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New Rules of Management

Does It Pay to Reduce Pay?

Once considered off limits for salaried managers and professionals, base pay reductions are becoming increasingly common in today's brutal recession. Many human resources experts believe the recent moves by major companies—household names such as FedEx (FDX), Hewlett-Packard (HPQ) and Saks Fifth Avenue are all trimming salaries—could present perils when the economy turns back up again. They argue that star performers could bolt to other companies and that morale and productivity could suffer.

But others see an upside to reducing pay rather than making more layoffs. One of them is Dan Ariely, the author of the popular behavioral economics book Predictably Irrational, and a professor at Duke University. He believes that in the right environment, pay cuts can even boost morale and loyalty. He spoke recently with Management Editor Jena McGregor. Below is an edited excerpt of their conversation:

You're a behavioral economist. How do you think people will respond to pay cuts when the economy turns back around?

People hate pay reductions as a procedure. We don't want to think that as we get older, we get paid less and less and less. Then our productivity will go down and down and down. But [the current salary cuts] are supposed to be a one-time thing, and that's more acceptable.

It also helps that salary is very much what we call a positional good. At some level you care more about how much money you make compared with other people than the absolute level. For people who struggle, of course, the absolute level of how much they make is important. But for people at high positions, it's basically a chase to the top. We see other people making more, we feel bad—not so much because we need the money, but just because it tells us something about who we are. So if you reduce pay at the whole company, you in a sense keep the relative position the same.

The other thing that's very interesting is the idea of voluntary pay reductions. I talked to a guy from a consulting company named Diamond Consulting. When the Internet [boom] went bust, he said all the partners decided to take a pay cut. And then all the consultants who were not partners wanted to join in as well.

Now, that's kind of an amazing thing. It also tells you something about the longevity of the company. Do you know the term cognitive dissonance? If you take an action in a certain direction, your opinions tend to shift in the direction of your action. Now imagine that you took a pay cut for your magazine, and then you thought to yourself: How much do I love my job? Ironically, with cognitive dissonance, you would think you would love your job more.

But isn't that a partnership, where the people who took the pay cuts had a vested interest in the business?

The amazing thing with Diamond was that the partners did it, and you can understand that. But then all those who didn't have a vested interest wanted to join in as well.

Why do you think they were willing to do that?

I think they wanted to be part of the company. They wanted to feel like they are participating. If you think about cognitive dissonance, I think it actually increased long-term loyalties to the firm. Because if somebody said: "My goodness, I had this [time] in the past where I gave 25% of my salary to help the company. How much do I love the company?" Now they've convinced themselves they love it more.

That seems like the definition of predictably irrational.

For a long time, people thought the only thing people care about is salary…. I think that's why loyalty became so low, because we just made jobs a commodity. I think meaning is a huge part of it. How much do you feel connected to your company? How much do they let you express your ideas, your individuality? How much do you feel you're pushing the company along? And I think it's actually a good time to examine all the things companies can give to people and that people can give to their companies, and stop making it just about salary.

How much does the idea of one-time pay cuts go against the way people traditionally thought about wage cuts? What are the perils?

I think it's actually a good thing. The real issue is: Are you going to reset and basically start escalating when the economy recovers again? I personally think the "Gini coefficient" in the U.S.—the difference between the [incomes of the] poor and the wealthy—is the worst of the Western world. We really have the pay structure of a developing country, and this has been escalating. So resetting the game is not a bad idea.

So it's a good idea in a company with engaged people, a good atmosphere, people who love their jobs. What about in places where people are not engaged?

That's important, right?… It's a question of how you feel about an institution. When I was at MIT, it lost about $1 billion in the stock bubble, and in that financial situation—they didn't ask—I e-mailed the dean and said: "I'm happy to take a two-year pay cut if this helps." I suspect many people would.

If we don't, then it means your job is not doing a good job of making you feel connected. It's your friends who are working with you. It's a mission that you're up for. And if you care about, you'd do it.

But it seems like in there's a big difference between pay cuts that take place in an organization where people are happy and one where they're not.

That for sure is the case….

Imagine if I asked you where would you be happier: If you made $70,000 in a company where you're the highest-paid employee or $80,000 where you're the lowest paid employee. People say if they had to choose they'd choose the $80,000, but if asked where they'd be happiest they say they'd be happier with the $70,000.

Regarding relative compensation, what happens when your competitors aren't cutting pay, and employees start comparing themselves to what their peers make at other firms? Seems like that's where it could backfire.

Yes. But it's not going to be trouble until people start hiring.

McGregor is BusinessWeek's management editor.

McGregor is BusinessWeek's management editor.

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