Inflation Update: Impact on Current Compensation Budgets

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Economic data from the first quarter of 2006 requires a close review, in terms of its impact on 2006 compensation budgets.

According to the Bureau of Labor Statistics, for the first three months of 2006, consumer prices increased at a seasonally adjusted annual rate of 4.3%.  Compare this to an increase of 3.4% for all of 2005.  The index for energy, which rose 17.1% in 2005, advanced 21.8% in the first quarter of 2006.  The energy index accounted for about 42% of the first quarter advance in the overall CPI.

The Federal Reserve Board of Governors reports that the economy appears to have rebounded in the first quarter of 2006, after a weak fourth quarter of 2005. Employment has expanded, the manufacturing sector has continued to grow, although at an uneven pace, and consumers have continued to spend. GDP grew at a 1.7% annual rate, according to the March 30 report by the Bureau of Economic Analysis.  Nonfarm payrolls added 243,000 jobs in February, the fourth consecutive month of solid job growth. The gains were broad-based, with 45,000 jobs added in the goods sector and 198,000 jobs added in the services sector. The unemployment rate, computed from the household employment survey, was 4.8% in February 2006, up slightly from 4.7% in January, but down from 5.4% in February 2005.

Other statistics of note also come from the Bureau of Labor Statistics.  Hourly compensation increased at an annual rate of 5.8% during the first quarter of 2006, as compared with 3.0% in the previous quarter.  Real hourly compensation, which takes into account changes in consumer prices, increased at an annual rate of 3.6% in the first quarter of 2006.

Economists in the federal government are optimistic about the economy moving forward.  The Congressional Budget Office (CBO) believes that the economy is growing at a healthy pace.  When considering the impact of inflation, the CBO believes that real gross domestic product (GDP), which is the total value of all goods and services produced by a country in a year, will grow by 3.6% in 2006, before dropping slightly to 3.4% in 2007.  That rate of growth is projected to slow to an average of 3.1% from 2008 through 2011 and 2.6% from 2012 through 2016. Business investment, however, will continue its recent strength because it has not yet fully caught up with the acceleration in the growth of demand in 2004 and 2005. The increases in employment and wages seen last year are also expected to continue, with the unemployment rate remaining near 5%, underpinning consumer spending.  The CBO forecasts a 1.9% change in the Consumer Price Index (down from 2.4% in 2005), and a 5.2% unemployment rate (no change from 2005). 

As we watch 2006’s economic trends unfold, Human Resource professionals need to be aware of the implications these statistics have on their current compensation programs.  Many organizations set their 2006 compensation budgets between 3.0% and 4.0%.  The all industry average was 3.5%.  In August, 2005 we reported 2006 compensation budget predictions in Astronology.

What then, according to recent economic projections, can we expect for compensation budget planning in the remaining months of 2006?

Compensation budgeting in 2005 for 2006 was based on an assumption that inflation would remain at low levels below 3.0%, and that hourly compensation levels would remain, on average, at 3.0%.  The 3.0% to 4.0% compensation budgets allowed for worker shortages as well as provided a way for employees’ incomes to stay ahead of inflation rates.  These budgets would also provide employers with more flexibility in how wage increases could be distributed.

What this all means is that with only the first quarter of 2006 in the books, many are rethinking their 2006 compensation budgets or at least making plans for a mid-year budget revision.  According to data provided by ERI (Economic Research Institute), the actual average adjustment for all industries in the first quarter of 2006 was 3.7%, 0.2% above the projected average of 3.5%. That is an annualized difference of 0.8%.  If this trend continues, 2006 could result in having a 4.3% average overall adjustment budget. 

Successful organizations must be flexible in how they manage their compensation budgets. The combination of a strong economy, rising energy costs, and continued growth in worker shortages has led to increased inflation pressures. The answer to this situation may not be in increasing overall budget levels, but rather in administering current budget dollars more wisely.  Consider the following options when reviewing your compensation budgets for 2006:

1.	Manage compensation to the market. There is increasing popularity in developing merit based compensation programs that focus on a salary range midpoint representing the desired market position.  While there are some issues in dealing with long-term employees under this approach, this system allows for maintaining an earlier established budget, addressing internal pay compression issues, and recognizing performance as it relates to the market position.
2.	Focus on your “Stars.”  Many organizations realize that regardless of the dollars available to them in the budget, they need to focus on those employees who make a difference in the success of the organization.  This may require adding an additional 0.5% to the compensation budget to fund special programs for these individuals’ continued competency & skill development, and career advancement.
3.	Generational Focused Total Reward Compensation Budgeting.  The “one size fits all” compensation program has proven to be difficult in today’s world, where multiple generations work side by side, each with a different need.  Many organizations are now looking at total rewards budgeting.  This approach takes all elements of total rewards, such as pay, benefits, pension, time off, etc., and creates a total pool of dollars that allows for flexibility not only for addressing generational needs but also to react to unexpected changes in the economy.