Pay compression can happen in any business, whether you’re growing a small company or working at an enterprise-level organization.
Yet what is wage compression exactly? How does it happen? And, when it happens in your business, how can you address it?
Let’s take a closer look at salary compression as well as how to spot, resolve and prevent it from reoccurring in your company.
What is salary, wage or pay compression?
Pay compression is a compensation issue that develops over time.
Also referred to as wage or salary compression, it occurs when there’s little difference in pay between employees regardless of differences in their respective knowledge, skills, experience or abilities.
When it occurs, it can be found between:
- Tenured employees and new hires (when new hires join the company at compensation levels similar to long-time employees)
- Managers and their direct reports (when there are small wage differences between employees within the same job family at an organization)
Why is pay compression a problem?
Pay compression can lead to turnover if employees feel they’re being undervalued. This is more apt to happen if long-time employees discover that they’re receiving little more money than new hires.
The situation can be especially troublesome when your best, most tenured employees decide to jump ship. Even if they’re not actively looking for a new job, employees can lose motivation resulting in lost productivity.
Wage compression can hamper recruiting efforts, too. For example:
- When there’s a significant disconnect between internal pay rates and what the market indicates is acceptable, you may lose out on top talent – especially if a job is posted with an inappropriate salary range.
- Later in the process, when it’s time to discuss compensation with a candidate, benchmarking an offer using an antiquated pay scale can result in the applicant turning away from your organization. (Asking for a job seeker’s salary history won’t help much, either, especially if a prospective hire knows they can find a higher paying job elsewhere. You must also be careful about state and local laws that prohibit employers from inquiries regarding salary history.)
What causes wage compression?
To understand how to avoid wage compression from developing, it helps to understand why it happens in the first place.
Below are four common causes of pay compression:
1. The minimum wage increases
A common cause is an increase in the minimum wage rate. When low-level employees receive a legally mandated pay increase that action can throw off the pay scale for an entire company. Over time, pay levels may converge.
Ideally, whenever the minimum wage is increased, all jobs within an organization should be reviewed to ensure pay levels make sense compared to the new minimum wage. Many companies, however, may not have the budget to do this. If money is tight, there are options (see “Encourage collaboration between HR and finance staff” section below).
2. The market rate for starting salaries increases
Sometimes a new hire is brought in at a starting salary or hourly wage that is close to (or in some cases higher than) what the new employee’s manager earns (or others in the same role with more experience).
Typically, this dynamic happens in a tight labor market, one in which companies must offer competitive salaries to lure high-demand professionals (software developers, for example).
When the market rate for starting salaries increases faster than organizations can afford to give raises to existing employees, wage compression often results.
A good rule of thumb to remember? Generally, direct reports shouldn’t exceed 90 percent of their supervising manager’s salary. This is something that HR professionals can and should keep an eye on, and a topic we’ll discuss in more detail momentarily.
3. Inconsistent pay practices over time
Market forces may drive a company to pay a higher salary to attract a new employee into a critical role.
If you continually fail to account for how that higher salary impacts the compensation levels of existing employees in comparable positions, you can inadvertently create pay compression.
Creating confusing job families can also play a contributing role. If one job family has multiple levels of a job function with different roles and responsibilities, but everyone is compensated using the same salary range, wage compression can develop.
For example, if a company has three distinct levels of accountants, each should have their own unique salary range.
4. Increased employee awareness
While not a cause of wage compression per se, employee awareness about the topic can transform what may have been a quiet reality into a growing issue of low morale, decreased productivity and talent loss.
Employers and managers must never prohibit employees from discussing pay as so doing would violate employee rights. Under the National Labor Relations Act, employees have the right to discuss working conditions, which includes compensation.
Employees will eventually learn about pay inequalities, even if you don’t spot it first. Whether it comes up in the wake of a new hire or when someone does online research, sooner or later word will spread about salary compression.
How to combat pay compression
Wage compression is a significant issue, and resolving it isn’t simple. There are steps that employers can take, beginning with determining appropriate pay rates. From there, you can take concrete steps to move toward better pay equity.
Here’s how you can start the process of getting back on track.
1. Assess current pay practices
Chart the course back to a more realistic internal pay scale by understanding why it’s an issue and researching the possible root causes for it in your organization.
Questions to ask include:
- Do your current pay practices reflect market demand?
- Did minimum wage recently increase in your location?
- Are there obvious wage inconsistencies between managers and staff? Within job families?
- Do your pay levels reflect your company’s vision and goals? If not, what needs to change to realign your compensation with those objectives?
Once you’ve assessed the situation fully, develop formal compensation practices and policies to prevent future problems.
2. Consider market conditions
When assessing current pay practices, it’s important to consider the labor market.
External labor factors that may impact your internal compensation plan include:
- Minimum wage laws
- A tight skilled worker supply
- Rapidly escalating wages for high-demand jobs
Some years these market drivers may not be as strong as others, so it’s good to view your compensation structure and policy as a flexible document that can be amended as needed.
Review changes in job descriptions, and check whether pay changes have kept up with responsibilities, especially as jobs evolve.
Also reconsider how to use incentives, especially ones such as at-risk pay – when an employee’s compensation is tied to their performance. This is another possible pay compression culprit. When at-risk pay is too easy to achieve, nearly everyone gets the full amount, resulting in wage compression.
3. Encourage collaboration between HR and finance staff
Adjustments in pay can be expensive if they haven’t been accounted for in a company’s budget. That’s why HR and finance professionals should work together to determine salary structures. Basic compensation knowledge and an understanding of economic restraints are essential.
There may be some instances where paying an employee more is warranted, such as when:
- They are working in a more expensive location
- The position generates revenue
- The job is in high demand
- The situation is temporary
If the finance department determines there’s no budget to address pay inequities, an organization can address salary compression in other ways.
Some options include:
- Variable pay plans
- Workplace flexibility
- Other desirable, non-monetary benefits or rewards
Additionally, these incentives may increase employee morale but not the company’s annual salary budget.
4. Consult legal counsel
While assessing your company’s pay structure, pay attention to any discrepancies that may have evolved that could appear discriminatory, such as gender-based pay differences.
Gather data and look carefully at these root causes, since they can present serious (and costly) legal problems if left unaddressed.
If you discover any evidence of discriminatory compensation practices, consult with legal counsel on next steps.
5. Communicate the new policy
Demonstrating to staff that current business leadership is proactive in addressing inequitable pay differences can help with the implementation of pay structure changes. It can also improve morale.
The revised compensation policy should outline how to pay new hires and how to compensate employees for promotions and merit increases, along with addressing other compensation topics. It should also be easy to understand and consistently referenced and utilized.
Ask managers or senior leaders to practice with talking points and make salary compensation discussions part of the workplace.
6. Maintain best practices
Once the entire pay structure has been assessed, the plan to bring employee pay in alignment with the market and with organizational goals may take time to implement.
You’ll also want to take steps to avoid future pay compression problems by:
- Monitoring market rates (especially for the most in-demand skills and positions)
- Keeping current employees paid at appropriate levels
To this end, review all compensation levels on an annual basis, but pay close attention to manager-staff and new hire-tenured employee salary levels.
How can smaller companies deal with pay compression?
Salary compression prevention solutions for smaller companies scaling rapidly are somewhat different from that of a large company with a pay compression issue that has accumulated over time.
Creative ways smaller companies can address wage compression include:
- Offering essential employees shares of equity
- Providing flexible work schedules
- Grooming longer-tenured employees for promotion
- Structuring compensation as a mix of base and variable, goal-based bonus pay
When combating salary compression, however, the basic goal is the same for every company: to continuously assess what can you afford to pay to attract and retain the talent you need.
For more information on how to address pay compression along with other issues arising from a company’s growth, download our free magazine: The Insperity guide to managing organizational growth.