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Cost of living versus cost of labor

     
November 05, 2020

Will we see changes in how they’re used to determine employee pay?

In light of COVID-19, most organizations have taken steps to have employees work from home as much as possible. Some did it temporarily and are now bringing people back, but many are not expecting all of their people to return to the office full-time. Unlike what many thought just a year ago, we’ve learned that many employees don’t need to be in the office to be productive and engaged and managers are still able to provide direction, gauge success, and meet objectives with distributed teams.

According to Mercer’s COVID Global Survey #5 conducted in June of 2020, 64% of respondents indicate that they anticipate virtual people management processes (e.g., for hiring, onboarding, coaching) becoming a fixture in the future. When asked a related question in July, 82% of companies indicated that they are considering implementing flexible working at a greater scale than prior to the pandemic. Why? Seventy-seven percent of employers responded, “employee engagement and productivity.”

Too bad it took a pandemic to bring us to this conclusion.

But what exactly are the implications to this new workforce dynamic? Will companies continue to maintain offices? How can organizations continue to create a “company culture” with a dispersed workforce? These are some of many unanswered questions that we will continue to explore, but today let’s talk about what it means to pay work-from-home employees (i.e., pay cuts that you may be hearing about).

Foundations of setting pay

Compensation practitioners have always been part of the seemingly never-ending conversation with managers and leaders on how to pay when moving an employee into a higher or lower cost of living location. Typically, the confusion is caused by explaining the difference between cost of living (CoLiv) versus cost of labor (CoLab).

Cost of living is a measure of the amount an individual has to spend in order to maintain a certain standard of living in a particular location and, in the US, is largely driven by housing costs. Cost of labor, though taking into account cost of living, is much more an indicator of the supply and demand of labor in a particular area and the cost to attract and retain employees (i.e., high demand, low supply = higher cost of labor, typically).

Traditionally, rates of pay are set considering cost of labor and a set location for each job. It may not necessarily be where the employee “sits,” but is typically the geographic area that from which the organization will recruit for the job. For some jobs, that recruiting area tends to be national — they want to hire the best (or sometimes available) candidate in the country and will figure out whether relocation is an issue later. For other jobs, the organization may require the job to be able to travel through, or manage, a region. Some of those jobs may require in-person visits to locations in that region, but others may not. Whether or not you’re required to actually be located in a region to do the job would dictate how the pay is determined. Press operators, for example, have to show up to a plant to actually use equipment and produce product — their pay would be set based on a very local cost of labor either by using local market data or adjusting national/regional data using a cost of labor adjustment.

Cost of living has not typically been a meaningful consideration when establishing pay in relatively low inflation countries like the US. Sure, when relocating someone, there may be a stipend or temporary pay adjustment provided for a significant cost of living increase, but it’s not typically a permanent part of the pay package.

But, what about now that employers and employees are more inclined towards a more geographically distributed workforce? And even more, what about the employees who, now that commuting to an office is not part of their reality any time soon, are deciding to relocate to lower cost of living areas?

Should employers consider reducing their pay?

Recently, Rebecca Adractas, our content strategy leader, spoke with two of Mercer’s experts, Tauseef Rahman and Vince Cordova, to get their opinion on how CoLiv and CoLab will impact pay in the new world of working.

Virtual working and impact on pay

RA: Vince and Tauseef, thanks for joining me today. Let’s start off by establishing the baseline. Tauseef, you’ve been a talent strategy consultant with expertise in rewards and analytics. Vince, you are an expert in global mobility. I’d like to hear from each of you how, pre-COVID, you see CoLiv and CoLab impacted pay practices and talent strategy.

TR: Since the inception of employment, jobs have been thought of as having a fixed time and place. Remote work was never a consideration and we always established pay using cost of labor. Most everybody finds it difficult to separate cost of living and cost of labor, and understandably argues for using the one that would best suit their situation. The distinction has never been clear to people working outside of rewards.

VC: I agree. Cost of living is not the starting point for setting pay. There are some cases where CoLiv is relevant — for example, collective bargaining agreements typically include cost of living adjustments with a schedule tied to the CPI. Another area where cost of living is a consideration is for relocation. If an organization has a national pay strategy, but is moving an employee to a higher cost of living area (due to a need to move an employee to that area) then the relocation package might include a lump sum or pay adjustment that would be temporary and disappear over time.

TR: The difference between CoLiv and CoLab is much more apparent outside of the US where the two indicators move at very different rates, in emerging markets for example. The concept of employee mobility and relocating employees there is dramatically different due to the significant differences in cost of living and cost of labor.

VC: Mobility has changed over the years too. An important shift has taken place — many employers segment how they handle their mobile population now. Those who willingly move because they see it as a career growth opportunity or for personal experience are less likely to receive a stipend/adjustment than those that move at the behest of the company.

RA: For companies that are considering adjusting pay for those employees that have moved to lower CoLiv areas, what advice would you give them?

TR: I have them think through a situation with two employees both doing the same job. One lives right in San Francisco, near the “office.” One lives in a suburb an hour outside of San Francisco. Both, pre-COVID, were commuting to the office. Would you pay them differently? No, you wouldn’t. Where that person chooses to live and how much of their life they spend commuting does not have an impact on their pay.

I also have them identify which jobs are really tied to a particular location versus not. Then ask, what’s the supply and demand like for those jobs?

RA: Tauseef, what do you think of the Silicon Valley companies that are saying they are planning to reduce pay?

TR: I think it’s a complex issue. There are competing demands. Employers may want employees to eventually return to work at campuses so that there is minimal distraction in terms of life activities by providing amenities such as food and access to an on-site gym. Employees may now question whether that co-location on campus is really a requirement of the role given they’ve been able to work from home. On the one hand, pay can be considered a deterrent to those considering moving. On the other hand, it’s a question of fairness of “keeping high cost of labor salaries” in a lower cost of labor market. Ultimately it goes back to the question — what is the labor market? If it’s a competitive national labor market for the job, I can see a move toward a national pay structure similar to what some companies have announced.

RA: Vince, back to the question of CoLiv versus CoLab and how it will be used going forward, do you agree with Tauseef?

VC: Companies look at CoLiv when trying to categorize office locations for different decision making (e.g., Tier I, Tier II categories for retail outlets) or when they are looking to open new locations. In some industries, that may not be such a prevalent practice any more. Presently, there is a lot of disruption in working from home for employees. Employers are looking at ways to still provide “value” that they used to provide in the office. Some are looking to cover cost of setting up and maintaining a home office and how that differs from one locale to another. Cost of living information does influence those calculations. However, there’s also the cost savings that employees are experiencing — for example, no more commuting costs and in some cases the ability to work in states/cities that don’t collect income tax. Companies will need to assess which jobs truly need to sit in a particular location and consider whether they can use a national pay structure for all others.

RA: So, if companies do decide to adjust pay based on cost of living, they’re not just going to cut pay, are they? That seems very damaging.

TR: No, they’d just slow down or eliminate an employee’s pay increases. And typically we’d suggest that the employer make it clear that the reason for the slowdown was the shift to comparing to a national pay system.

VC: And, we have to keep in mind, some industries have been impacted very differently by this crisis. For those industries who have seen significant business revenue declines, it will become even more critical to determine how to allocate their spend on compensation, and they should consider how both the factors, CoLab and CoLiv, can inform strategies aligned with their current business reality. For industries who have prospered, demand for employees may be outstripping supply, and without a requirement to work in a physical office, recruiting and retaining employees will present new challenges, including understanding how this new environment is impacting the way CoLab is considered with respect to compensation philosophy and strategy.

TR: Before making any changes, organizations will need to build their capabilities and methodology to determine which jobs should be paid locally versus nationally. Some are clearly local, some clearly national, but it’s the grey area in between where they need to make sure they have a way to make consistent decisions. They should be asking, “Where is the work best done?” If it’s a job that would require some in-person time, is the company better off just flying people to a central location once in a while, rather than insisting people are in an office?

RA: Thanks to both of you, this is really helpful. In closing, if you had to tell companies one thing today, what would that be?

VC: Don’t lock yourself into one model at this point.

TR: We’re in a world where you can’t just consider one thing anymore. The idea that there is an office population versus a work from home population is outdated. There’s a continuum.

VC: It’s likely that overall compensation will look a little different, but companies have to choose what they are going to spend money on to best enhance the employee experience and drive business performance.

TR: And the boundaries of the employee experience has expanded exponentially.

RA: Tauseef and Vince, thank you again for your time. I think you’ve given our readers some great ideas to consider. We’ll look forward to hearing more from you as we move into the future of work in 2021.

Need more information about revising your compensation strategy or looking for other ways to enhance your employee experience? Mercer is here to help. Contact us at 855-286-5302 or surveys@mercer.com.

About the participants

Tauseef Rahman, Partner

Tauseef Rahman, Partner

Tauseef is a partner at Mercer and is based in San Francisco. He consults organizations on a range of workforce strategy and analytics issues, and on the business impact of the changing nature of work.

Vince Cordova, Partner

Vince Cordova, Partner

Vince is a Partner in Mercer’s Career Practice based in New York City. He has over 20 years of experience in mobility, compensation, and HR.