Managing Compensation in a Downturn



It seems like we are in for a rocky ride in 2016. While underlying economies of many countries and the financial performance of many companies still appear solid, numerous firms are preparing for a tough year ahead.

Overview

Over the years, McLagan has assisted our clients through challenging times. Emerging markets economies move fast and often get hit harder in a downturn. As such, many firms feel that they need to take drastic action.

In a downturn there are numerous issues for Management to deal with. However, within the financial services industry, human capital is by far the largest expense, and usually the first thing firms look at when they need to control costs.

In this McLagan Alert we highlight areas of consideration for Boards, Management, and Human Resources, when cost control becomes an issue.

1. Market Benchmark

Knowing where your firm is placed in the market and knowing what the market is doing is a critical first step.

For example, if your firm’s total compensation is benchmarked at the high end of the market, you have much more room to maneuver than if you are already at the low end of the market. Recently one client thought their salary levels were at the top of the market, but after benchmarking them to a peer group they realized they were well below the market median.

Understanding what your competitors are planning to do in terms of salary increases and incentives is also critical in good and bad times. In addition, understanding your mix of pay (salary, allowances, and short and long-term incentives) is useful. In uncertain times, staff will often be happier with a larger salary and smaller incentive.

Other items to benchmark include assessing your grade pyramid and front to back office ratios. For example, do you have more senior staff as a percentage of total staff or do you have a greater percentage of support staff than your competitors?

Answering these questions will help you make rational, versus emotional, decisions about cost control and possible headcount rationalizations.

If it is determined that the headcount rationalization is required, understanding how the market manages severance situations including typical packages provided is also needed to ensure that you are fair with departing staff members and to protect your firm’s reputation in the market.

Rather than making headcount rationalizations we have seen clients ask staff if they would be willing to take a sabbatical, unpaid leave or reduce their number of working days. This not only ensures morale is not impacted, it allows the firm to staff up with experienced talent as soon as market improves.

2. Salary and Allowances

Over the years we have seen many firms freeze salaries in reaction to a down turn. Most recently, a few international banks have announced a global salary freeze to all or part of their firm (later retracted at one firm).

While salary freezes are an obvious cost savings initiative, they are one of the most demotivational things a firm can do. This is especially the case for junior staff and in economies with a high rate of inflation. Being very selective about salary increases, for example only providing increases to junior staff and/or high performers in middle management while freezing senior management salaries would be a much more effective strategy.

One area of cost saving that may be more palatable is to look at is allowances. Housing allowances could be indexed to rents in the local market. Travel allowances could be reduced. Over the years we have seen a number of firms move to one consolidated allowance, which is typically not based on family size. There are also significant cost savings possible in medical, disability and life insurance expenses.

3. Short and Long-Term Incentives

A number of Persian Gulf governments have recently announced no bonuses as well as salary freezes for all government linked entities. Again, taking a broad brush approach to incentives is hugely demotivational. Selectively giving bonuses to top performers has a much more positive impact on an organization. But, management has to be prepared to make very tough decisions and “zero-out” poor and mediocre performers.

Over the years we have seen firms being very creative when there is simply no money for bonuses. One firm provided staff with long-term incentive awards that had real value if the organization hit certain long-term performance hurdles. Staff believed they could turn the company around, and that they would get paid if they did. And it worked! Indeed, the best time to establish a stock-based long-term incentive plan is when the stock price is low.

During the global financial crisis we are aware of a number of firms that refused to pay any bonuses, even though in the performance year they had done very well and had committed to funding a bonus pool based on the achievement of financial KPIs. As a result the entire senior management team of one firm resigned the day after the decision was announced.

We have also seen firms refusing to pay out carried interest and other long-term incentive awards. In all such cases, these firms ruined their reputation in the market. When business improved and they tried to hire again, they found it extremely difficult to find anyone who would join without at least a two year bonus guarantee.

Short and long-term incentives only work when management and staff believe that they will pay out if the firm and the individual perform. When this trust is broken, it is almost impossible to regain it.

4. Communication

One client in Asia was facing a difficult time after the Asian Financial Crisis. Rather than terminate staff or freeze salaries, they told their staff what the situation was and allowed them to vote on the issue; staff reductions or salary freezes (the staff chose a salary freeze by a large majority). This may not work in every corporate culture, but the communication in this example speaks volumes about the organization’s level of maturity.

No matter how your firm decides to address compensation management in a downturn, communication with management and staff is critical. The Board and Remuneration Committee needs to communicate with the CEO and Senior Management. The CEO and Senior Management need to communicate with staff. Communication needs to be clear, honest and frequent, so that people understand why changes are happening and if there are possibly more changes to come.

“There are no jobs out there so why we do we need to worry about compensation”

We have heard this said many times during downturns. It’s a dangerous mind-set to foster in a company. If Management and Human Resources thinks this way about compensation; they probably exhibit the same mind-set around giving feedback to staff, training and development and performance management.

Another firm that we worked with during the global financial crisis did a remarkable job of keeping all stakeholders frequently informed of human capital and compensation changes. Juxtapose this, with another firm where changes were made with little formal communication (but lots of gossip and speculation) and the CEO stayed in his office with his door closed. You can guess which firm and CEO are still around! Comparison of performance across business units, it would also allow the focus to be around efficient usage of capital instead of a singular focus on margins.

The possibility of such a cascade is not restricted to business units – counterparty, geography, industry, desks etc. are viable too, depending on the sophistication of the firm. Such cascade of risk should be made an integral part of the performance management system and process.

In Conclusion

A firm’s most valuable resource is its human capital and in times of difficulty, it is this very commodity that needs to be protected the most. We have highlighted areas of consideration for Boards, Management, and Human Resources to review and think holistically about to manage compensation spend and ensure this resource is protected in the best possible way in challenging times.

We have encountered several firms that have failed to effectively manage compensation changes in a downturn. It was no surprise that when the markets recovered, these firms had significant staff turnover and a reputation as a bad employer which ultimately impacted its business results and long term profitability. Borrowing from the future, for the present, is not an advisable business strategy.