Lisa Shuster, MBA, SPHR, SHRM-SCP, is the Chief People Officer for iHire, an industry-specific recruitment platform.
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When the job market is as competitive as it is today, many employers find they need to up the ante to attract top talent. This often means increasing compensation. However, bringing in new hires at starting salaries higher than or close to what existing employees are making in similar roles can lead to pay compression. This is when salaries don't properly reflect employees' skills, professional experience or their role's responsibilities. Pay compression may also happen when a newly promoted worker makes more than their colleagues at the same level or when nonexempt or hourly employees earn more than their supervisors due to overtime pay.
Regardless of where pay compression is occurring in your organization, if not addressed properly, it can negatively impact your workforce by lowering staff morale, decreasing engagement and driving turnover. Further, with pay transparency laws expanding and more companies including salary ranges in job postings, the odds are greater that current employees will find out what their peers are making. (Yes, employees do talk about pay with each other, and there are laws protecting those conversations).
So if tenured employees are complaining that the only way to get a decent raise is to go work for a different company, you may have a pay compression problem on your hands.
The Causes Of Pay Compression
Candidate supply and demand is a leading cause of pay compression. Suppose you’re hiring for a position with a low supply and high demand of qualified applicants, like healthcare workers. You might be forced to offer higher salaries to convince talent to work for you instead of your competitor.
Pay compression may also stem from a failure to correct for market changes when giving raises. On average, companies offer annual raises of 3% to 5%. However, inflation and other factors could negate the effect, meaning employees are actually making less money or could be making more money elsewhere. In fact, a Pew Research study showed that half of workers who changed jobs between April 2021 and March 2022 received a 9.7% increase in pay.
Another contributor to pay compression is poorly structured or broad pay scales because wages could become muddled between different levels of seniority. For instance, if you employ Sales Associates I, II and III but only have one salary range for all of them, the difference between the positions is unclear. This can lead to overlapping wages and a sense of stagnation, pushing employees to look elsewhere for work.
Preventing Pay Compression
The first step to combatting pay compression is conducting a compensation study. You’ll want to analyze two things: external market competitiveness and internal equity. Take note of any discrepancies, such as two payroll employees who have similar jobs but one is paid less for arbitrary reasons, such as differences in titles or education. Then, research what comparable companies are paying for similar roles as well as averages for your industry and geographic area. If the pay you’re offering is below these averages, adjust it accordingly.
Being proactive is critical in preventing pay compression, so resolve pay inequities before posting an ad for a new position. If you can’t give raises across the board, consider budgeting for merit-based increases for high-performing employees who could easily get a job anywhere and leave you with a large gap to fill. (For more guidance on determining fair compensation and what to do if you can’t afford raises, check out my previous article).
Another factor in play for pay compression is counteroffers. If you’re not providing a competitive salary, employees with one foot out the door may come to you with a competing job offer. More often than not, counteroffers end up being counterproductive. Money is not the only motivator for someone to leave, so it may be too late to retain the employee with a raise alone. Within six to 12 months, 80% of employees who accepted their employer's counteroffer end up leaving anyway. This is another reason why proactively fixing wage discrepancies is beneficial.
The Importance Of Pay Transparency
As mentioned, more states are adopting pay transparency laws, which means employees are more likely to figure out if pay compression is occurring. Along with being proactive in preventing pay compression, embracing pay transparency practices is a smart HR strategy. However, this doesn’t mean posting everyone’s salary on a bulletin board! It's about educating your employees on how salary decisions are made and why.
You could include a total compensation statement, sometimes called a hidden paycheck, when explaining pay. This statement outlines all monetary aspects and benefits each employee receives from you. Additionally, you’ll want to discuss career paths and advancement opportunities, clarifying any misconceptions about compensation for different levels of roles along the way.
Remember that pay transparency helps build trust with your employees, which is critical to fostering a strong company culture. In fact, 91% of employees who believe their organization is transparent about how they make pay decisions trust that their company pays staff equally for their work. As a rule of thumb, every manager should be able to respond to the question, “How is my pay determined?”
Without a doubt, pay compression has become more common due to unprecedented competition for talent, the rising cost of living and inflation. By taking proactive steps to address it, correcting compensation inequities and embracing pay transparency practices, you can get ahead of this phenomenon before it impacts your workforce and ensure all employees are paid fairly.
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