Our Irrational Approach to Paying Internal Talent

“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.

Now suppose you are the CFO. You’re likely thinking: I can’t afford to give everyone a 20 percent increase or anything near that. I might be willing to give a few marketable people an increase now to keep them from leaving, but we don’t know which ones will actually leave, so it’s cheaper just to let some leave. The huge interest in trying to predict “flight risk” is largely to address that way of thinking.

Think of this as the equivalent of trying to decide whether to replace worn parts on your car before they break: If you don’t replace them and they don’t break while you own it, you win. That’s the bet, and there are situations where it makes perfect financial sense. In this case, though, the “parts” are breaking all the time, on a predictable basis, and once employees figure out that they aren’t going to make more money until they leave, the trickle turns into a stampede. Anyone who could leave becomes a flight risk.

Now let’s say you are an employer with a 10 percent turnover rate among employees that you’d like to keep–pretty reasonable these days. For those 10 percent of your jobs, it’s costing you 120 percent more to cover the turnover costs and the wage premium for outside hires–overall, 12 percent more–at least in part because of the strategy of not wanting to raise wages. Not that it is the ideal strategy, but it would be cheaper to give everyone in the company a big raise.

Is no one thinking like this? Is the message not getting through? Or am I missing something altogether?

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Peter Cappelli
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.