What causes pay compression and how can you address it?

The state of the labor market is causing employees to reconsider their options when it comes to compensation, and many organizations are feeling the pressure. This is especially true if your employees perceive that their pay is unfair compared to what other employees with the same job are making. This perception becomes reality when new hires earn close to or the same wage as more tenured or senior employees, which is an example of pay compression.

What is pay compression? 

Pay compression (also called wage compression or salary compression) is when the pay of one or more employees is very close to the pay of more experienced employees in the same job. The term also applies when employees in lower-level jobs are paid almost as much as their colleagues in higher-level jobs, such as with managers and direct reports.  

Pay compression is not a new phenomenon, and it’s not something that organizations do intentionally. It often happens accidentally and/or gradually over time. It is especially common when market conditions change rapidly so that salary offers have to increase to attract new talent, while experienced employees do not see pay increases on the same level. Pay compression results from numerous issues and typically flares up in times of high economic uncertainty. With recent regulatory requirements around pay transparency, pay compression has become an even hotter topic as more organizations are now required to post their salary ranges. 

In really tough circumstances, pay compression can turn into pay inversion, which is where newer or less experienced employees make more than tenured, more experienced employees, which can also include managers. 

How causes pay compression to happen? 

Pay compression happens when pay is increased for some employees — especially new hires due to changing labor costs — without being increased for everyone. A variety of factors can lead to raising wages for only some of the workforce, such as:  

  1. Outdated salary data and a lack of market adjustments   
  2. A hot labor market that leads to increased competition for talent   
  3. Raising wages for only the lowest-paid workers to offset inflation  
  4. Raising wages for new hires with hot skills to fill specialized roles   
  5. Mandated minimum wage increases   

In 2022 and continuing into 2023, we see a combination of these factors hitting at once. In some ways, this situation is overdue — a reaction to the wage stagnation following the Great Recession of 2008, which impacted some occupational groups more than others. But it’s also a unique circumstance brought about by the COVID-19 pandemic and the Great Resignation or Great Reevaluation that followed.  

If you’re struggling with pay compression or pay inversion within your organization, the best reaction to this situation is to view it as an opportunity to review and adjust your compensation strategy and processes, including managing pay equity and pay increases on a more consistent or even continual basis.  

Should you be worried about pay compression?  

Pay compression isn’t necessarily always a concern. Or, at least, there are a few scenarios that might get conflated with pay compression, which are acceptable situations that do not need redress.

For example, managers don’t always need to make more than their employees. Some individual contributors are subject-matter experts with specialized skills. These hot skills plus many years of experience can catapult their pay to the top of a range that outstrips some managers. 

Employees may also make more than their manager if they receive premiums related to their location. This is becoming more common with remote work and distributed teams where the organization utilizes an employee location-based pay strategy. This can also happen among teammates, because employees doing the same jobs in different locations may not earn the same wage if location is a compensable factor — even if they work on the same team and under the same manager.  

Likewise, new hires are only sometimes new to the job you hired them for. If you hire workers with years of relevant experience, that experience should factor into where they are slotted in their pay range. Suppose you divide your pay ranges into quarters and tier employees based on their years of experience or overall competency in the job. In that case, you shouldn’t worry if employees in different tiers earn different pay. Of course, this does need to be consistent across the workforce. However, years of experience is a compensable factor that can be used to explain differences in pay, which would still be true even for employees who are new to your organization.  

None of these situations encompass what is typically meant by pay compression. Still, if your compensation management practices aren’t appropriately structured so that you are accounting for these compensable factors consistently, it can certainly present that way. In that case, you have some work to do to ensure you are monitoring and maintaining pay equity in a manner that is documented and defensible.  

What to do about pay compression 

If employees with less experience are making more than those with more experience (assuming location and performance factors are equal), pay compression is something that should be addressed. In this case, you should take a proactive approach to compensation management. Here are a few things to consider to do that.  

Budgeting increases and fair pay  

Addressing pay compression may mean allocating more budget to employee pay. This is easier if a commitment to fair pay is central to your organization’s culture and values. If fair pay is not a cultural value, changing that isn’t necessarily easy. It might even be impossible — at least in the short term. But if your organization is feeling pain from the current labor crisis, now is a good time to start laying the foundation for why the employee experience matters to business operations and how pay is a key component. If your organization already has these values, encourage the business to demonstrate its commitment to fair pay.  

Salary data and pay analysis  

To get started, you must first invest in salary data to inform your pay ranges and make sure you have the right job matches, especially if you suspect that your traditional market data sources may be out of date. You may find that you need to recalibrate pay ranges for some of your employees. Next, you can calculate the compa-ratio for all of your employees so you can see where everyone falls along their range in relation to the midpoint. Combined with an updated compensation philosophy and strategy, you will see how far off you are from your target pay. From there, you can calculate the pay-increase budget required for getting all employees to an acceptable distance from the midpoint.  

Growth and profit

Will employee pay increases cut into corporate profits or shareholder dividends? Possibly, at least temporarily. But a decrease in EBITA doesn’t necessarily mean a decrease in revenue or growth. Spending more on employees can be central to a growth mindset. You have to spend money to make money, and at present, spending more money on talent may be the most important allocation you can make to drive productivity and remain competitive.

How much do you need to expand your pay-increase budget? Well, that depends on how dire pay compression and pay inequity are at your organization currently. Do a market analysis. If the amount you need is significant and resources are limited, you may need a multi-year plan to right the ship.  

Total rewards 

Remember that an effective total rewards package should address the entire employee experience. A mature and proactive compensation approach is an important part of the package; however, base pay is not the only reward option. In lieu of base pay increases, bonuses can be an effective tool for rewarding high-performing talent and retaining employees. You should also look into stock equity and other forms of rewards, including trading time for money like with additional PTO, preferred scheduling, and other non-monetary perks.   

Agile compensation planning

Compensation planning is traditionally an annual activity that corresponds to annual pay increases. This makes sense for many reasons. First, some organizations depend on traditional salary surveys, which have a year-long participation and output cycle. In addition, annual pay increases often align with an organization’s budget processes, which can be efficient when working with executive leadership. But how relevant is annual in an agile world? Increasingly, organizations need to build flexible and resilient compensation practices that can adapt to changing labor market dynamics.

Compensation planning and pay increases don’t have to be done just once a year. In fact, relying on years-old survey data alone can put your organization at risk when it comes to ensuring pay ranges are an accurate reflection of the current market. With modern technology and expanding sources of salary data, market analysis can be done twice a year, quarterly, or even continuously. It’s best practice to regularly evaluate current market rates and monitor pay equity across the organization.

Agile compensation management can reduce the time required to determine pay increases. If you are continually watching the market and monitoring both internal and external pay equity, you will be in a strong position to identify jobs that are suffering from pay compression or are underpaid compared to external market analysis. In that case, you’re poised to make proactive pay adjustments before compression becomes a problem. Just imagine telling hiring managers that a whole group of employees is eligible for an out-of-cycle pay raise before even asking for it. 

While addressing compression may feel like a difficult endeavor, avoiding the issue can lead to trouble recruiting new talent and increased turnover. The perception of pay inequalities that coincide with pay compression will negatively impact engagement and can potentially lead to lawsuits if protected class inequities do exist. Indeed, with the right tools, fair pay is something you can check with every offer, promotion, or lateral shift within the organization.

To learn more about how to address pay compression, check out our Quick Guide to Pay Compression.

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