EVERYTHING IS CONNECTED:   HOW CHANGES IN PAY MIX

CAN UNDERMINE PENSION AND BENEFITS OBJECTIVES

Susan Marshall

The way in which companies pay their staff has changed substantially over the past number of years. At the core of this New Pay transition is the wide array of bonuses, incentives and other types of variable pay that have now become major parts of the compensation package for many employees who once received only salary.

The positive impact of these kinds of changes has been great. Clearly they forge a link between employee pay and company and individual performance. They have also had an impact on some key parts of employees' non-cash compensation. Unfortunately, in some cases, the effect has been unintended, and has tended to penalize staff who are earning significant amounts of their pay through these expanded variable pay programs.

And the amounts are significant. Variable pay for senior managers and executives is now typically 20% to 25% of base salary in many industries, and bonuses in excess of 100% of salary are reported by some companies in some years.

Even at lower reaches of the corporate hierarchy, profit sharing, gain sharing and similar programs can represent very significant proportions of total cash compensation for many staff.

Many important company benefit programs like pensions and disability insurance, however, were originally designed before variable pay became as important a part of cash earnings as it is now. These benefit programs typically were designed to ensure that an employee's lifestyle would be maintained if he or she retired or became disabled. Specific coverages typically were defined as a percentage of salary, because salary represented the whole of employee earnings, and this was not expected to change significantly.

As the structure of cash compensation has changed to emphasize variable pay, many companies have revised the way that they have defined earnings for pay-related benefit programs. Unfortunately, many other companies have failed to make corresponding changes. As a result, some incongruous situations have arisen.

In effect, pension, disability and similar benefits have come to be determined not on the basis of how much an employee earns, but in terms of how that pay is delivered in such companies.

Consider the situation of two Managers from two different companies with identical annual earnings and identical pension plans. Assume that both retire at the same time, at the same age, after 35 years of service, and with final average earnings of $80,000. Assume also that both have pension coverage designed to provide 70% of final salary to retirees with at least 35 years of service.

While one might assume that both Managers would receive identical pensions, and that their respective companies intended that they receive identical pensions, this would only be the case if their cash compensation were structured identically.

The following table assumes that pay was delivered differently for the two Managers. In the case of Manager 1, the $80,000 final earnings is assumed to be wholly salary. In the case of Manager 2, the $80,000 is assumed to be composed of $64,000 in base salary with 25% bonus as a percentage of salary.

Clearly, under these assumptions, Manager 1 and Manager 2 would not receive identical pensions. Manager 1 would receive a pension 25% higher than that of Manager 2. Manager 1 should be able to maintain his post-retirement lifestyle at the level envisioned by the pension plan design. Manager 2's post-retirement lifestyle is unlikely to be similarly maintained.

Importantly, it is very unlikely that Manager 2's pension plan was designed to deliver a pension equivalent to 56% of final earnings. In effect, Manager 2's company has no more than pension policy defined by idiosyncrasy. Disability and other pay-related benefits are similarly affected.

It is one thing to recognize that pay strategies designed to provide incentive to employees may unwittingly be penalizing them with respect to many non-cash compensation programs. Unfortunately, correcting the situation can be much more problematic.

The obvious solution is simply changing benefits practices to reflect the changes that have been introduced in pay delivery systems. Doing so reaffirms the original objectives of the affected benefits programs. Doing nothing represents a decision to reduce the level of benefits originally envisioned.

But reduced benefit levels also mean reduced costs. With benefit cost expansion unfashionable these days, the do-nothing alternative is very attractive. Inaction saves dollars and avoids the appearance that new dollars are being directed toward benefits enhancement.

This pressure to avoid benefit cost increases is not currently being met with a corresponding pressure from staff to maintain benefits objectives. At the moment, the impact of variable pay on pay-related benefits is simply not an important issue for many staff. Most are still probably not aware that, although the focus of their pay system has changed, the income-related non-cash benefits have not made a similar shift. Generally, younger staff tend not to invest a great deal of time exploring the details of a company's non-cash compensation plan. They are primarily interested in their cash compensation and they view non-cash items with a "toggle" mentality. That is to say, their interest in benefit plans extends only to the question of whether or not they exist, and the comparative value of these programs is often unappreciated.

How long is this situation likely to remain this way? Probably not indefinitely.

For one thing, the incidence and magnitude of variable pay plans is likely to continue to increase. As the number of staff affected by such plans grows, the general level of knowledge surrounding the implications of variable pay will also grow.

As the work force ages, more and more staff will recognize that a company's retirement benefits are not necessarily in line with their expectations. The incongruity between final pay and pension benefit levels becomes a more visible issue when staff covered by variable pay plans begin to approach retirement age. This will likely lead to an increase in the attention and concern that staff have about their employer's pay practices.

The other issue that will likely produce change is competitiveness. Competitive recruiting issues are now in the forefront of corporate concerns, and the need to retain and recruit high quality staff is one that companies will continue to face as the economy continues to roar. 

Up to now companies that included incentive compensation as a major element of their pay delivery systems have argued that a $64,000 salary with a $16,000 bonus is just as competitive as the $80,000 salary offered elsewhere. As the economy grows, so will the level of staff mobility. Companies that carry programs that tie income-related benefits to total cash will be able to use those benefits to attract staff. In effect, those companies that have superior pay packages will heighten awareness of the issue. 

Actual and potential staff mobility, therefore, will increase the level of staff sophistication regarding pay competitiveness. Companies' whose variable pay programs carry no income-related benefits, are likely to find that potential staff will examine non-cash programs as carefully as they do the cash components. Such companies are likely to discover that their ability to attract staff may be hampered as much by the lack of full earnings coverage on income-related benefit plans, as it would be if they were offering a non-competitive cash compensation package.

So what should concerned companies do?

Ignoring this issue is not an appropriate long-term strategy.  Companies will want to review their current compensation programs carefully from a total compensation perspective.

First of all, companies should examine all of their compensation plans. What were they originally intended to do? Do they meet continue to meet those goals? Do those objectives continue to be relevant?

Secondly, companies should determine what staff have been adversely affected by the changes in the pay delivery systems. To what extent have they been affected? What will the long-term impact be on them at retirement, or in the case of disability? What will the impact be on their survivors if they die?

Lastly, they must determine their non-cash objectives in terms of cost containment and staffing objectives. Based on that determination, they must develop a policy that is based on an informed choice, not the result of idiosyncrasy.

Policy determination will differ from company to company. That is to be expected. Some companies will decide that their objectives demand that they adjust their benefits plans to bring them in line with their original intent. Other companies may determine that the original objectives of their plans are largely irrelevant, and new plans must be developed in light of new goals. What is crucial is that companies actively devise compensation strategies to meet their objectives, and avoid the pitfalls of policies entrenched solely on the basis of idiosyncrasy.