Cutting Salaries Instead of Jobs

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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.

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