A Beginner’s Guide to Pay Compression

Have you been wondering: "what is pay compression?" It can be tricky to spot, even for seasoned HR pros.

It's time to get a better understanding of what pay compression is, how it can negatively affect pay equity and employee engagement, and how you can take corrective action to prevent it within your organization.

What is Pay Compression?

Pay compression, also known as wage compression or salary compression, occurs when employees with the same skills and experience are paid differently.

Sometimes, new hires or employees with less experience may end up being paid significantly more than tenured employees with more experience. This often occurs when the market price for the job rises quickly, forcing employers to pay more to land qualified candidates than they had previously. When these market changes outpace merit and other annual increases, you may end up needing to pay more to attract a new candidate than you're currently paying more tenured employees in the same job in your organization.

Salary compression can also occur when individual contributors are paid more than their supervisors. In highly skilled job families and departments with deep employee tenure, this can sometimes occur when employee salaries rise above those of low-level managers.

If word gets out among your employees that these pay inequities exist, it can cause turmoil, especially among employees who are more skilled or have greater tenure in their roles than their peers. While in most cases these inconsistencies are not deliberate, they can still be disruptive to your organization.

What Really Causes Pay Compression?

In many cases of pay compression, especially classic salary compression between new hires and tenured employee, the external labor market is to blame. Market factors, like the ones listed below, change over time and can inadvertently lead to pay compression.

• Inflation – pay compression can be caused by the inflation rate over time. For instance, Employee A earns $50k a year for Job B and gets a 3% raise for 5 years, landing them just under $58k a year. Meanwhile, Employee X joins the company after that 5-year period, and because the market rate for Job B has changed over time, they are hired at $65k. The difference between the $58k and $65k is pay compression.
• Hot Jobs – if there is high demand for a specific skillset or level of seniority, the market rate for such jobs can be driven up. This could cause previous employees in similar roles to appear underpaid or below market.
• Competition – sometimes, companies need to compete to get the best talent, and will pay high sums to land a perfectly-skilled employee. While the employee reaps the reward and may be a great hire, the organization runs the risk of pay compression.
• Fast-Growth Companies – organizations hiring new roles quickly (especially hot jobs) may run into pay compression if they don’t have a roadmap for all their new hires, especially compared to older, established companies with refined compensation structures.
• Tight Job Market – if employers are having a hard time filling jobs with qualified candidates, then new hires could potentially earn more due to increased demand.
• Minimum Wage – required minimum wage increases, whether state- or federally-enforced, can lead to hourly workers earning more than comparable salaried coworkers.

What Problems Can Emerge from Pay Compression?

All types of pay compression can cause challenges with employee engagement and morale and lead to organizational problems, including:

• Increased Turnover – more tenured or experienced employees may be a flight risk because they feel their production and contributions are being undervalued compared to their inexperienced coworkers. The cost of replacing veteran employees with the highest levels of institutional knowledge likely outweighs the cost of managing their salaries.
• Reduced Revenue – when employees feel they are being underpaid, they can quickly lose interest in their responsibilities, leading to decreases in engagement and productivity. This has a direct correlation to output, and ultimately, revenue. Whether they leave or not, poor productivity and engagement can be contagious with other employees if not addressed.

How Do You Handle Pay Compression?

To avoid pay compression, your organization must first identify if it's occurring, and under what conditions. You then need to prevent it from happening in the future – or correct it if it already has.

To decrease pay compression between employees, gradually bring up the base salary of underpaid employees. Meanwhile, halt or reduce pay increases for overpaid workers. Eventually, the pay for these employees will become (more) equitable.

If it’s not feasible to close these pay gaps through increasing salaries, consider compensating employees with other total compensation rewards, such as bonuses, stock options, additional PTO, or additional benefits (such as paying a higher percentage of health insurance). Promotions or title changes can also improve morale, and perhaps align with further salary increases.

Above all, you should communicate with employees and be transparent about your total rewards system. Share your pay structure, showcase salary ranges for each role, and explain the rationale behind compensation decisions. When employees are confident your organization is promoting pay equity, they’ll be confident their pay is fair and that you have their best interests at heart.