Every industry faces the challenge of retaining quality employees in these unprecedented times, but financial services firms are on the bleeding edge.

How can they respond with clear vision at a moment of tremendous uncertainty? It won't be easy, but far-sighted firms will seize the chance to alter their human capital management models and ultimately win.

There's no denying that financial services careers have been all about pay, especially in the investment banking sector. But attraction and retention can no longer be so compensation-driven. Instead, the process must include training opportunities, career development, and flexible working arrangements.

There has been a trend in financial services firms to use performance management programs to differentiate strong performers from average or weak ones. Firms need to structure their incentive compensation to appeal to the top performers, and any available bonus money should go to them. However, employees who receive reduced bonuses should not necessarily interpret that as a directive to look for another job.

Firms that want to align pay with performance should consider putting less emphasis on annual results and bonuses and more on rewarding performance over a longer period of time.

In addition, firms need to strengthen performance metrics to consider risk management. Rather than funding bonus pools as a percentage of revenue, firms should focus on profitability after accounting for the cost of capital and adjusting to reflect the level of risk incurred in the business.

These steps will help ensure companies are compensating people for sustained, realized performance.

Then there is the issue of mark-to-market valuations of illiquid securities. Executives have been compensated according to market values that are not actually achieved. Companies should consider basing compensation only on amounts that have been realized.

There is also a great deal of concern about long-term and stock-related incentives. Firms are considering cost-sustainable alternatives for delivering long-term compensation that will be looked on favorably by shareholders. These alternatives may include stock options with an exercise price above the fair market value, options or shares with performance-based vesting hurdles, or share/option exchanges for underwater options.

Unfortunately, with stock prices down, companies would have to give out many more shares, and even more options, to provide similar values. That could cause a dilution problem for most companies, unless participation in these awards is cut back significantly. That will likely result in shifting the mix of options, shares, and cash, with firms making awards much more selectively.

And let's not forget that banking is a global business. Companies based Europe face similar issues. Stock prices are down, but European firms have fewer underwater options than U.S. firms, because traditionally they have tended to depend less heavily on stock options for compensation.

Financial services firms in Europe have had performance-based compensation for some time, though they put more emphasis on executives' base salaries and offer a different mix of long-term incentive vehicles. However, many firms are increasing the emphasis on variable pay, and we are seeing a narrowing of the gap between U.S. and European practices. A common challenge for both, of course, will be setting performance targets in this unstable market.

As for putting more compensation into equity, there is a limit to how much firms can do. They are struggling with the ability to pay cash versus offering more shares and diluting the stock.

One possibility is to lower the entry point for mandatory deferrals, giving lower-level employees deferred shares or deferred cash as a portion of their bonus. This also lets firms manage risks and assess performance over multiple years, adjusting the final payouts if necessary.

In the short term, strategies are likely to include staff cuts and a net reduction in compensation. But firms are not likely to cut base pay, and some may even use it as a way of balancing the risk in the overall compensation package. We will likely see reduced overall payouts where there are performance issues, a reduction in cash bonuses, and an increase in deferrals. Companies will be moving toward measuring performance over a longer time frame, tying payouts to both service and performance.

Looking ahead to yearend bonuses, Mercer is projecting overall pool reductions of at least 20% to 30% from last year, with variations by business line.

It's no surprise that investment banking will be hit hardest, with rewards for everyone from revenue-generating employees to staff and support functions coming more in line with the general banking industry.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.