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The big squeeze: Is pay compression costing you good people?

Jafar Owainati, Barley
Jafar Owainati
Jafar is the co-founder and CEO of Barley, a compensation management software that makes it easy to structure, analyze, and manage pay--and keep a pulse on changing salary trends in the market.

Over the past few volatile years, the war for talent has meant that companies will often prioritize hiring at any cost. While many have increased salaries for new hires, few gave corresponding increases to current employees—giving rise to a compensation issue called pay compression. Pay compression is what happens when there is little difference between the wages earned by a tenured employee and newcomer, or between a junior- and senior-level employee working within the same job family. If left unchecked, pay compression can lead to higher turnover, lower productivity and the erosion of employee morale and organizational trust. But as we move into an economic downturn, with a greater emphasis on capital efficiency and cost reduction, many companies are encountering a difficult challenge: How can we remediate pay compression problems without an ample budget to give out pay increases?

Getting to the root of pay compression

Pay compression can arise from a number of factors. In addition to being spurred by employers offering new hires high starting salaries—driven by the hot job market or inflation—it could also occur when a company merges with or acquires another company, which might have a different compensation philosophy or pay structure. Bringing all the employees’ salaries into alignment can be a massive undertaking, with lots of inherited inconsistencies, and it’s work that is often outsourced to a consulting firm.

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Pay compression can also happen when a company gives raises to junior employees (to comply with an increase in the minimum wage, for example), but does not increase the salaries of intermediate and senior employees at the same rate. Or it can be the result of a lack of career advancement, where senior employees don’t have a path to growth and are stuck at the top end of their salary range. As a result, the pay difference between newer and more experienced employees becomes compressed. In areas of high demand or talent shortages, you may even get salary inversion where new or less experienced employees out-earn more senior colleagues or even their managers.

In all these cases, pay compression issues are not intentional or malicious. They might be inherited or created by the lack of a consistent and data-driven compensation strategy.

Pay transparency shines a spotlight

Pay compression has always existed, but the rise of the pay transparency movement has made pay compression more visible to employees. As states like California, Colorado, New York and elsewhere enact laws that mandate employers share salary ranges on job postings, organizations are struggling to justify their pay decisions. Research shows that pay compression was a reality for a whopping 56% of American companies last year.

Previously, employees might have found out about inconsistencies by having conversations with their peers or stumbling on an unsecured HR spreadsheet, but they were likely hesitate to discuss it with their managers. But now, many employees are able to see how their pay compares to the salary ranges on job postings at their own and at other competitive companies. Since this information is public, they are more likely to raise concerns if they feel that they are not being fairly compensated.

The positive impact is that, to comply with pay transparency, employers find that they need to have important internal discussions about their compensation philosophy and create a consistent framework of job levels and salary ranges to guide equitable pay decisions going forward.

How to identify pay compression at your company

To explore the potential of pay compression, compare new offers to the salary ranges and pay of existing employees. Are new hires being offered the same or higher pay as current employees with similar titles and responsibilities?

Another way is to look at the distribution of employees within your salary ranges. If you have salary ranges where employees are clustering at the top or above the range, this might indicate that the difference between your ranges is compressing. In that case, you might need to update your salary ranges to more accurately reflect actual salaries and market conditions.

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See also: What to know about salary trends in 2023

You can also look at compa-ratio, which is a compensation metric that compares an employee’s pay to the midpoint of the organization’s salary ranges. Do newer employees have higher compa-ratios than more experienced employees? Do managers and senior employees have unusually low compa-ratios? This might indicate that your current and senior employees are not moving through the salary range at the same pace as newer employees.

How to address pay compression

The reality is that a company might not have the resources to immediately address every instance of pay compression. It can require a substantial investment of time, budget and administrative resources.

When looking at the budget, it’s important to also consider what pay inequity issues might already be costing in turnover, lost productivity and damage to brand reputation. In many cases, the cost of not addressing pay compression can be even higher than investing in right-siding pay.

Here are a few steps to get started:

Build a remediation plan: This could involve a benchmarking analysis, writing a compensation philosophy, creating guidelines for giving pay increases and training managers. At the end of the day, the best way to address pay compression is to create a consistent compensation strategy to avoid creating compression in the future.

Develop a clear compensation philosophy: This should include guidelines or “guardrails” for how offers and raises should be given out and how your company wants to approach pay relative to its competition for talent.

Conduct a benchmarking analysis: Stay up to date by researching the market rate of pay and build salary ranges that are competitive in the market according to your company’s compensation philosophy.

Consider the impact of new hires on salary ranges: When bringing on new employees, it is important to consider how their pay will fit into the existing pay structure and whether it will lead to pay compression. Some common solutions might include creating a hiring range within the broader salary range or bringing in junior external candidates at the bottom of the range and investing more in their learning and development.

Regularly review and update salary ranges: By making market adjustments to keep employees aligned with updated salary ranges, you can ensure that the pay of existing employees remains competitive and consistent with the market.

Leverage other elements of total rewards: If your company can’t close the pay gap with cash compensation, there might be other elements of your total rewards package that are valuable to more tenured employees. This could involve giving equity refreshes (additional grants) or other benefits such as more paid time off. While this might not entirely solve an underlying pay compression issue, it allows you to address pay gaps as soon as possible, which will help boost morale and restore trust.

Prioritize pay increases for employees who need to catch up: If you’re on a limited budget, you may wish to prioritize base salary increases for employees who need to catch up with their colleagues. Employees who are already high in their salary range, or even above it, can be incentivized with one-time discretionary or performance bonuses.

Offer opportunities for career advancement: Prevent pay compression by giving current employees a path to higher pay through promotions and additional responsibilities.

Communicate transparently with employees: Explaining the “how” and “why” behind a company’s approach to compensation is absolutely vital. Employees want to know why they might or might not be receiving a salary increase, or whether their company is or is not thinking about how to close pay gaps. Providing reassurance and explanations through open communication can go a long way toward creating goodwill and trust, even when the budget might not stretch to fix every problem.