What is Indirect Compensation and Why Does it Matter?

Confused about indirect compensation? Imagine this scenario: You have been tasked with staffing an important leadership position within your organization. You’ve found the ideal candidate for the job, the person who ticks every box and would bring more knowledge and skill to the position than you had hoped for. You make an offer, only to hear from that candidate that, while your salary range was fine, they are taking a position with another company offering more and better benefits. Now, you have to go to the hiring manager and explain that the other company’s benefits package was more attractive. Does this sound familiar? And, if it does, what can you do about it to prevent it from happening again in the future?

Previously, we discussed three different types of compensation: direct compensation, indirect compensation and non-financial compensation. In today’s article, we will focus on answering your questions about indirect compensation. What is indirect compensation, why does it matter to your current employees and how can it help make your organization more attractive to prospective employees?

What Is Indirect Compensation?

Let’s start with a definition. Indirect compensation includes any form of non-monetary benefit that is given to an employee. These benefits can range from organization-sponsored health insurance to company-paid gym memberships. There are other forms of indirect compensation, which we will go into more detail about later in this article.

direct vs indirect compensation

Direct compensation includes salary, hourly pay, bonuses, and commissions. Because it has a financial value we can calculate, direct compensation is monetary. Conversely, indirect compensation isn’t always in the form of cash. Indirect compensation can also encompass the benefits your company offers employees.

These benefits include anything monetary that is sponsored by your organization, such as health insurance or the contributions your company makes to an employee’s 401(k) retirement plan. Additionally, if your organization offers stock options or profit-sharing, those might be counted as indirect compensation as well. Finally, tuition reimbursement or assistance, company-paid services such as a gym membership or dry cleaning, and other things of that nature also qualify as indirect compensation. There are other forms of indirect compensation, which we will go into more detail about later in this article.

3 Reasons Indirect Compensation Matters

Compensation management is one of the cornerstones of effective human resources management. A strong compensation plan helps your organization attract and retain the best and brightest employees. There are three main reasons why indirect compensation matters:

1) Indirect compensation makes your company competitive: The most important reason for providing indirect compensation is to show your employees that your organization cares about them, values their contributions, and wants to ensure their needs are met to the best of your company’s ability. Additionally, all other things being equal (direct compensation, job description, etc.), your company’s benefits package could tip the scales in your favor, making your company’s pay brand more competitive and attractive. According to Glassdoor, 57 percent of candidates in 2016 reported benefits being among their top considerations before accepting a job.

In a previous article, we discussed the importance of a company’s pay brand and how a strong pay brand affects the candidate pool. “When job-seekers believe that your organization values people and pays them well, you’ll attract more qualified applicants. In fact, data show that a strong employer brand leads to 50 percent more qualified applicants. Additionally, a strong pay brand will make existing employees feel more comfortable convincing their network to apply for open positions. With more qualified applications, recruiting teams can spend less money and time filling roles.”

2) Indirect compensation improves morale: When you have worked hard to create a fair and competitive rewards plan, you also want to ensure employees understand the benefits element. Our research shows most employees tend to undervalue their compensation package. According to last year’s Compensation Best Practices Report, just 22 percent of employees believed they were paid fairly.

According to BambooHR, you must also seek to understand the importance of indirect compensation for your company’s bottom line. “As employees feel more valued and motivated, not only will employee engagement, morale, and retention rates be higher, but your organization will also appeal to the type of talented, dedicated, and hard-working employees that can best represent and better the company brand.”

3) Indirect compensation helps reduce turnover: A 2019 study found the average turnover rate for organizations with no benefits plan is 157 percent, while organizations that offer benefits (including standard health benefits, vision or dental insurance and life insurance, to name a few) saw a 138 percent decrease in turnover. Indirect compensation, when done thoughtfully and intentionally, benefits all employees, regardless of seniority, age, title or tenure.

Employee turnover is expensive. There are a number of replacement costs to consider, including sourcing, hiring expenses, new employee training and the time it takes a new employee to ramp up in a job. Plus, losing an employee could cost your organization money when it comes to unemployment compensation, COBRA coverage costs and more. To calculate the cost of turnover, check out our formula.

The cost of turnover goes beyond just dollars. High turnover can lower the morale of remaining employees which can lower organizational engagement. Plus, when an employee leaves your organization, you risk losing knowledge or skills. Finally, if you are constantly recruiting because of high turnover, you are spending your time hiring when you should be spending your time engaging with and encouraging your high performers.

To learn more about turnover, check out our whitepaper, Turnover: The Good, the Bad and the Ugly.

What Are examples of Indirect Compensation?

So, what are some types of indirect compensation your organization can offer to employees? Below, we’ve listed some of the most common types. Now, we understand not every organization will be able to offer all of these benefits. But, we hope you’ll read this with an open mind thinking about what you could do to help make your company more competitive when it comes to benefits and indirect compensation.

  • Insurance: Insurance is one of the most common types of indirect compensation. Supporting the health and well-being of your employees is an important part of being a competitive employer. Consider how much of your employees’ health insurance coverage you contribute. Do you offer employer contributions into FSA or HSA accounts? Do you fully cover vision and dental insurance? What about life insurance? These are important questions to answer as you audit your indirect compensation offerings.
  • Retirement Contributions: This includes employer contributions to a 401(k) plan as well as pension plans. What does your organization currently contribute to retirement? Do you offer retirement planning advice or other financial planning benefits? Helping your employees plan for their futures is a great way to have a solid reputation for providing good benefits.
  • Paid Time Off: You might be surprised to see PTO on this list, but it’s true. Paid time off is an indirect benefit. How is your organization’s vacation policy? And, more importantly, how does it compare with other companies you might be competing with for talent? To learn more, check out this article about three different types of PTO policies.
  • Parental Leave: In the United States, paid parental leave is not federally mandated and is up to the discretion of the employer. According to the Encyclopedia for Early Childhood Development, “Parental leave is an important accommodation, designed to increase the ability of families to balance the needs of the workplace and home.” Building in a paid parental leave policy is a surefire way to make your organization more competitive to women, parents and those who wish to become parents someday.
  • Childcare: Childcare costs are astronomical in most major cities. If you want to gain a competitive edge with working parents, offering a company-paid subsidy for childcare is a great way to achieve that.
  • Equity Programs: Equity programs include stock options, profit-sharing, etc. They are a great way to align the financial interests of employees with the financial interests of the company. Equity programs can also incentivize employees and help increase the tenure of younger employees.
  • Technology: Do you provide company smartphones? What about laptops to help employees work remotely? Gadgets are another opportunity to improve your indirect compensation. One Seattle startup, Socrata (acquired by Tyler Technologies in 2018), had a policy where new employees could choose their own laptop (typically a Mac). Then, after 18 months of employment, that laptop was theirs to keep, regardless of whether they continued as an employee beyond that point.

There are other forms of indirect compensation, including tuition reimbursement, bonuses and gym memberships. To offer the best indirect compensation possible, do your research and figure out what would be most appealing to candidates in your location.

How to Communicate Indirect Compensation to Employees and Prospects

How you communicate indirect compensation is part of a larger picture of how you communicate your compensation philosophy overall. It’s generally best to be candid with employees when it comes to your compensation philosophy. For example, you might open by saying: “Your compensation is part of a total rewards package, which is a mix of base pay, variable pay, and benefits” and then laying out the major components of each.

The bottom line is that your employees and prospective candidates need to understand exactly what comprises total compensation, and that includes indirect compensation. It’s best to be clear and explain why your compensation is competitive.

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