Mid-Year Moral Hazard

Moral hazard is normally only discussed at year end, in terms of the usual and typical issues of perverse incentives in executive compensation schemes.  It should be discussed at mid-year, as well, when there is a more serious threat.

Another tragedy of the commons threatens the compensation community.  It stems from the tendency to follow our rewards, do what is reinforced and to behave in accord with the incentives we find motivating... to pump up salary budget increase predictions.

I found myself impressed at the end of the American football season when both professional and college games featured marvelous instant replay reviews.  Referees made extraordinarily good use of the current technology by (usually) swiftly and effectively checking and reviewing the accuracy of difficult calls by the officals.  They were usually right, but what was more impressive was their dedication to getting it right, quickly.  No nonsense like, Shut up. I’m the man in the striped shirt and my word is law!   No, to the contrary, they would take a quick break for commercials while they double-checked the initial call, getting instant immediate feedback to confirm accuracy and precision.

Why don’t we ever do that?

This quick and amusing exercise perfectly captures this dynamic of the problem.  There are some things so omnipresent and ubiquitous (funny, how people use that term much more frequently in writing than in speaking) that they escape our conscious notice and can lead us into serious error with terrible consequences. 

The case example is salary budget increases.  Forget the more valid technical issue that relative increase rates are almost totally meaningless.  Prepare to consider the topic at the usual dim low level of comprehension experienced.  Let’s say that in response to the constant survey question, “what increase percentage do you plan for next year?”, you honestly report that you requested 6%:

• As a strategic catch-up move to match with selected peer competitors (see the ratchet effect);
• To reallocate tight budgets for more appropriate absolute pay levels that will retain key talent;
• In anticipation of the inevitable economic recovery talent wars that will otherwise leave you only able to attract the bottom-feeders rejected by other employers; and,
• Because you realize that asking for 6% might possibly generate some support for a 5% budget and thus create sufficient pressure that your management committee will actually authorize the 3% you expected in the first place.

While everyone is reading tea leaves, your padded 6% factoid gets accurately picked up in a few surveys of a limited sample of like-minded HR and compensation data suppliers.  Everyone understands, of course, that your actual 6% request is only what you had announced you would like to get.  The world also realizes, when it considers for two seconds, that HR people-people and comp nerds neither control the purse strings of their enterprises (I’ll wait for the laughter to die down) nor possess the final word on actual payroll expenses permitted during the fiscal year.  We propose but they dispose. 

Nevertheless, everyone wearing the tradecraft robes waits with bated breath in hopes that the early salary increase budget reports will be rosy, optimistic and (especially) high, so as to justify more spending on wages and salaries and bonuses and such.  When lots of money is flowing through compensation pipelines, the “controlling” department gains power, influence and prestigue.  A total rewards executive who asks for less money is an oddity.  Yet, the generous predictions of initial salary increase budget surveys so breathlessly flourished rarely come true in real life.  

The figures projected for year A are almost never actually found to have been expended in reality when we look back from year B.  And all eyes are averted from the dissonance.  Few if any enterprises who publish such surveys bother to compare their original predictions for the next year to the actual results found after the year has passed.  One would expect the accuracy and reliability of salary increase budget surveys to be an extremely popular thesis topic or dissertation subject. 

The entire future of the working world revolves around the accuracy of such forecasts.  Why isn’t it being studied and reported?  

It’s a sad commentary when the accuracy of the decisions that might influence the fate of a game played as a sport by multimillionaires gets more attention than the basis for payroll increases that affect virtually every worker.   Salary increase budgets are much more important than the position of a game-player’s shoe along the sideline.  Or are they?

E. James (Jim) Brennan  is Senior Associate of ERI Economic Research Institute, the premier publisher of interactive pay and living-cost surveys. Semi-retired after over 40 years in HR corporate and consulting roles throughout the U.S. and Canada, he’s pretty much been there done that (articles, books, speeches, seminars, radio/TV, advisory posts, in-trial expert witness stuff, etc.), and will express his opinion on almost anything.

Creative Commons image "Caution" by Nina Matthews Photography

Comments

[Chris Greenhalgh]

Thanks for your thoughts Jim. I have oftened wondered about this area but nobody puts this data out there presumably because the survey providers don't want to highlight that the data is inaccurate. Do you think the real problem is that people say 6% hoping for 3% or that the numbers submitted are simply unrealistically high as they lack an understanding of the wider business context? And if we have to submit a big number to secure a small number that doesn't reflect well on our ability to build a business case that will persuade our management committes does it? Either way I think this doesn't show our profession in the best light. Bring on the studies you called for so that we can shine a light on this murky area.

[E. James (Jim) Brennan]

Good questions, Chris.

I don't think that "high" requested numbers are GREATLY exaggerated, because the requestors must document their logic; and it's never hard to show a "need" for more money. Smart budget managers know you don't get more if you ask for less than you really want; so I do think people tend to ask on the high side.

HR and comp people don't usually get to carve up the turkey. The budget allocation decisions are made by top management. Our profession is usually not privy to details of their criteria. We certainly do not view the enterprise exactly the same way nor do we have the same "business case" outcome expectations as they do. Whether that is good or bad depends on your viewpoint.

In the end, the usual reality is that no function (operations, finance, sales, HR, purchasing, MIS/IT, research, etc.) gets everything it wants unless it is the lead central income-generation component.

Believe I have some past studies of actuals vs predicted around somewhere because this has bugged me for many decades, but can't recall if we had published them: probably not, because they would tend to embarrass some powerful folks whom we have no good reason to antagonize, particularly since they are usually our customers. Besides, those other surveyors tend to be consultants who primarily poll their clients, so they have valid reasons for different results. Some industry sectors have unique cycles, too. Bottom line: ask for an original copy of last year’s prediction and compare it to the actual later observed, to determine the accuracy of a prognosticator.