The consultancy carried out research on firms in the UK and Middle East and found 43% are planning to reduce UK headcount and 70% will cut budgeted pay increases.
Less than a third of companies are targeting their reward budget on key employees but focusing on high performers rather than those with business-critical skills.
But employers are engaging employees in other ways, such as increased communication around change (75%), better communication on business results (74%), higher visibility of senior managers (45%), more communication on pay and reward (41%) and greater focus on mentoring programmes (35%).
Carole Hathaway, European head of strategic reward consulting at Watson Wyatt, said: "Despite a majority of companies claiming to have a greater focus on their key talent, few are supporting this by actually targeting their reward spend on them. Top performers are not necessarily the same as those with business-critical skills.
"Few companies appear to have the reward and performance programmes that enable them to make this important distinction. But failure to reward adequately those with business critical skills - as well as high performers - can have implications on retaining these key workers when the economy recovers."
Cost-cutting employers are setting themselves up for long-term problems
Employers are so concerned with cutting costs they are setting themselves up for more problems in the long term, claims Watson Wyatt.