Inflation is the new hot topic among economists. Consumer Price Index (CPI) indicates the cost for all consumer goods rose by 0.8% in November and called into question the notion that 2021 price increases were only a temporary spike. While economists debate whether inflation will continue to rise and what should be done about it, this provides an opportunity for HR to understand the impact inflation may have on their total rewards strategy.
We are currently experiencing the highest inflation in decades and for many, the first time in their working lives they’ve had to worry about how their wages will keep pace with the cost of goods.
While many companies grapple with the great resignation and simultaneously hire for growth, inflation may be low on the agenda for now but, if price increases continue, HR leaders will have to start thinking about how to best prepare and respond to the insidious challenges that inflation can create.
It is also worth reminding ourselves that most companies still pay women and people of color less on average. Given that inflation hits lower earners harder than higher earners, it is important to be aware that changes to the cost of living will disproportionately impact these employee groups the most.
When thinking about setting pay levels, we can broadly divide the inputs into three pillars:
- Wage legislation
- Cost of labor
- Cost of living
Wage legislation is generally aimed at hourly workers to ensure fair pay at lower levels. Many companies have minimum wage workers and we should be aware that in high-inflation periods in particular, this may result in financial challenges for lower wage earners. There are various sources of research to indicate the problems with paying minimum wage – this analysis by MIT indicates that the hourly living wage for an individual with one child in San Francisco is $56. The statutory minimum wage in San Francisco is $16.32, leaving a large gap to close.
Cost of labor
Cost of labor has become the default input for determining compensation – either with formal compensation surveys, or informal sources including crowdsourced databases and recruiters. The main challenge with these data points is they are backward-looking. Current increases to costs of living may not be reflected in market data for months making it difficult to respond to inflationary pressures.
We should also be aware that relying on market data may be beneficial to some companies, but it may not be applicable to other companies or entire industries. While targeting above the 50th percentile may sound generous, there are still 75th percentile data points that fall short of a living wage for some roles and markets. Market data is a valuable input to the compensation philosophy but not necessarily the only one.
Cost of living
Cost of living has not traditionally been a key driver of pay levels, with most companies leveraging cost of labor and assuming cost of living to be factored in.
Having said that, we have encountered a small but notable movement of companies using cost of living as a prominent component in their compensation philosophy. For example, PayPal was one of several companies that have explored Net Disposable Income (NDI) calculations, in addition to market benchmarking, and adhering to minimum wage legislation.
The realization that benchmarked pay levels did not provide enough for their employees to make ends meet, let alone save for retirement and their children’s education, led PayPal to rethink their compensation philosophy. Leadership decided they should target a minimum NDI of 20% for everyone, rather than relying purely on market or minimum wage data. In addition to modifying salary levels, RSU eligibility, and company healthcare contributions, PayPal also offered personal financial education to help employees plan for the future. These fundamental changes to PayPal’s compensation philosophy resulted in a 16% increase in the average NDI for employees while PayPal posted two of their most profitable years ever.
We also know that while increased earnings do not materially impact subjective happiness for higher earners, the story is different for lower earners and each additional dollar will have an incremental impact on their happiness levels. Employee happiness is key to both retaining, and getting the most out of employees meaning that targeted pay increases are a smart investment.
Investing in lower paid individuals through a living wage will improve pay equity and employee happiness, and in a high-inflation environment, will help insulate employees against the worst effects.
Six initiatives to combat inflation
What can leadership do to combat the effects of high inflation? Ultimately, many companies may need to rethink their total rewards strategy in 2022 — and this may be the first time in some years that their ongoing strategy needs fundamental changes. Anchoring pay around a target percentile may have worked for the past decade, but it may not be enough going forward. For 2022, there are a number of changes that companies may wish to consider that place financial wellbeing more prominently in their value propositions:
- Incorporating cost of living calculations to determine pay levels
- Using inflationary data, rather than market data, to determine merit budgets, and increasing the frequency of merit cycles
- One-time bonuses to cover inflationary costs to the workforce until the long-term outlook becomes clearer
- Financial wellbeing resources to help employees plan for the future
- Adding financial wellbeing to people management training curricula
- Increasing company contributions to benefits such as retirement savings, medical coverage, and even employees’ HSA
When developing a workforce strategy for the long-term, companies may need to address the impact of inflation in several key areas:
- Reexamine your EVP and total rewards strategy. Is your current EVP fit for purpose in an inflationary environment? Should you redefine it and update your total rewards strategy?
- Reconsider your workforce plans. Do you need to accelerate plans to reshape the location and composition of your workforce?
- Understand the future of work. Can you adopt new ways of working that enable employees to be more efficient and productive?
As with many unfavorable situations, opportunities emerge. Clear and honest dialogue with employees is key to successful changes in your compensation philosophy and this new environment provides a moment for companies to build trust with their employees.