Inflationary Pay Awards – Is There Actually a Right Answer? Andrew Jackson, Partner at FACT3, shares his views…

Every year we at FACT3 find ourselves having the same conversation with clients. 

"What should our annual pay increase be?"

It sounds like a simple question seeing as inflation is published every month, employees want their salaries to keep pace with the rising cost of living, and businesses want to reward and retain good people. 

But after discussing this with numerous business owners over the years, I'm still not convinced there is an obvious answer. 

At FACT3, we work alongside SMEs across a wide range of sectors and sizes, and almost every one of them has the same question…

Which inflation figure should you actually use?

 Should it be: 

• The inflation rate at the time you make the award? 

• The average inflation over the previous 12 months? 

• Or the forecast inflation over the next 12 months? 

 Each approach has its merits, but each also has its flaws.

The current inflation rate

Using today's inflation rate feels logical because it's current, transparent and easy to explain to your team. However, inflation rates can move quickly.

Following Covid and then the start of the war in Ukraine, UK inflation peaked at 11.1% in October 2022. If a business was looking at its pay award just after this time, as many would have given the number of December year-end and awarded pay increases referencing that figure, it would have permanently built a double-digit increase into its salary costs, despite inflation actually falling steadily over the next 12 months.

Equally, if inflation happens to be unusually low when pay reviews take place, employees may feel they're falling behind should prices begin rising again only a few months later. 

Looking backwards

Another option is to use the average inflation rate over the previous 12 months. 

This smooths out some of the volatility and arguably reflects the cost increases employees have actually experienced. 

However, it is still a backward-looking measure. It tells us where we've been, not necessarily where we're going. 

Looking forwards

Some businesses prefer to use economic forecasts from organisations such as the Bank of England. 

The logic is that salaries are intended to cover the year ahead, so perhaps future inflation is the more relevant measure. 

The difficulty is that forecasts are exactly that—forecasts. As we've all seen over recent years, economic predictions are rarely accurate! 

Then there is another challenge...

Some of our clients don't just employ people in the UK. They have operations across Europe and further afield, which raises another question as to whether you apply one consistent percentage increase across the whole business because everyone works for the same organisation. Or salary increases reflect the inflation experienced in each country. 

 The latest inflation figures in the UK and the Big 4 EU countries show the challenge: 

Country

Current Inflation (CPI/HICP)

United Kingdom 

      2.6%

Germany 

      2.4%

Spain 

      2.2%

France 

      2.0%

Italy 

      1.8%

Should someone working in Italy receive a lower pay award than a colleague performing the same role in the UK simply because inflation has been lower? Or should an international business adopt one consistent approach across all territories, regardless of local economic conditions? 

There isn't a universally accepted answer. 

Treat everyone the same and local economic conditions aren't reflected. 

Treat each country differently and comparisons between colleagues become inevitable. 

 Having been through this in my role as CFO for Proveca Limited where we have teams in multiple EU locations we landed on applying the rates applicable to each territory at the time, but we also looked at economic forecasts to ensure there were no significant increases on the horizon expected. As it happened and not too surprisingly all were forecasting reductions. 

Affordability versus inflation

Many SMEs would genuinely like to award pay increases that match inflation, but that isn't always commercially possible. 

This is particularly true for many SMEs, where payroll is often the single largest operating cost and margins can be far tighter than those of larger organisations. 

Pay awards therefore become a balancing act between rewarding employees fairly, remaining competitive in the recruitment market and ensuring the long-term sustainability of the business. 

 We saw this at FACT3 more than ever recently when the government introduced the increase to employers NIC and as a result employee costs were increasing before the pay increases could even be considered. Many businesses had to opt for no or much lower than inflation increase to their teams at this time putting more strain on the real people facing the impacts of inflation. 

So, what is the right answer?

I don't think there is one. 

I don't think inflation should ever be the sole factor when determining annual pay increases. 

Business performance, profitability, affordability, labour market conditions, recruitment challenges, staff retention and individual contribution all have an important role to play. 

As an accountant, it's easy to focus on percentages and calculations. 

But pay awards aren't just numbers, they're about people. 

They're about recognising contribution while ensuring the business remains financially healthy enough to continue investing in its employees for years to come. 

At FACT3, we're fortunate to work with ambitious SMEs across a broad range of industries and sizes, and this is a conversation we're having with more and more clients each year. 

There may not be a perfect methodology, but the businesses that tend to navigate these decisions most successfully are those that have a clear and consistent approach, communicate openly with their teams and make decisions that are sustainable for the long term.

If you’re looking for further advice on inflation, or on financial strategy in general, we’re here to help. Contact us today.