How to Cut Compensation Costs

By Jim Fox and Bruce Lawson, Fox Lawson & Associates, A Division of Gallagher Benefit Services, Inc.

Question: My boss wants me to suggest some ways that we can cut compensation costs. Are there ways that we can deal with reduced revenue and remain competitive without making the hole we are currently in deeper? We would like to avoid layoffs, if possible.

CompDoctorTM: We are glad you asked. You see, the last time we faced this issue was in the years right after 9/11. Revenues were reduced, and organizations were scraping by. Some organizations cut staff, some froze compensation, and some tried to make do with fewer people by not filling vacancies or hiring new employees. How you address this issue will help to determine how you come out when this financial meltdown ends. We can assure you that, based on the 9/11 experience, there are things you can do to make yourself more resilient and there are things that you should do only as a last resort.

Interestingly, your question is one that we have dealt with repeatedly in recent months. If you have not thought of the options and the consequences yet, then you are obviously living in one of the few states that are not suffering from the downturn. (Specifically, we know that Wyoming and North Dakota are actually doing very well, relatively speaking.) Some agencies have continued to deal with compensation issues while others have deferred them. The problem with deferring any problem is that, in the short term, it is probably not a big deal, but in the long term, you might have a bigger problem. For example, if your car needs an oil change at 3,000 miles and you go an extra month or two, the car is probably not going to stop running. Any potential damage to the engine will probably be minimal so long as you actually do change the oil at, say, 4,000 miles. However, if you defer the oil change until 12,000 miles, bigger and more expensive problems could surface.

Unfortunately, if you defer addressing one problem, you are probably deferring others as well. The problems will then come home to roost when the economy does finally turn around and there are resources available to begin to address the problems that were deferred. That is when the fun begins since you will have to decide which problems are the most pressing and how much is available to deal with these deferred problems. If the turnaround is like past situations, (which, by the way, usually last 11 to 16 months) there are always policy makers who want to throw a little money at every problem thereby ensuring that nothing gets fixed right.

For example, we had a medium sized client that had some severe internal equity and market parity problems with some of its jobs. In addition, they had not looked at the market for some time. So, a comprehensive classification and compensation study was in order. The board funded the study and found that they were behind the market. Some jobs were worse than others and these were the ones that they had difficulty hiring. Recommendations for pay changes based on the findings were made to correct the internal equity and the market problems. Unfortunately, rather than deal with the problems that caused the study, the officials decided that they had to make everyone happy. When the study came to a vote of the board, they voted to raise everyone’s pay by three to five percent, depending on the employee’s pay grade, (lower paid employees got five percent and higher paid employees got three percent). Now they have the same problem that gave rise to the study in the first place, and a bigger payroll!

As public sector managers and custodians of the public purse and trust, it appears to us that our obligation is to use the limited resources that are available to get the “most bang for the buck.” The above situation does not appear to us to be a good application of the “most bang for the buck” theory. You might also find it informative that those organizations that were able to provide some pay increases to employees during the last economic turndown were much better off when the downturn ended. But those who decided to cancel raises because they thought that “no one else was giving pay raises” found that when the economy turned around and they went to the market to hire new employees, the labor market had left them in the dust and they were substantially behind the market. They were having difficulty hiring new employees at rates that did not cause severe pay compression with their current employees. What they found out was that other organizations had raised employee pay, and found other ways to reduce compensation costs.

Given that we are such great prognosticators of the future, we would like to suggest several things that you might do now to at least better position your agency for the future, rather than mortgaging that future.

One strategy is to simply downsize the organization—hopefully without crippling it by decimating every service area. That of course means that you need to decide whether the agency can or should continue to provide the full range of services that it has historically provided. If you decide that you should focus on only selected or the most critical services, then it becomes a lot easier to do those things well.

Unfortunately, we see many organizations take the easy way out – let’s just cut everyone’s budget by 5%, 10%, or 20% so that everyone feels a little pain. (This is really not a solution since it is just delaying the tough choices). These reductions can come in the form of layoffs, unfilled vacancies, or other steps that may reduce employee headcount but will create other, longer term, problems. This approach is certainly easier than saying to one or more constituencies that certain services are simply not going to be performed so that the rest of the organization can provide the services that are considered most critical. Others have done it, so you can too. For example, one of the more creative solutions we have heard—not the most creative, mind you—was to cut back on general fund parks and recreation staff so that they could keep more police and fire personnel on the job. You may have other examples where higher priority needs are retained, while the “nice-tohaves” are reduced or eliminated.

Now, assuming that there is no way to avoid across the board cuts, your next decision will be to do lay-offs or try other measures. Here are some steps that we have seen used to cut costs without layoffs. Obviously, for those agencies that have labor agreements, some or all of these approaches may require you to work collaboratively with your employee organizations.

Transfer employees: This is a version of having all members chip in for the good of the team. Essentially, this involves transferring employees from functions with lower needs or work volume to areas with higher needs or work volume. For example, support staff in the planning and building functions could be transferred to other departments where workloads are greater, thereby reducing or eliminating the need for overtime in those departments or functions. We see this in counties during elections and property tax collection time. Staff from other departments are “loaned” to another department for a short period of time to handle the increased workload. And guess what? For the time they are assigned, the employees do not get to say “but it is not in my job description!” All we are saying here is that the entire organization should be considered the employer—not the individual department.

Freeze hiring: By holding vacant positions open and transferring employees from other departments or areas to cover critical needs, layoffs can often be averted. Again, you need to think organizationally—not parochially. Employees work for the whole organization, not an individual department. That is just their current duty assignment. Having said that, layoffs may not be the worst thing to happen if you have the ability to address performance in the process. If you are able to eliminate the least productive employees, you can often increase overall efficiency within the organization. This can be beneficial to those organizations that profess to have a high performance culture. Recognize too that governments normally experience about a seven to nine percent turnover rate per year. If you just leave vacant positions open, you can substantially reduce overall compensation costs, although not as fast as you might like.

Reduce hours: Reduce the number of hours worked by each employee. Many organizations have asked employees to work only 32 or 36 hours per week with proportionate reductions in compensation. Obviously, this strategy does not work in all functional areas (such as public safety) and may require agreement by labor organizations, but it certainly can reduce costs while eliminating the need for reductions-in-force.

Reduce the workweek: In response to the high gas prices of last summer, some organizations explored moving to a four-day workweek. While this is more complex than reducing hours because there may be expectations that public services should be available eight hours a day, five days a week (except public safety which is typically a 24/7 operation). Now may be the time to brake away from that thought and consider what life may be like with less government. Organizations as large as the State of Utah are implementing this approach. The success has not yet been validated but these organizations are certainly evaluating whether it is something that should continue even after the immediate crisis is over.

Early retirement incentives: Another way to shrink a force without layoffs is through voluntary reductions and/or early retirement options. While not painless, at least the reductions are limited to those who are in a position to leave voluntarily. The risk here is that employees who you most want to retain could exercise the option and leave while those that you want to leave may choose to stay.

Phased retirements: Here is an idea whose time has come, but may require so much debate and changed policy that, by the time you figure out how to do it, the current downturn will be over. This option simply means that you allow eligible employees to phase into their retirement. It goes something like this: The first year, the employee cuts back their work to 75 percent of their normal workweek. They receive 75 percent of their pay as an employee, and 25 percent from their retirement pay (this is not 25 percent of their regular pay but 25 percent of the pension that they would normally be eligible to receive.)

The next year, they reduce their time to 50 percent, and income is split proportionately. The third year they reduce work to 25 percent, and their retirement pay increases to 75 percent of their pension amount. In the fourth year, they are off of your payroll and fully retired. This option, coupled with an early retirement incentive, might work for some populations. By the way, about 60 percent of organizations are now seriously considering this option.

Reduced or elimination of pay increases: This is an option we do not like, but we are sure that many will take this approach. The actual cost savings will be temporary and may actually cost more in the long run. Last time this happened, organizations found out that they were way behind in the market because they reduced their pay increases. While they were patting themselves on the back for such a brilliant management move, the market continued to increase salaries for their employees and hire the best ones away. The organizations that found this out needed to make substantial pay adjustments to everyone just to get back to being competitive. Keep in mind that even though the current news is doom and gloom, only about 25 percent of the organizations are cutting pay increases. Those that are, are cutting increases by only by about one percentage point. In other words, if the normal pay increase was planned to be 3.5 percent, only 25 percent of organizations are cutting it to 2.5 percent. That leaves the rest of the market at 3.5 percent increases.

Cut temporary staff: Many organizations use temporary employees to fill a variety of needs. Use of regular employees to handle the work that would have been done by temporary employees can reduce the need to eliminate regular positions. See “transfer employees” above.

Create efficiencies: While some organizations have used “gain sharing” as a technique to look for more cost effective ways to do business, now may be the perfect time to pursue efficiency efforts. Employees who understand that changing the way business operates is better than eliminating jobs just to maintain the status quo will be better positioned to weather the turbulent times ahead. There is an old saying in compensation circles that “what gets measured gets done.” Sometimes the simple fact of measuring performance and posting the results on a periodic basis so all can see can cause employees to improve their efficiency.

Broaden your class structure: From a classification and compensation standpoint, one of the best approaches to becoming more efficient is broadening the classification and compensation structure: fewer titles but broader responsibilities. This gives the organization the flexibility needed to change work assignments as needed without having to deal with the bureaucratic process related to reclassifications. It reduces wasted manager, employee and HR staff time in documenting, justifying and rationalizing changes in job duties. It also allows you to reorganize more easily if you decide to take a critical look at how you are delivering services.

Donate services: Offer to provide services for other agencies that may have greater needs than your organization. Conversely, you may want to ask other agencies to provide services to your agency if you have needs that you can no longer meet. This approach also relates to how you can most cost effectively provide certain services.

Our biggest concern when organizations face economic difficulties is that you will do things that may save you a dollar or two now but will cost you significantly more later when the economy turns around. While layoffs may reduce costs now, the combination of unemployment costs, severance costs, loss of knowledge and trust, and the subsequent costs of hiring, training, lost productivity or increased errors (which can exceed the new employee’s first year salary) can quickly drive your organization back to unsustainable costs. Because of the way layoffs are often structured, you may also lose some of your most valuable personnel. We have one client who recently had to reduce staffing levels and one of the positions eliminated was their “Employee of the Month” for the prior month.

Not dealing with compensation programs will simply make it more difficult to recruit key talent when the need arises. We have been urging public agencies for many years to think ahead about organizational needs when adopting a compensation philosophy and strategy.

Unfortunately, not all agencies have taken that approach. We consistently find that public organizations will have a knee jerk reaction that will end up kicking them in the backside a few years later. Those agencies will be the ones that will incur the greatest strain when looking for ways to function when resources are limited, and will be at the greatest disadvantage when times begin to improve.

We know that there are other techniques that can be used to ease the strain but hopefully we have stimulated your thinking. Just keep in mind that what you do now will impact your ability to be responsive and competitive a year from now. Often a unique combination of several of these ideas will help you see through the tough times and better position you for the future.