Our Irrational Approach to Paying Internal Talent

By: | January 28, 2019 • 3 min read
Peter Cappelli is HRE’s Talent Management columnist and a fellow of the National Academy of Human Resources. He is the George W. Taylor Professor of Management and director of the Center for Human Resources at The Wharton School of the University of Pennsylvania in Philadelphia. He can be emailed at hreletters@lrp.com.

“Follow the money” is not only a useful guide to tracking criminal behavior, it is also an important way to learn about priorities—which takes us to a new report on the compensation plans of employers, Mercer’s 2018/2019 US Compensation Planning Survey, and my conversation with Mercer Partner Mary Ann Sardone about it.

The labor market is tight and has gotten tighter every year for the past decade. But you wouldn’t know that by looking at the budgets of employers for pay increases over that period, as they have barely budged. The budget for annual increases for current employees, the so-called “merit” budget—a misnomer because it is supposed to cover cost-of-living and market-wage changes, and increases to reward good performance—is only 2.9 percent. That is up only trivially from 2.8 percent last year, despite the view in many quarters that the labor market is extraordinarily tight.


OK, by itself that isn’t such an exciting piece of news, just another indicator that the labor market is not as hot as is often thought. The irrational part begins with the fact that talent acquisition and retention are the top concerns in virtually every survey of top executives. Companies are paying roughly a 20 percent premium to hire a worker away from another employer to do exactly the same job—but now just for Company B rather than Company A.  At the same time, the Mercer survey finds that the budget for salary increases suggests that the pay increase for a typical promotion is only about 8 percent.

Let’s put that together in an employee context: If I stay, I get about a 3 percent raise. If I stay until I get promoted, I get an 8 percent increase. But if I move now to do the same job someplace else, I’ll get a 20 percent increase. And if I could move to a bigger job someplace else, who knows how much more I’d earn?

Is it any surprise that virtually all employees report they are open to moving to a job elsewhere?

On the irrational part for employers, let’s say that turnover costs are the equivalent of a year’s salary—that’s high for hourly workers but low for managerial and professional workers, but it’s easy to interpret. When I lose an employee and I hire someone to replace him or her, it’s costing me about 120 percent more the first year and 20 percent more thereafter as opposed to if I had retained the employee.

It may seem crazy that we are giving people so little in terms of increases if they stay, even if they are promoted to a bigger role, yet at the same time we are willing to pay so much more when we bring replacements in from outside. This is known as price discrimination in the world of economics: paying different prices for essentially the same thing.