The New Rules

Cutting Salaries Instead of Jobs


To cut labor costs, Ari Bousbib has tried almost everything. The president of United Technologies' (UTX) $34 billion-a-year commercial businesses has frozen hiring, deferred pay increases, and required some executives to take a week of unpaid leave. His company is getting rid of more than 11,000 jobs this year. But one thing he refuses to consider: direct cuts to salaries. "Across-the-board pay cuts have an impact on morale," he says, "and it is very difficult to rebuild motivation."

But Bousbib's thinking is not as universal as it once was. For decades, reducing salaries was anathema to managers. Employers could cut bonuses, eliminate raises, and even slash benefits, but an employee's base pay was sacrosanct. "It has always been off limits," says Ken Abosch, who heads up the North American compensation practice at human resource consultancy Hewitt Associates (HEW). "The rationale has always been that it creates very deep emotional scars and very concerning issues about morale, distraction, and productivity."

But in the past nine months a growing number of major companies, including FedEx (FDX), Hewlett-Packard (HP), Advanced Micro Devices (AMD), and The New York Times (NYT), have all trimmed their staffers' base pay. Most have made larger cuts for senior executives and smaller ones for the rank-and-file. According to a Hewitt survey, some 16% of companies in a study of 518 large U.S. employers have made base salary reductions during this recession, and another 21% say they are considering one. During the 2001-02 downturn, the number was so marginal that Hewitt didn't even publish the results.

In a time of rising unemployment and battered business models, some praise such moves as a welcome alternative to layoffs. Uniform pay cuts can be felt as a shared sacrifice in the interest of the common good. President Barack Obama even made reference to them in his inaugural address, noting "the selflessness of workers who would rather cut their hours than see a friend lose their job." In the first-quarter earnings call for Gymboree, which cut base salaries up to 10% and execs' pay even more, CEO Matthew McCauley said "what we are finding is the employees are grateful that we have done everything we can to protect their jobs." Rather than dampen morale, he added, in the last quarter "we had our best service scores in the stores that we ever had." A spokeswoman for HP says her company's "difficult" decision to cut pay will allow the tech giant to create more long-term value and "be in a better position to fund 2009 bonus programs."

Dave Ulrich, a professor at the University of Michigan's Ross School of Business, adds that trimming salaries is less risky in well-managed companies. He thinks pay cuts may even boost morale if they avert layoffs among highly engaged employees. "I don't think it's just pay that keeps people connected to a company," says Ulrich.

But other human resource experts argue that managers are paying too little attention to the perils of such cuts. "We haven't yet seen the unintended consequences," says William J. Conaty, who ran human resources at General Electric (GE) for 14 years and is now an adviser to private equity firm Clayton, Dubilier & Rice. "People have long memories. They'll remember whether they think they were dealt with equitably."

CORPORATE COWARDICE?

Traditionally, criticism of pay cuts has focused on the impact they have on morale and productivity. Telling an A+ player that he or she is going to take home less money this year, despite stellar performance, seems like a sure recipe for undermining enthusiasm. While average employees will put up with a smaller paycheck because they have nowhere else to go, the stars may bolt for a better opportunity when headhunters come calling again. Pay cuts, says Hewitt's Abosch, "fly in the face of all the theory and philosophy that companies have been talking about for decades around pay for performance."

Some people charge that cutting pay can amount to little more than cowardice. Instead of making tough decisions about whom to reward and whom to fire, some companies are inflicting the same pain on everyone. "To me it's just chicken managers," says John Sullivan, a human resource consultant in San Francisco who works with many companies, including Whirlpool (WHR), PepsiCo (PEP), and Microsoft (MSFT). Managers need to make tough calls about prioritizing jobs and people, he argues, as "top performers always have choices."

Why the change of heart this time around? The depth and severity of the current downturn is one obvious culprit. "This is a disastrous recession," says David I. Levine, a professor at the University of California (Berkeley) who has studied pay cuts. "Workers have less options, and companies have a lot more credibility" when they say drastic actions are needed. Plus, some argue the push for greater productivity has left organizations so delayered and "optimized" that there is far less fat to cut when times get tough.

Another important consideration is a demographic one. Many companies are acutely aware of the need to hold on to people with global experience and a particular set of technical skills. While such employees may be expensive or even underutilized in the current environment, managers may be worried about a broader talent shortage once the economy picks up.

For now, workers may be willing to watch their paychecks shrink as long as they're able to keep a job. The key is to make sure stars still make more than their lesser-performing colleagues, even after a pay cut. Dan Ariely, a behavioral economics professor at Duke University who sees value in cutting pay vs. jobs, notes that salary is what economists call a "positional good," meaning people care more about how much they make relative to their peers than the absolute level of what they take home. That's why Wall Street bankers get angry if their bonuses don't match what rivals are pocketing a few blocks away, and why distressed U.S. autoworkers who have given up years of hard-won benefits take some solace in the knowledge that they still many more than many other industrial workers.

The real question, though, is what happens when employees start comparing themselves with peers in companies that haven't cut pay. What used to feel like a good place of employment could suddenly feel like a trap. As Ariely says, "it's not going to be trouble until people start hiring." Once they do, some HR officials say, the challenge will be to keep the best people from heading out the door.

McGregor is BusinessWeek's management editor.

Jena_mcgregor
McGregor is BusinessWeek's management editor.

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