Early Fall may signal the beginning of autumn colors, pumpkin spice everything, and sweater weather for some. For compensation professionals, however, it means gathering salary budget projection data to report to senior leadership and solidifying how to apply salary increases for the coming year. Last year, like many things unique to 2021, this meant trying to understand why U.S. salary budgets looked like they weren’t moving much higher than the 3% they’d been for the past decade.
While there typically is some discussion on what drives annual salary budget projections (AKA merit budgets) every year, 2021 felt different. It felt like a true mystery. “With workers shortages and low unemployment, why aren’t we seeing higher merit budgets for the coming year?” could easily be heard in the virtual hallways across corporate America – second only to the question, “With inflation on the rise, shouldn’t we be thinking about raising salary budgets?"
Given the crescendo of these questions, this article helps explain why projections are what they are, and serves as food for thought about how to think of salary budgets as a barometer of overall compensation spend in the future.
While it is true that salary budgets reflect the supply and demand of labor, which also is measured by the unemployment rate, there is a lag in the timing of that reflection. That is, as the unemployment rate drops, logic would suggest that pay (and salary budgets) should go up. But these actions don’t happen simultaneously. Even with this lag, it would be natural to expect greater movement than the 2022 median projections of roughly the same 3% they’ve been for so long, but that hasn’t happened. Again: We ask why?
The global pandemic affected the U.S. economy beginning in early 2020. The latest unemployment rate, as measured by the U.S. Bureau of Labor Statistics and reported at the time this article was written, is 4.2%. This feels comparatively low – especially if you look back at April 2020 when unemployment spiked at 14.8%. However, also consider that the rate was 3.5% in January and February 2020, and then went up slightly in March 2020 to 4.4%. Then it completely skyrocketed when COVID-19 hit. High unemployment started to ease in the summer of 2020 and was back below 7% by the end of the year.
The extreme labor market swings in such a short time meant that salary budget planning never really caught up to the craziness of the pandemic. Salary budgets remained steady overall at 3%, in part because of the aforementioned lag, but also because, while unemployment was high, it was only high for about three months. It dropped significantly throughout the rest of 2020.
Had the pandemic never happened, we likely would still be facing labor shortages. According to WTW’s John Bremen, despite overall population growth (11.9%) and labor force growth (4.5%), the labor force shrank 3.4% from 2010 to 2020 among the historical entry-level talent pool (workers ages 16 to 24). It also shrank 10.6% among the historical leadership talent pool (workers ages 45-54). The data show the same result when analyzed from 2010 to 2019, demonstrating that this problem originated before the pandemic. Thus, population trends show that there are – and will continue to be – fewer workers to fill needed positions.
As noted, unemployment in January and February 2020 – before the pandemic took hold – was lower than it is today. Given the reality of worker shortages, without the pandemic we may have seen a greater impact on salary budget planning. We would have faced a steady decline in available workers rather than the drastic layoffs and unemployment increases that we experienced in spring 2020.
COVID-19 also affected the financial health of different industries to the extremes. Unlike the financial crisis of 2008 to 2010, when virtually every industry was impacted the same way, the economic fallout of 2020 was a health crisis certainly, but financial systems remained sound and strong. In 2020, we saw financial outcomes of extremes that resulted in some industries having significant financial gains and others huge losses.
In the Hospitality, Travel and Oil and Gas industries, companies likely lowered their salary budgets in 2020, with many going well below 3%. However, companies in the Distribution, Health Care or Food Manufacturing businesses either kept salary budgets at 3% or perhaps even raised them. The extreme differences experienced by industries drove a true mashup of salary budget results. For those industries that were losers in the pandemic, going from a 1% or 2% salary budget back to 3% is a huge increase, even though it isn’t telling that story in the overall salary budget data.
The other phenomenon we saw in 2021 was a sharp increase in starting salaries for many jobs, but especially for frontline, hourly workers as the $15 per hour bandwagon took hold. Many large U.S. employers followed Amazon’s lead of paying hourly workers $15 per hour, even as Amazon announced that its average hourly wage would go up to $18 per hour.
Set aside salary budget projections to look at real wage growth. The U.S. Department of Labor’s Employment Cost Index showed that pay rose 1.5% in the third quarter of 2021 (the latest data), up from 0.9% from the prior quarter – a significant increase. The Great Resignation has forced employers to pay higher starting salaries for talent they’ve lost, while also adjusting salaries to retain those they are trying to keep. While payroll increases are real, they are not reflected in salary budgets. 3% of a larger total payroll is still 3%.
History shows that salary budgets dropped in prior recessions and never actually recovered to pre-recession levels, as shown in Figure 1. It seems that once we hit a new “floor” on salary budgets, it tends to stick for a while and slowly inch its way back up, only to be slammed down again by the next economic downturn.
Sources: 1990-1994 Data: American Compensation Association Salary Budget Survey.
2000-2002, 2008 Data: Towers Watson Database on Merit Increase Budgets taking averages of WWDS, Mercer, and World at Work Surveys
2009-Project 2011 Data: World at Work Surveys Only.
Salary budgets are not quite as responsive to changes in the labor market as we might think. With a strong propensity to control fixed costs, it’s no wonder that executives and HR look to tightly manage salary budgets. It’s also easy to see that there aren’t many who would buck the trend of remaining as close to overall salary budget projection levels as possible.
However, we have not seen a labor market like this one in quite some time – if ever. Much has been written about The Great Resignation, but it appears that workers do have more leverage to demand higher pay and benefits (as well as more flexibility) than ever before. That may mean changes to how salary budgets have historically responded to economic pressures. But, for now, it appears that the same “Let’s not be the first to significantly raise salary budgets” mentality is at play for 2022 projections.
Finally, there is a certain psychology that says those in leadership that managed through the Great Recession of 2008 to 2010 still have a hangover mindset driving their conservative approach to increasing fixed costs. Like the Silent Generation that lived through the Great Depression, this generation of leaders remembers what it was like to try to survive with extremely scarce resources and strive to be prepared even when faced with unpredicted financial gains.
Through the pandemic, we saw this conservatism in several organizations in the “winning” industries. Some had record earnings and paid out significantly above-target bonuses but, in many cases, targeted at or below the typical 3% salary increase level that also was reported as the going rate in 2020. When asked why, responses spoke to the likelihood of sustaining the gains earned in 2020 and that conservatively managing fixed costs protects companies from having to take more drastic measures if high financial gains reversed in 2021 or beyond.
If “How fast should pay move to effectively attract and retain talent in this market?” is the question, then perhaps salary budget trend data is not the best answer. While salary budget projections may still be the best way to understand how others are setting salary budgets for the coming year, are they really the best barometer to reflect pay outcomes in times of extreme labor market changes?
Understanding pay growth comes from studying year-over-year outcomes for different groups as well as for the entire organization. The best way to understand how your organization may need to increase pay in the future is to analyze all changes to pay throughout a complete calendar year, not just the one-time event that represents the merit pay process.
For example, if pay for the same population from 2020 to 2021 was analyzed, it is likely that the findings would show a spend well above the 3% reflected in a salary budget that was planned for that same time. That’s because employees get promoted, they get counteroffers and retention monies, and equity increases. Most (if any) of these are not factored into a merit budget or the data reported for salary budget projections.
It also is smart to review pay changes for the overall population (not just the same population) because that shows the true growth in compensation spend as increases in starting salaries for new hires also are factored into that analysis. In the end, these analyses would confirm salary growth that eclipses the 3% salary budget. They also would provide compensation professionals and organization leadership a greater understanding of what’s needed for the coming year (which includes those one-time merit increases) as well as a real picture for overall salary movement.
Today, a discussion on salary budget projections in the U.S. cannot exclude the notion of how or, more importantly, whether inflation should be factored into salary increase budgets. For those having this debate, here are a few considerations:
Making salary decisions can be challenging when topics like inflation, labor shortages and wage increases are creating a stir in headlines. However, bowing to public pressure and succumbing to gut instinct won’t serve anyone in the long term. It is critical for compensation professionals and organization leaders to understand the philosophical and economic factors that can – and do – influence compensation growth, then incorporate sound data to make defensible decisions that everyone may not like, but can live with.
Have feedback on this article? Email author Lori Wisper and continue the conversation.
