Designing compensation for the new realities. (Special Section: Compensation).

Compensation has changed dramatically over the past few months. In just a short time, employers have shifted gears - from tackling attraction and retention problems, to reevaluating their compensation expenditures. Even before September 11's effect on the economy, recession fears were causing many employers to make cost control and balanced budgets top priorities. Since salaries and benefits represent a huge proportion of corporate spending, it was inevitable that human capital investments would become a focal point of those efforts.

This emphasis on cost-containment has put employers in a very challenging position. With most economic analysts predicting an eventual rebound, employers must be careful not to take steps today that will jeopardize their firm's future competitiveness. This means they must balance short-term goals of reducing compensation costs against their long-term concerns about employee morale, attraction and retention.

It's unfortunate that some companies have been fooled into thinking a long-term approach to compensation is unnecessary because the labor shortage has eased. Some managers are responding to recent events with the belief that employees should be happy to have jobs, and that concerns about managing human capital are old news. In reality, the current softening in U.S. labor markets is most likely just a temporary dip in what will continue to be an historically tight job picture for decades to come.

Even more critical for employers is the fact that during the current decade, the growth in the labor force will be much slower than during any recent decade. In the 1970s, the growth rate was around 2.5 percent, compared with 0.75 percent projected for this decade. Add to that the Baby Boomers nearing retirement, and it's apparent there just won't be enough young talent available to fill their shoes. Factor in the millions of new jobs that will be created as the economy recovers, and it's clear companies will continue to face a severe labor crunch for the foreseeable future.

In practical terms, this means that employers cannot afford to lose sight of the big picture. Attracting and retaining employees with critical skills will remain a challenge and compensation strategies will need to reflect that reality.

In response, many employers are taking steps to address short-term needs without jeopardizing their long-term interests. Many are balancing staff reductions with across-the-board cuts in bonuses and pay raises. Many are also considering overhauling stock option programs as more options go "underwater." And, many are considering tailoring their compensation practices to meet the unique needs of specific employee groups.

Adjusting Compensation/Avoiding Layoffs

Over the past year, many companies laid off employees through down-sizings and closures. Initially, many of the cuts were through attrition, although more significant layoffs ensued as the economy worsened. Going forward, layoffs will continue, but there'll be fewer of them, due, in part, to employers' willingness to modify compensation practices as a means of lowering expenses, in lieu of additional job cuts. The following four strategies are likely to be popular:

* Lowering or delaying, but not eliminating, merit increases. According to the Watson Wyatt survey, New Assumptions: Operating in the Current Business Environment, conducted in late 2001, approximately one-quarter of employers have delayed or reduced salary increases or are considering doing so. Few employers reported any plans to cut or freeze salaries, and of those taking such actions, a typical approach is to provide an exchange for other compensation, such as stock options.

In addition, savvy employers are changing the way merit increases are distributed. Instead of spreading them out evenly over the entire workforce, employers are giving top performers the bulk of the available money, leaving poor performers with limited increases, if any.

* Reducing executive pay. Reducing executive pay serves a double purpose. It helps companies meet cost-containment objectives and it sends a positive message to employees that executives are willing to share the pain.

* Reducing work time. Reducing work time may mean shifting a position from full-time to part-time, taking unpaid days off or forgoing vacation pay. However it's done, it provides a way to eliminate some costs while keeping all employees on board.

* Modifying incentive pay. Consistent with well-designed variable pay plans, nearly 60 percent of employers expect to reduce annual bonuses for executives this year, while 54 percent will cut bonuses for middle managers. About half (48 percent) will pay smaller bonuses to individual workers.

Also, to achieve reward plan objectives, some employers (41 percent) are changing their incentive plan formulas to adjust performance targets or payouts to match the current economic realities. Employers taking this approach typically do so out of concern that morale issues will arise as a result of decreased incentive pay, since many employees have come to rely on incentive pay as part of their expected income.

Scrutinizing Stock Options

Over the past two years, stock options have become highly controversial. Clearly, stock options helped drive the extraordinary 10-year bull market that abruptly ended, and it also appears that stock options -- given their motivational power -- could help end the current bear market and recession. However, potential dilution levels, as measured by overhang (options already granted plus those remaining to be granted, divided by total shares outstanding), are higher than ever, and a very large percentage of these options are underwater.

This vast number of underwater stock options has limited their usefulness as attraction and retention tools, and it's clear the issue must be addressed for employers to continue using stock options as effective compensation tools.

More than 40 percent of respondents to a recent Watson Wyatt survey on stock option overhang said underwater stock options are indeed a problem, and a similar number said they are considering overhauling their programs. Those making changes are split between issuing more options at a lower strike price or canceling existing options and reissuing them at a lower price.

Looking ahead, the use of stock options for motivating employees to think like owners will continue, and firms will also increase their use of direct stock ownership. As the willingness of shareholders to suffer dilution reaches a limit, there will be pressure on employers to increase direct stock ownership at all levels and to slow down the increase or even reduce the size of stock options plans. Value-maximizing firms will effectively manage both the levels of their stock-based incentive compensation and the mix between stock options and direct stock ownership.

Tailoring Compensation

It is increasingly apparent that different types of rewards are attractive to different types of people. Findings from Watson Wyatt's Survey of Top-Performing Employees revealed that flexible and tailored compensation programs benefit a broad range of employee groups. Men over age 50 with high-income levels rank cash as the most important reward tool. The under-30 crowd is more focused on opportunities to advance and the chance to develop skills, although they do value above-average compensation. And, workers on the lower end of the income scale rank flexible work schedules, paid time off and benefits as their top three reward preferences, likely because workers at this level have little control over their work schedules and purchasing benefits, such as healthcare, which can be especially costly to lower-wage workers.

Given this feedback, employers increasingly will move away from one-size-fits all compensation systems. However, no matter how flexible or tailored the program is, it will be most effective if it's predicated on the concept of pay for performance. Be it bonus, salary, stock options or days off, the key is being very clear that only those employees who perform will be rewarded.

By definition, for rewards to be strategic, they must be linked to business strategy and should change to reflect changes in that strategy. Organizations that designate revenue growth, profit margins and cost control as their top goals must review their reward programs to ensure that they are, in fact, rewarding the kinds of performance that advance these specific goals.

As employers make adjustments to their compensation practices to bring them in line with new business strategies and economic realities, they must pay close attention to the impact that changes may have on their top-performing employees. To be effective, they cannot view their actions as part of a six-month or one-year strategy; instead, they must have a long-term outlook and plan.

Those without a long-term focus will find it difficult to compete when the labor market tightens up again. Respondents to the top-performers survey made it clear that compensation was a large factor in their decisions to stay or leave. And, as they make such choices in the future, top performers will remember what employers did -- and did not do -- during this period.

Richard F. Beal, an attorney and consultant, serves as strategic rewards practice leader with Watson Wyatt Worldwide. He provides counsel on the design, development and implementation of reward and recognitions programs, and the linkage of programs to business strategy. He can be reached at [e-mail].