What is pay compression? How to address it and fix it

What is pay compression or wage compression?

Pay compression (also referred to as wage compression or salary compression) is when employees who have been in a job for a long time makes less than new hires in the same position. With pay compression, there are small differences in pay that ignore experience, skills, level, or seniority. You see pay compression happen when starting salaries for new employees in a particular job title are set too close to the wages of your existing workers. In really awful circumstances, the starting salaries exceed what your current employees are earning, even if your tenured employees have more skills and experience.

Pay compression can be also be seen between managers and their direct reports. Most people would assume that managers have a higher compensation than the employees they are managing, but if the organization suffers from pay compression, this might not be true, and it can cause issues with your staff.

Pay compression can lead to employee disengagement, unproductive turnover, or even lawsuits.  If you have employees complaining that the only way to get a raise at your company is to quit and reapply, or to go a different company offering competitive market rates for their expertise, then you likely have a pay compression problem. You probably also have flight risks.

What causes pay compression?

There are a couple of main causes of pay compression.

1. Demand exceeds supply

The first cause of pay compression is when supply and demand is out of sync, meaning the need for a particular skill set exceeds the availability. Nurses and software engineers come to mind as examples of positions that are so in demand that workers with these skills are commonly rewarded with more pay for changing employers than remaining loyal to an organization. In other words, pay compression happens when organizations increase salary to attract new hires and don’t give market adjustments in salary for current or tenured employees.

2. Stale or outdated data

The second cause of pay compression is when your internal pay ranges become stale and out of alignment with external market data. This might result from a lack of analysis of the market or reliance on free data or old data to inform pay decisions. If your pay data is out of date, your hiring manager may start making “higher than targeted” offers to get offer acceptance from talent telling them what the going rates are. Hiring too many new employees at these higher salaries compresses pay for all your tenured employees. If they suspect or perceive they are underpaid compared to other employees they work alongside, those employees will start job hunting.

3. Broadbands or too-broad pay grades

Lastly, pay compression can happen from a muddled compensation structure, such as broad pay grades or job families that don’t apply tiers to positions where employees can grow into more senior or experienced roles. For example, if you have two or three levels of accountants, software developers, or copywriters but only one job range for all of them, pay compression can develop. You might also create a sense of career stagnation for those employees, which can lead them to look outside your organization for advancement. In this case, it is best to have unique pay ranges for each level of proficiency within the job and promote employees to the next tier when they achieve a new level of expertise and responsibility.

4. Minimum wage increases

Pay compression can also result from minimum wage increases in which employees with less experience receive a pay bump but those with more experience remain at their current levels. Ideally, when minimum wage goes up, every employee in the organization would receive a commiserate percent increase in wages, but this is not always possible. Even when it is, it can cause issues higher up in the ranks. Ideally, your organization will pay workers above the federal minimum wage in the United States and raise pay for your lowest paid employees even if not legally obligated, but this depends on the organization and minimum wage laws for where you employ workers.

5. Rapid inflation

Another cause of pay compression is rapid inflation. In 2022, inflation climbed to the highest it has been in 40 years. Inflation is hardest on your lowest paid employees, but it can also affect other employees in your workforce. When inflation increases, so do expenses. Employees who make barely enough to live on will need to consider all their options just to stay afloat, and that may mean seeking a higher paying job elsewhere. Giving pay increases when inflation spikes is a controversial practice, though. Inflation can be temporary, which would make a permanent pay hike unnecessary. Raising wages when inflation spikes can also lead to increased prices, which can loop back around to raises wages. This cycle is unproductive and can spiral into dangerous territory. There are some solutions, though. First, if workers are underpaid outside of inflation, you need to fix that. Beyond market adjustment for the going cost of labor, you can also look at variable pay to offset inflation. Some organizations also opt to provide stipends or allowances for food, utilities, or gas that is separate from base pay and only in effect for as long as inflation remains unmanageably high. The right solution will depend on where your workforce is the most stressed and what your budget will allow.

Pay compression can happen in any organization or industry. It is seen in small businesses, growing companies, and enterprise-level organizations. When businesses don’t have a compensation plan or don’t have processes in place with approval from executive leadership to consistently follow their compensation strategy, employees occupying in-demand positions are going to make less by remaining with your company than they will by leaving.

In 2022, all of these factors hit organizations all at once. And with another economic downturn on the horizon, the cycle could repeat. Organizations worries about paying workers too much when revenue or investment money is harder to get may pay for it latter when the market picks back up. This happened during the COVID-19 recession and could happen again.

What is the problem with pay compression?

Many organizations don’t want to make market salary adjustments for all of their employees because it is expensive but failing to pay fairly does have consequences. The obvious problem with pay compression is the negative impact it has on the morale of your workforce. Who wants to welcome a new hire to the team when you learn that that person is already earning more than you? What if you are a manager with subordinates whose salaries are higher than yours? What will you do if the only way to get a pay increase is to leave?

The most common consequence of pay compression is unproductive turnover. This is especially likely to be true of your best and longest tenured employees or of high performers or managers who have not seen pay increases along with their increased responsibilities or output.

Don’t assume that employees don’t know what is going on either. Although employees may not be familiar with “pay compression” as a term, it is likely that they know who is paid more and who is paid less for the same job and that they talk amongst each other about how unorganized or unfair the policies around compensation and raises are.

You can’t punish employees for talking about their salaries either. Although some organizations try to keep this from happening, employees are legally protected by the National Labor Relations Act (NLRA) to talk about what they earn. If they don’t do so at work, they may still do so outside of work or online, and you will see issues with pay equity and pay compression reflected on company review sites like Glassdoor or Comparably or in social media like LinkedIn, Facebook, or Reddit.

As previously mentioned, pay compression can lead to employee disengagement, unproductive turnover, or even lawsuits. If one employee doing the same job as another employee makes less for no justifiable reason, that employee can go to the EEOC to lodge a complaint of pay inequity under the Equal Pay Act. This is especially concerning if the employee receiving lower pay than another employee is female or a minority, but fair pay matters for everyone.

Pay compression can also impact recruiting efforts. Candidates may have heard or read that your organization does not pay competitively to market or does not give merit increases to existing talent. This can result in rejection of offers as candidates may feel that your organization does not have a sophisticated approach to rewarding employees or does not offer much room for career growth.

How do you address pay compression?

Pay compression is one of the ugliest pay issues that compensation professionals face. It tends to be a no-win, lose-lose situation, and the ways to deal with it are limited.

Many companies in a down economy are prone to rely on current high unemployment rates as their de facto retention strategy and justification or why addressing pay compression is unnecessary, at least right now. However, once the economy picks up, if you have not addressed pay compression issues, it will be your best performers, not your mediocre or troublesome ones, who flee to your competitors. And some won’t wait for the economy to turn around.

Those that don’t flee may just lose interest in performing at their best. They may rationalize that if you are paying them the minimum amount to retain them that they owe you minimum effort to perform the job you are paying them for.

So how do you deal with it?

Resolve pay inequities

The obvious answer is to pay employees what they are worth by resolving pay inequities and enacting merit and market increases across the board — or at least for your most critical roles. This would require allocating budget for pay increases everywhere pay inequity exists. If your response is “But we can’t afford that!” you should at least consider first what you would have to pay to replace all the employees affected if your underpaid employees leave. You should also consider the additional expense incurred in the recruiting process and the loss to productivity while positions remain unfulfilled.

Make a plan

If you are struggling with pay compression because the funds have just not been available, especially in a down economy, you can at least develop a plan for how you will adjust compensation when conditions improve and invest in better pay communications to disseminate this strategy. Let your employees know the situation — or train managers on those conversations — and create some criteria for what is needed to enact pay raises when the situation changes. Keep your word when that criteria are met. If you make promises to address pay compression issues, you need to implement market adjustments as soon as your organization can afford to do so. Going back on your word, or even just delaying action, will definitely cause employees to lose confidence in HR and erode any value of remaining with the company.

Consider variable or incentive pay

In the meantime, you might ask what else might bolster morale and ensure employee loyalty other than pay? You might be surprised at what employees will trade for pay increases — at least temporarily, and sometimes permanently. They might be interested in mentoring or developmental opportunities, a more flexible work schedule, the ability to work from home, earned time off, or paid time off to volunteer. Explore your options with extreme creativity.

You might also look into variable or incentive pay as an option in lieu of base pay increases. For example, you might be able to award bonuses for strong performance, especially performance tied to new revenue or renewals for non-commission positions. Although this doesn’t resolve the pay compression issue, it may bolster morale and can increase productivity and restore faith that you will address pay compression and pay inequity as soon as it is possible to do so.

Address the compensation budget with finance

Finally, you should find ways to collaborate with the finance team on market adjustments, pay equity corrections, and bonus incentives. If pay issues are causing the business to bleed its top performers, addressing it is critical and the money may be found somewhere if you work with the finance team on allocating budget. It is also generally a good practice for HR to work closely with finance on compensation structures and strategy. Helping the finance team to understand the basics of compensation management can go a long way toward removing restraints, especially during an economic downturn.

How to prevent pay compression

The best way to deal with pay compression is to prevent it from happening in the first place. If you are savvy about compensation planning and use modern software and tools for compensation management, pay compression can be avoided.

To avoid pay compression, forecast ahead and anticipate what your future hiring needs will be. Keep an eye on market changes by reviewing market surveys or consulting other salary data (i.e. from Payscale) for your key positions and steadily adjust your pay ranges as needed. Consider having a dedicated person within your organization fill the role of compensation manager.

When it comes to raises for current employees, don’t default to annual base pay increases of three percent or so applied indiscriminately across the entire workforce. You need to look at what your key positions are worth on the market, how minimum wage or inflation has impacted certain locations, whether there is inequity in how employees are paid in the same job, whether there have been changes in employees’ job descriptions, and how individuals have performed in their roles. Compensation should be adjusted accordingly or as much as you can justify given your budget.

Annual adjustments are often enough, but your recruiting team can give you early feedback on positions that are moving more quickly in the marketplace in case you need to make more frequent adjustments.

The ROI of addressing pay compression

It is true that salary adjustments can be cost prohibitive if they haven’t been budgeted for, but this is exactly why HR needs to work closely with finance on the importance of managing compensation according to a compensation strategy, especially in a down economy. If market adjustments are an annual part of compensation planning and accounted for in the budget, and the organization continually monitors for pay inequity and pay compression, the funds needed to adjust pay won’t be so high and won’t come as such a shock.

Even if the amount of budget needed to address pay compression is significant, it is typically less expensive to address pay inequities up front than to continue to lose the organization’s best talent to the competition over something that is within your control to address — and the right thing to do by your employees. It is also critical to proactively address pay inequities that might result in legal trouble, such as a gender pay gap or racial pay gap, even in a down economy.

In the end, organizations that take a proactive approach to pay compression and pay inequity, especially with corresponding pay transparency and pay communications, are more likely to be companies where the best talent wants to work. Competitive pay throughout the organization is a significant selling point for any employer brand, resulting in attracting the strongest candidates and having the most engaged and productive workers. In addition, organizations that invest in compensation management software will have all the information they need at their fingertips to model new pay structures and get pay right.

For more information on how to eliminate pay compression and manage compensation competitively, check out the following resources from PayScale:

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