Ellason lens on… Inflation: Considerations for FY23 salary increases

Whilst UK inflation returned to single digits in August, following a drop in petrol and diesel prices, the CPI rate has increased again (to 10.1% in September). It remains the highest in the G7 and is predicted to remain around the double-digit level for the remainder of 2022. In this second Ellason Lens of a special series on inflation’s impact on remuneration, we consider the implications for the FY23 salary review process, taking into account guidance from major investors collected through Ellason’s Autumn shareholder outreach programme.

What is the purpose of the annual salary review process?

Before we consider possible approaches for FY23, it is helpful to consider the objectives of the annual salary review, which are often multi-faceted and include:

• Protecting against increases in the cost of living to ensure individuals are able to maintain an appropriate standard of living;
• Ensuring salaries remain market competitive, enabling the attraction and retention of talent;
• Maintaining internal pay relativities and providing suitable differentials in reward that reflect individual responsibilities and experience.

In recent years, low inflation levels have allowed companies – through the annual salary review process – to keep individuals whole in real terms. The low-inflationary environment has also enabled a largely consistent approach to be applied across the organisation (with executive salary increases typically broadly aligned with the budgeted increase for the wider workforce). However, in the current high-inflationary environment, alternative approaches may be required.

What should companies and remuneration committees be considering when planning for the FY23 salary review?

While few companies apply a direct link between inflation levels and budgeted salary increases, inflation is often a key factor in the decision-making process. In a high-inflationary environment, however, greater care needs to be taken to ensure that the rates used are an accurate representation of the pressures facing employees:

• Increasing household costs, such as energy prices, tend to have a disproportionate impact on lower paid employees as they account for a higher proportion of household spending. The ONS personal inflation calculator suggests that higher earners typically have a slightly lower personal inflation rate than lower-paid employees due to their different spending mix.
• Inflation is a benchmark of the additional cost associated with being able to maintain a particular pattern of spending. For lower earners, living costs are likely to take up most, if not all, of their take-home pay. Living costs for higher earners, while substantial, are likely to account for only part of an individual’s take-home pay, with the balance being used for savings, investments or discretionary spend (source: ONS, Family Spending Survey).
• Current levels of inflation are predominantly a result of the direct and indirect consequences of high energy costs. It is difficult to predict how long this might last, but forecasters are suggesting inflation rates may fall in 2023 and the recently-announced Government energy price cap may also help bring rates down. Current rates may therefore not be sustained longer-term.

Early conversations with investors suggest executive salary inflation is likely to be high on the agenda for the 2023 AGM season, with calls from investors for restraint. Many major investors are due to be updating their guidance over the coming months, but a general view from Ellason’s recent shareholder conversations is that senior executive salary increases are not expected to be aligned with the average workforce increase; furthermore, remuneration committees will be expected to justify any salary increase for executives.

In a typical year, around 25-33% of companies freeze salary levels for their executive directors. Whilst we anticipate that most companies will award some increase for 2023, budget constraints and investor pressure are likely to result in the median salary increase for senior executives being materially below prevailing rates of inflation, mitigating the competitive pressure to ‘keep pace with the market’.

Investors will also be reiterating the need for remuneration committees to be mindful of the multiplier effect that increases in base pay can have on the overall quantum of remuneration for a senior executive. With variable pay typically linked to salary, even relatively modest increases in base pay can have a significant impact (in £ terms) on the value of the total reward package. As an illustration, for a typical FTSE100 CEO, a £30k (c.3%) increase on the median base salary of £940k would increase total target remuneration by approximately £100k due to the potential uplift on variable pay. In comparison, for an employee on a salary of £40k, a £1.2k (3%) salary increase would increase the total reward by only c.£1.35k due to the significantly reduced leverage in the package.

What approaches might companies adopt for the FY23 salary review round?

Companies are likely to use a variety of different approaches for FY23, and which may include:

• Applying different levels of budgeted salary increase for different groups of employees;
• Applying a lower ‘blanket’ increase to the whole workforce (meeting the principle of alignment) but with additional, targeted cost-of-living adjustments for the lowest paid;
• Fixing or capping salary increases at specified £ values;
• No (or limited) increases for higher-paid employers (e.g. those with salaries above a certain £ threshold) to allow available funds to be targeted at lower-paid employees;
• Taking a longer-term view on inflation rates (e.g. 12+ months) to smooth the impact of short-term volatility;
• For international companies, having a greater focus on cross-border variations (e.g. harmonised CPI data from the ONS shows 9.9% inflation for UK versus 8.3% for US and 6.5% for France, etc.); and
• Leaving open the possibility for more frequent reviews (e.g. twice-yearly), to mitigate the risk of forecasting error and enable companies to respond more quickly to the fast-evolving landscape; an approach that has been used historically in very high (i.e. hyper) inflation markets

In making decisions on executive pay, remuneration committees will be encouraged by investors to consider the wider stakeholder experience. With cost of living pressures most acute for lower-paid workers, applying a uniform % salary increase across the workforce, whilst tolerated in recent years, is likely to come under increased scrutiny (and result in greater voting risk) in the 2023 AGM season.

 

Given the continued high level of inflation during 2022, we shall be covering other implications for remuneration in future editions of our Ellason Lens and webinars. Please do not hesitate to contact any of the Ellason team should you wish to discuss this issue further.