Impact of economic downturn on psychological contract between employer and employee

The currently gloomy economic environment could encourage the psychological contract to tip back in employers’ favour away from employees, explains Victoria Furness

Watching events unfold over the past couple of months in the financial services sector has been a bit like watching a soap opera. The collapse of financial institutions such as Bradford & Bingley and Lehman Brothers, the rapid takeover of HBOS by Lloyds TSB, and both the UK and US governments’ multi-billion pound bailouts of banks were some of the most shocking financial events the world has witnessed in decades. With the UK economy shrinking for the first time in 16 years in the third quarter, the governor of the Bank of England Mervyn King has warned that the country is likely to go into a recession.

But as with most macroeconomic events, it is only when you hear the personal stories behind the headlines that they stop sounding like fiction and become real. What was most striking in the media coverage surrounding the meltdown of some of the banks was the anger and resentment felt by members of workforce at being let down by senior management in taking these businesses to the wall.

It wasn’t just the potential termination of employment contracts that hurt staff, but also the breaking of the psychological contracts they had signed up to on joining the banks. In many respects, it is the psychological contract that determines whether an employee will go the extra mile for his or her employer. Unlike the employment contract, which is written down and has legally binding consequences if any condition within it is breached, the psychological contract refers to the unwritten agreement between employer and employee about their mutual obligations at work (see box right). This matters because if an employee perceives their employer to have broken a psychological contract it will affect their overall engagement with, and ultimately their willingness to work for, the organisation in question.

This has significant implications for employers feeling the impact of today’s economic environment. Unemployment and inflation are rising, while economic growth has stalled. The number of employers planning redundancies has risen slightly from 22% to 27%, according to the Chartered Institute of Personnel and Development and KPMG’s quarterly Labour market outlook, published in August. Bryan Finn, founding partner at consultancy Business Economics, says: “What happened in September made a short, sharp recession much less likely.”

All this is likely to tip the balance of the psychological contract in favour of employers. Mark Eaton, director at Personal Group, says: “For the past 10 years this has been steadily moving in employees’ favour, to the point where potential employees were effectively interviewing employers for jobs. I think the pendulum will now swing back.”

In tough economic times, employees are often less willing to move jobs, preferring their current job security to career development elsewhere. Staff are also more interested in the long-term viability of their employers, says Uzair Bawany, group managing director at Contact Recruitment, which serves the finance sector. “Candidates are wanting to know about the strength of companies and whether they will be the next to go under. These are questions we have never heard asked before,” he says.

Dr Judith Barwick, author of One foot out the door, believes the problem is not so much a potential economic recession but rather what she terms a “psychological recession”. She defines this as “an emotional state in which people feel extremely vulnerable and afraid for their futures”.

When economic conditions worsen, psychological recession inevitably worsens too. “When stock markets are falling and foreclosures are increasing, it is getting close to panic time,” she warns.

In such circumstances, it is not enough to simply offer a good reward package. Instead, employers need to revise the way they regard staff. “If [they] see employees as a cost rather than an asset [they] will be preoccupied with trying to get that cost down,” says Barwick.

Reducing costs
The problem is that many employers are under pressure to reduce costs, so even if they are not considering staff layoffs they are certainly looking at ways of reducing their pay and benefits bills.

One way of employers making savings is to consider the use of tax-efficient benefits offered through salary sacrifice arrangements. This can produce tax savings for employees as well as savings on national insurance contributions for both employee and employer.

Employers will also be keeping a tighter rein on salaries. Staff, however, do not always look fondly on perceived controls in this area. In the public sector, there is already growing industrial unrest, with strikes taking place in response to the government’s decision to curb pay increases. Hannah Reed, a senior employment rights officer at the Trades Union Congress, says: “At this stage, employees and unions are saying to employers that they need to be realistic in terms of pay increases, which should reflect increased living costs.”

However, the government has shown little sign of budging so it is likely most of the public sector will have to follow private sector employees in taking below inflation pay increases on the chin. While some staff may simply be grateful to have jobs, Neil Conway, senior lecturer in organisational psychology at Birkbeck, University of London, warns this could change the psychological contract. “Employees might balance any pay deal privately by thinking ‘I have got my job but I won’t be as committed as before’,” he says.

The economic situation could also affect benefits provision. Mark Groom, director for HR and tax services at PricewaterhouseCoopers, warns the downturn could hit any defined benefit pension schemes still in operation. The full impact of this, however, has yet to be seen. Although exact figures vary according to the accounting method used, deficits do not yet appear to have risen substantially, although this may not continue long term.

Taking control
On the other side of the coin, Bawany has seen many employees wanting to take control of their own pensions to reduce the possibility of losing their investments along with their jobs. “Employees want portable pensions and some people are putting these with fund managers,” he explains.

Many employers are also considering forging closer ties between reward and business performance. Ben Wells, head of managing change and engagement at Buck Consultants, says: “Variable pay gives employers the ability to control cost and pay out reward when they can afford it. Something we saw happening with two or three clients even before the downturn, is [offering] pension contributions based on performance. It can even be extended to things such as the flexible benefits allowance. In this way, employers can engineer reward packages targeted at appreciating key performers.”

However, there is a danger in cutting back the benefits budget too far. Paul Roberts, a healthcare consultant at IHC, is particularly concerned by the trend for employers to take on more risk to reduce their private medical insurance bills through cost-plus contracts which require employers to assume the risk for claims incurred for a set period. Insurers levy an administration charge for handling these claims. However, Roberts says: “The short-term gain may be offset by a medium-term loss. The reason people are in insurance is because they are specialists at it [but] an employer is not.”

Ironically, given the poor performance of stock markets in the past few months, this could be a good time to encourage staff to invest in all-employee share schemes, not only because shares are better value but also to foster a culture whereby everyone works to improve organisational performance.

While trying to get the best return on investment from their benefits package, employers should remember it is ultimately there as an attraction and retention tool. When the economic gloom inevitably lifts, employees will readily jump ship if they feel they have been mistreated or their psychological contract has been breached in some way. This applies whether they are considered key talent or otherwise.

Conversely, organisations that support their employees with development opportunities could strengthen the psychological contract in difficult times. Michael Wellin, director of consultancy Business Transformation and author of Managing the psychological contract, says: “Employees will think, ‘this is a really good place to work’.”

This applies even if redundancies are made, so long as any decisions are considered fair and employers maintain a constant dialogue with staff. Ceri Roderick, head of asse-ssment at business psychologists Pearn Kandola, says: “Tell people what is going on and give them as much transparency as possible.”

Interestingly, it was in the aftermath of the 1990s recession that the term psychological contract returned to HR discussions, as the concept of jobs for life gave way to a performance-based reward culture. It will be interesting to see if this downturn produces a similar shift in HR thinking. “My sense is that there will be a greater acceptance of the employee attitude that they don’t owe anything to their organisation unless it’s a good place to work. I also think organisations will increasingly recruit people who fit in with their culture and their psychological contract,” says Wellin.

The latter trend is already visible in organisations as diverse as Google, Richer Sounds and Asda. Whether other employers follow suit depends, in large part, on how bad the economic situation gets.

Understanding the psychological contract
Employees promise to:
Work hard
Uphold company reputation
Maintain high levels of attendance and punctuality
Show loyalty to the organisation
Work extra hours when required
Develop new skills and update old ones
Be flexible, for example, by taking on a colleague’s work
Be courteous to clients and colleagues
Be honest
Come up with ideas

Employers promise to provide:
Pay commensurate with performance†
Opportunities for training and development
Opportunities for promotion
Recognition for innovation or ideas
Feedback on performance
Interesting tasks
An attractive benefits package
Respectful treatment †
Reasonable job security †
A pleasant and safe working environment†

Case Study: BT links reward to its business strategy
In the present economic climate, Jim McInally, HR director, reward, resourcing and employee relations at BT, believes employers should ensure that their business strategies and reward packages are closely linked in order to maintain a strong psychological contract.

BT places a great deal of emphasis on performance and reward, and has changed its bonus scheme this year. “We have moved from having thousands of scorecards in the organisation to having just over 130 teams, ensuring far greater alignment. Now, all employees who are eligible for our bonus schemes are members of these teams.

“If you have got your bonus arrangements aligned correctly you can see concerted efforts from employees to both control costs and accrue value from activities in a way that is more assertive, or more attuned to the prevailing economic climate,” explains McInally.

He adds that employers should also aim to provide flexibility and choice in the structure of their reward packages to enable employees to focus on gleaning the most benefit from the total reward framework.

These benefits programmes do not all need to be fiscal. “One of the best things we do is to provide all our UK employees with a home broadband connection,” says McInally.

Legal implications of the psychological contract
Although there is no basis for the psychological contract in employment law, if an employee resigns they can claim constructive dismissal if they feel that a ‘relationship of mutual trust and confidence’ has been breached.

More likely in the current economic climate is an increase in the number of tribunal claims as a result of employers failing to implement appropriate redundancy procedures and disgruntled employees thinking they have nothing to lose.

Esther Smith, a partner at law firm Thomas Eggar, explains: “Employment law is terribly procedural so if employers are making redundancies or changing terms and conditions of employment, they need advice. The maximum compensation for unfair dismissal is £63,000 so it can be a costly mistake.”

Case Study: Laing O’Rourke gets in touch with staff thinking
Construction firm Laing O’Rourke aimed to identify where problems with the psychological contract could occur by holding exit interviews to find out what had motivated employees to leave the organisation.

James Bray, head of HR policy and programmes, says: “While we were getting positive feedback from staff about the opportunities they were being offered, our turnover rate was still higher than we wanted.” The firm commissioned Roffey Park to interview 71 leavers between March and October 2007, while previous exit surveys were also examined. The interviews were designed to tap into the psychological contract of leavers by analysing their expectations from recruitment through to their departure.

The findings suggested that small changes in a few areas, such as managing expectations, communication and consultation processes, could make a big difference.

“We have good employee engagement but must do more to offer effective career development which, for some employees, was where the psychological contract was breaking down,” explains Bray.