: “So do employers lower the target to make it more realistic? But then, if it is a lower target, would they still pay the same bonus amount that was for the first target, given the fact that they are not generating the same revenue and profitability? A lot of calibration is going on to make sure it is still motivational for the individual, but that the organisation has the means to pay a bonus out of a reduced income.”
Brett Smith, practice manager at Towry Law, says all bonus payments are likely to be subject to more differentiation. “If employers have a bonus pool, they want to ensure it goes to people who have really pulled their weight and contributed, which puts a lot of pressure on performance management systems. Do they really determine who is contributing the most? It is not just about numbers.”
Employee share schemes are another benefit that has had a hard time in the downturn. Many staff, previously motivated by a steadily-rising share price, will be disillusioned by its decline. Janet Cooper, global head of employee incentives at Linklaters, says: “Employees will be feeling they have lost out, but now is not the time to pull out of employee share ownership because when the share price is low, for most businesses the price will appreciate quickly when we pull out of the recession.”
She adds innovation is the key to adapting share plans to be fit for purpose in the recession. “We have been putting some plans together that have never been seen before to meet particular business needs. Employers are very much re-evaluating the role share ownership has within the business, both at executive and employee level.”
When setting up share-based incentive plans, the main issue for employers is the tension between what is achievable in the current climate and what investors want the targets to be, says Cooper. As with bonuses, certain prudent measures have begun to feature prominently in share-based incentive plans. “Many employers are adopting new terms of deferral, such as forfeiture for subsequent underperformance,” she says. “Then there is a clawback clause, when shares have been paid and the employer has to get them back.”
But perhaps the biggest casualty of the economic downturn has been final salary pension schemes, with a seemingly endless list of employers cutting the benefit amid rising life expectancy among the population and falling returns on investments. Actuarial scheme evaluations of defined benefit (DB) plans are forcing many to take swift action to stop their liabilities spiralling further out of control.
For example, BP closed its DB scheme to new joiners last month, and Fujitsu, Morrisons and Barclays have all announced plans to scrap their final salary schemes for existing members. PWC’s Terry says the recession has seen an acceleration of restructuring to ensure sustainability. “The cost catalyst is much higher,” he explains. “Previously, organisations would not have changed the benefits for existing members, but that sacred cow has disappeared now.”
The by-product of these cutbacks is a series of more economical measures, such as: increasing employee contribution rates; moving from final salary to career average earnings, with pensions based on members’ average earnings while with the employer rather than their pay just before retirement; and hybrid arrangements, with a mixture of DB and defined contribution schemes.
If rising pension deficits were not enough to contend with, many employers have also begun to prepare for the 2012 pension reforms, which will see the introduction of compulsory contributions and auto-enrolment. Steve Bee, head of pensions strategy at Scottish Life, says: “Most medium-sized and larger businesses will be operating three-year planning cycles at the very least and should already be factoring the 2012 changes into their plans. The new requirements on employers to contribute to the pensions of employees who decide to remain in schemes once auto-enrolled need to be taken into account, recession or no recession.”
Bee believes the best way for employers to mitigate this potential increase in costs is to adopt a salary sacrifice arrangement. Such schemes will be particularly effective by 2012, given the impact of the 0.5% rises in national insurance contributions due to come into effect in April 2011.
Paul Waters, senior consultant at Hymans Robertson, says that when employers are looking to share the risk or make their scheme more affordable, salary sacrifice should be top of their list. “It has been interesting to see how well it is accepted by employees,” he says. “They understand the current economic climate. The question is: why aren’t more employers doing it?” But whatever changes or restructuring employers see fit to put into action, the focus will remain firmly on motivating and engaging talented staff during these challenging times. More than ever before, reward professionals have a key part to play in an organisation’s success or failure
Is variable compensation the best solution?†
Recent activity in the financial services industry may have given the concept of variable compensation a bad name, but there is little doubt that it can be an immensely powerful tool. However, it must be modelled, audited and managed with discipline and objectivity.
Variable compensation refers to the provision of additional benefits to an employee if they hit certain agreed targets. It also allows employers to be more flexible in setting targets, which can be amended in tune with business priorities.
Bill Schuh, vice-president for EMEA at Callidus Software, says variable compensation motivates employees to achieve their objectives and support an organisation’s targets. “Managed properly, it provides transparency for both employees and other stakeholders, such as shareholders,” he says.
“People need to realise that the banking crisis was not caused by bonuses per se, but more by their poor application without real control or linking to overall company objectives. Stopping variable compensation effectively robs employers of the possibility to retain and motivate their best performers, which help drive business.”
Restructuring risk perks brings savings
Employers that offer expensive risk benefits can make significant savings through a restructure.
With group income protection schemes, for example, employers can transfer some of the risk to employees. Brett Smith, practice manager at Towry Law, says employers should take a less paternalistic approach to reduce costs.
“Why should they insure the earnings of the employee for up to 40 years when the employee might only be working there for five years?” he says. “It can be capped for a period of time.” Malcolm Brebner, director of Fulcrum Insured Employee Benefits, says employers are trying to mitigate their costs and challenge their insurance premiums.
“Most group income protection plans still assess disability in terms of the impact on an employee’s own specific job, whereas most employers don’t think it unreasonable to apply a tighter definition, or to share some of the initial claim liability, especially if their claims incidence is already low,” he says.
“In the current market, a good risk might see a 10% to 15% saving from simple price competition, but you could easily double those percentages with the right plan design changes.”†
Case study: City and Guilds goes hybrid
Vocational awards body City and Guilds restructured its pension arrangements this April to improve its scheme’s sustainability and increase employee take-up.
Previously, the organisation operated two pension schemes for most of its 1,000 employees – an open final salary scheme for staff aged over 40, and a money purchase scheme for employees below this age. Like many final salary schemes, it had a deficit, and take-up of the money purchase plan was low.
To overcome this, City and Guilds introduced a hybrid scheme that combined a career average revalued earnings (Care) plan with a money purchase element. This gives employees the security of a defined benefit plan with the opportunity to boost their pension at retirement by contributing to the money purchase part.
Moving to a hybrid scheme also allowed City and Guilds to better share the risks associated with providing a retirement income between employees and employer.
Sharon Saxton, HR director at City and Guilds, says: “The new scheme design helped move away from a two-tier workforce, albeit with a slightly different benefit structure for existing members of the final salary scheme in order to reflect their historical higher benefit promise.”