Five Strategies for CFOs to Adjust Compensation amid High Inflation and Labor Shortages

CFOs caught off guard this year by the "Great Resignation" are responding with a "major compensation adjustment." U.S. Labor Department data shows private-sector hourly wages rose 4.8% year-over-year in November. According to multiple business surveys, CFOs will open corporate wallets more substantially in 2022, with expected pay increases ranging between 3.9% (The Conference Board), 5% (Grant Thornton), and 5.2% (Deloitte).

The pandemic and supply chain disruptions are the short-term drivers of inflation reaching a 39-year high and heightened wage pressures. But economists and labor experts point out that over the long term, labor shortages will more significantly push up employment costs.

The ratio of job openings to unemployed workers hit a record high. The quits rate (quits as a percentage of total employment) rose from 2.3% in January to 2.8% in October, the third-highest level since data collection began in 2000, the Labor Department said this month.

"When we talk about real estate, we talk about a buyer's market or a seller's market—in the labor market, it's now a worker's market, which is completely different from the environment we've seen over the past three decades," said Peter Henry, professor of economics and finance at NYU Stern School of Business. "Wages will continue to rise rapidly."

Many CFOs have never experienced an economic environment where labor gains wage bargaining power this quickly, economists and labor experts say.

When attracting and retaining employees, CFOs must walk a tightrope: adjusting compensation (often the company's largest expense) without dragging down profit growth.

"The more you pay, the better people you hire and the lower your turnover," said Gad Levanon, director of The Conference Board's Labor Market Institute. "But the more you pay, the lower your profits."

To set optimal compensation and win the "war for talent," CFOs can take five major steps: closely tracking wage and employment data, expanding scenario planning, broadening geographic recruitment, ensuring pay raises are supported by productivity gains, and broadening the definition of compensation, economists and labor experts suggest.

1. Track wage trend data

CFOs can confidently fine-tune compensation by carefully monitoring wage movements, economists and labor experts say. The Employment Cost Index (ECI), released quarterly by the Bureau of Labor Statistics, reflects growth in total compensation (including wages and benefits) across hundreds of occupations and industries. The September report showed construction worker compensation rose 3% over the past 12 months, while leisure and hospitality employees saw a 6.9% increase.

The Atlanta Fed's monthly updated Wage Growth Tracker shows median hourly wage growth based on a 12-month period (using a three-month moving average to reduce volatility and distortion). Median wages rose 4.3% year-over-year in November, the largest increase since 2007.

Quits rates soared in 2021, hitting a record high of 3% in September before easing to 2.8% in October. "Wage growth, quits rates, and labor shortages are more pronounced in blue-collar and manual service jobs," Levanon said in an interview.

While monitoring current wages, CFOs should also track leading indicators of compensation levels. Typically, the unemployment rate can be used for such forecasts: a falling unemployment rate signals rising wage pressures, Levanon said. But pandemic lockdowns have somewhat blurred the correlation—even with unemployment still elevated, labor markets have tightened and wages have risen.

The National Federation of Independent Business reports monthly on the share of small businesses planning to raise compensation in the next three months. In November, 32% of businesses said they would raise wages and benefits within the next 90 days, unchanged from October and the highest level in 48 years.

Inflation is both a leading and lagging indicator of wage trends. Rising prices can signal upward wage pressure because workers demand higher pay to keep up with prices; inflation can also follow wage increases because businesses raise prices to offset rising costs such as labor, Levanon said.

2. Expand scenario planning

Since the outbreak of COVID-19 and the sharp pandemic-induced recession, CFOs have faced the broadest and most severe risk portfolio in decades. When considering pay raises, they need to track threats to growth from extreme weather, the Omicron variant, persistent supply chain bottlenecks, and heightened U.S.-China and U.S.-Russia tensions.

CFOs cannot count on Washington to support the economy and financial markets as vigorously as it did in the early days of the pandemic. Congress has so far blocked the Biden administration's roughly $2 trillion stimulus plan for healthcare, education, climate change, and social welfare. Meanwhile, the Federal Reserve, having underestimated the surge in prices, accelerated its tapering of stimulus this month in response to a 6.8% increase in the Consumer Price Index.

CFOs need to prepare for a range of outcomes, said Daryl Baker, CFO of Redirect Health, an employee healthcare management company. "Scenario planning is important to me," he said in an interview. "Companies that stick to an annual planning cycle, lock in an annual budget, and declare 'this is my 2022 budget' will miss the mark."

CFOs heading into 2022 need to incorporate rising labor and other cost pressures into scenario planning, Baker said. "We have to figure out how to adjust pricing to offset costs, but without creating an out-of-control, crazy inflationary spiral."

3. Broaden geographic recruitment

Even before the Omicron variant confirmed the value of remote work, a Deloitte survey found that 88% of Fortune 500 CFOs said in early December they would adopt a hybrid work model in 2022. Next, CFOs looking to cut labor costs can work with HR to expand recruitment beyond the regions where the company typically operates into areas with lower average wages, economists and labor experts say.

"Companies operating in expensive labor markets can shift some wage spending to cheaper regions," Levanon said. But this strategy could backfire if CFOs engage in "compensation arbitrage," cutting pay for employees relocating from high-cost to low-cost areas. Meta Platforms CEO Mark Zuckerberg approved remote work and a permanently distributed workforce in May 2020, but adjusting compensation based on location sparked controversy.

4. Justify pay raises

Since January 2020, pandemic-driven changes such as remote work and online shopping have lifted annual productivity growth from 1.5% during 2005-2019 to 3.5%, according to San Francisco Fed data. CFOs can more confidently approve pay raises that do not exceed productivity growth, Henry said. Facing strong wage pressures, they should improve their measurement of output per hour, whether in services or manufacturing.

"For executives, the key is to think carefully and systematically about how to measure productivity," he said during a Protiviti webcast. "If accompanied by productivity gains, pay raises don't necessarily erode profitability."

Measuring employee output "may sound good in theory, but how do you measure the productivity of office workers?" Levanon said. "For many types of jobs, it's very imprecise and could raise more questions than it answers."

Technology can boost productivity and provide a basis for pay raises. Deloitte says 92% of Fortune 500 CFOs plan to reduce labor costs in 2022 by increasing the use of automation.

5. Broaden the definition of "compensation"

CFOs should not expect generous bonuses or one-time perks to stop employee attrition, economists and labor experts say. "Labor is so mobile that one-time payments or bonuses won't necessarily retain people," Baker said. "You need to look at stickier things, like health benefits."

Companies should take multiple measures to improve the "employee experience," including offering flexible or hybrid work arrangements, launching learning and development programs, providing high-quality technology equipment as standard, and fostering a "well-being atmosphere," said Fran Maxwell, managing director at Protiviti. "Organizations that win the war for talent will focus on differentiating the employee experience so every employee feels something different."

Offering a diverse menu of benefits may cost less than recruiting and training replacement employees, economists and labor experts say. CFOs should determine which programs most appeal to each demographic group within the company, said Catherine Hartman, North America compensation practice leader at Willis Towers Watson, in an interview. They should ask "which of our offerings have the highest return on investment for specific employee segments."

Without such due diligence, CFOs may roll out benefits that employees don't embrace. Hartman described a company that launched a generous pension plan, but it only appealed to employees planning to retire within five years.

Balancing expectations

Facing labor shortages and overheated prices, many CFOs are struggling to balance company needs against employee expectations for higher pay and flexible work arrangements, economists and labor experts say.

"If I were an employee, I'd say: 'Okay, how much of a raise did I get last year? And by the way, the things I buy—gas, food—have all gone up more than 5%,'" said Robert Licht, CFO of Hertz Investment Group, a real estate company with $2.5 billion in properties across 25 U.S. cities. "We're trying to balance those expectations."

"Another challenge is getting everyone to recognize the benefits of being in the office," Licht said. "I can't imagine underwriting a new real estate acquisition with everyone in different locations."

Given current challenges, candid conversations with employees are essential, he said. "You need to create an environment where they feel comfortable being open and honest."

After "realizing the full impact of wage growth and inflation, and seeing what other companies are doing," CFOs may raise pay by more than 4% in 2022, Levanon said. Compensation budgets may need to grow rapidly for years, he noted, as the U.S. labor pool of people aged 15 to 64 has shrunk since early 2020. "The working-age population is no longer growing."