Addressing the Common Issue of Pay Compression

By Jeanette Coleman, SPHR & SHRM-SCP on Mar 11, 2021
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Addressing the Common Issue of Pay Compression

Any business, regardless of its size or how long it has operated, can struggle with pay compression. Also known as wage compression, salary compression or internal equity, letting the issue go unchecked can cause resentment among co-workers and a hostile work environment. When employees perceive they are not receiving fair pay, companies could even face lawsuits. While these salary issues don’t happen overnight and are likely not intentional, businesses must make fixing wage compression an urgent priority once properly identified.

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What is Pay Compression?

Pay compression happens when newly-hired employees with less experience earn a salary close to or higher than tenured employees with many years of experience. The most common reason pay compression arises in organizations is when a new hire’s starting salary is set too close to the current salary of experienced employees.

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Which Positions Struggle the Most with Pay Inequities?

When wage or salary compression becomes an issue, little difference exists between employee compensation despite experience, education, skills, knowledge, and seniority. The problem appears most often between new hires and cohorts with the same or a similar job title who have been with the company for a long time. Another typical place to see pay compression is in departments where different levels of employees exist (managers, supervisors and the employees who report to them), but all levels share the same salary range instead of having separate ranges for each level. As a result, employees in lower-level jobs may end up being paid almost as much as their managers.

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Factors Contributing to the Problem of Pay Compression

The external labor market and changing government regulations frequently contribute more to unfairness in salary issues than anything the company itself has done. The factors below also undergo significant change over time, leading to unbalanced paychecks for certain categories of employees.

  • Inflation
    Adjusting starting salaries to compensate for inflation is a common practice. However, companies risk pay compression when not giving the same consideration for inflation to current employees and increasing their pay accordingly.

  • Labor Market Conditions 
    People applying for jobs during periods of low unemployment can often command a higher salary, especially when they have multiple offers. Employers may feel like they have no choice but to offer a higher salary than others in the department earn to enable them to attract top talent.

  • Minimum Wage Increases
    When the federal government or the state government where the business resides increases minimum wage, it can sometimes result in hourly employees earning more than salaried employees. Changes to minimum wage can change a company’s entire pay scale to the point that new hires earning more than experienced workers become commonplace.

  • Rapid Company Growth
    A common mistake among start-ups is to hire a lot of talent quickly without creating a solid compensation plan for new hires. Wage compression is less common in more established companies that have had the time to develop a fair compensation structure for employees in the same or similar positions.

Understanding how the compression between employee salaries developed is the first step towards resolving this potentially explosive issue.

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How To Fix Salary Compression

Coupled with the data from studying both internal and external causes of pay compression, organizations of all sizes and across a wide spectrum of industries can implement some or all steps listed below to ensure payroll fairness.

  • Accelerate Pay of Affected Employees by Making Periodic Equity Adjustments
    This requires identifying employees on both the low and high end of the pay spectrum for each department. With this information, organizations know which employees receive pay that does not commensurate with their level of experience and performance. These employees should receive catch-up raises until their hourly or salaried figure is equal to the rest of the department, barring any differences for performance or seniority.

  • Look for New Employees Who Seem Eager To Advance
    External hiring is often competitive, but it need not cause salary compression if hiring managers take a careful approach. One way to avoid the common trap of overpaying for outside talent to join the organization is to start at a salary more comparable to employees already working in the department. This also provides an incentive to the new employee who may have turned down a higher-paying offer for the chance to move up the ranks more quickly.

    Another option is to place a cap on pay for new hires to avoid creating an immediate salary inversion. While hiring managers might initially balk at this idea, it is a good tool for keeping salaries between new and experienced employees at a more even level.

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  • Determine if Current Pay Grades Need an Overhaul
    A common problem among organizations suffering from pay compression is that not enough of a monetary spread exists from one pay grade to the next. Adjusting internal pay grades to better match pay ranges outside the company is an important step to making across-the-board pay more equitable.

  • Use Comparison Ratios To Identify Salaries Outside the Market Range
    The comparison ratio is a useful tool to ensure that employees receive fair pay when compared to the going market rate for their skills and experience level. To use this technique, locate the employee’s current annual salary and divide it by the midrange salary for that position.

    As an example, assume that an employee earned $75,000 per year and the midpoint for the position is $50,000 annual compensation. The employee in this example earns 1.5 times the market rate, which could mean the company needs to review issues related to salary compression.

    Pay compression isn’t always an issue, especially when considering seniority, job performance, and increased level of responsibility that factors into pay increases. Companies would need to evaluate if each employee in question deserves to earn higher pay if their comparison ratio is 1.0 or less. Those who qualify for higher salaries would then be candidates for payroll equity increases while those with a comparison ratio above 1.0 could potentially receive smaller increases to provide greater equality in pay.

  • Consider Upgrading Job Descriptions
    Position duties tend to change over time, but job descriptions don’t always change with them. Pay equity issues can arise when some employees have too narrow of a job description. When it’s apparent that an employee’s responsibilities and roles have changed and the current job description doesn’t reflect that, rewriting the job description can justify moving the employee to a higher pay grade that he or she has rightfully earned.

  • Adjust Wages Annually To Match Market Rates
    Companies that fail to adjust both starting wages for new employees and salaries of existing employees at least once a year risk falling behind in the marketplace and losing good workers. While it isn’t necessary to restructure the compensation schedule each year, the annual adjustment of pay is one of the simpler solutions to the issue of wage compression.

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