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Pay Compression Explained: Causes, Risks & How to Fix

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If an organization is facing challenges with employee retention, wage compression could be the underlying issue. It occurs when newer or less experienced employees receive pay that’s nearly equal to that of experienced employees.

Wage compression can occur in any position across any business, especially when inflation is rising. It also frequently arises when employee skills develop more quickly than their pay, causing pay rates to appear less competitive compared to other employers.

This article explores what pay compression is and its causes. It also covers how employers and HR leaders can identify the issue and take action before it impacts retention, engagement, and workplace fairness.

What is Pay Compression?

Pay compression, also called wage, salary, or compensation compression, occurs when employees have minimal or no pay differences despite differences in skills, experience, or tenure. This issue arises when employees receive equal pay despite differences in their knowledge, skills, qualifications, experience, or abilities.

Wage compression often occurs when companies provide higher starting salaries to attract new talent without changing the salaries of existing employees. While wage compression isn’t technically illegal under federal law, it can lead to discrimination complaints if it causes unfair pay differences between people in protected classes.

What are the Causes of Pay Compression

Wage compression can result from outdated wage approaches that fail to reflect current employment trends. For example, the demand for the position has risen, and organizations have adjusted the new hire’s salary to reflect that rise. However, existing employees in the same position continue to earn according to the previous market rate. The following are some of the most common causes of wage compression.

Rising Market Rates and Talent Competition

• Insufficient increments that fail to align with inflation or rising market rates can result in employees earning less over time, contributing to pay compression.
• When the job market is competitive, there is pressure to secure candidates with in-demand skills. To attract top talent, employers offer higher pay, neglecting the potential impact on current employees in the same position.
• Technology areas, such as software engineering, are especially susceptible to this problem. When current employees don’t receive comparable raises, their salaries tend to level off.

Increases in Minimum Wage

• When governments increase the minimum wage, entry-level employees earn higher compensation, while the salaries of more experienced employees remain stagnant, thereby reducing the pay gap.
• For example, the recent minimum wage increase from $10 to $12 per hour has an interesting implication. A new hire now earns nearly the same as an employee with three years of experience, who currently makes $12.07 per hour. As a result, the pay differential will now be only seven cents between new and tenured employees.
• Whenever the minimum wage increases, organizations should assess wages for all positions to ensure compensation meets the updated minimum wage.

Inflation and Cost-Of-Living Adjustments

• When inflation rises sharply, offering higher salaries may become necessary to maintain competitiveness. However, many organizations find it challenging to keep up with the pace of escalating costs.
• As costs rise, 71% of organizations plan to increase pay by at least 4%, resulting in increased compensation budgets. Many employees still struggle to make ends meet. Regularly reviewing remuneration packages and incorporating cost-of-living adjustments (COLAs) can help make sure that employees receive fair wages.

Broad or Outdated Pay Bands

• When compensation structures are not regularly reviewed and updated to match industry benchmarks, they may become outdated. This often leads to situations where newly hired employees get higher salaries than existing employees.
• When pay bands are too wide, they can include a broad range of experience and skill levels, leading to a lack of distinction between salaries for employees at various stages of their careers.

Inconsistent or Infrequent Salary Reviews

• Companies that lack a clear plan for employee pay may face issues such as wages becoming too similar or unfairly ranked.
• Without ongoing monitoring, certain salaries remain stagnant while others rise, even within the same role. Develop a structured compensation plan to track salary ranges.

Mergers, Acquisitions, and Organizational Restructuring

• When companies merge, employees at one organization may be offered a significantly higher (or lower) salary compared to those in similar roles at the other company.

What are the Risks and Impacts of Pay Compression?

Companies try to avoid pay compression due to its negative consequences. Below are the potential impacts of wage compression:

Decreased Employee Morale and Job Satisfaction

• When employees realize that new hires are earning similar or even slightly higher salaries despite having less experience or tenure, they may feel undervalued.
• They might also believe their loyalty and hard work are not being properly acknowledged. It may adversely affect their morale and job satisfaction.

Increased Turnover and Retention Challenges

• When employees notice minimal pay differences regardless of their experience or role, their dissatisfaction may increase, resulting in higher turnover.
• This satisfaction may lead to increased turnover, particularly among mid-level and senior employees, who are more likely to seek higher-paying opportunities elsewhere.

Potential Legal and Compliance Issues

• Although pay compression is not illegal in itself, it may lead to potential legal issues in some cases, particularly if it results in compliance issues.
• This is because pay disparities are perceived as discriminatory based on protected classes like age, gender, and race.

Training and Development are Wasted

• When pay compression causes turnover, companies lose their investments in onboarding, training, and developing employees for success.
• Unanticipated departures can result in skill gaps that are both costly and time-consuming to fill, hindering key projects and strategic initiatives.

Hindered Brand Reputation

• With employer review platforms, news of underpaying employees can spread quickly and widely. This can significantly damage a company’s brand reputation.
• Negative publicity around discriminatory compensation practices can also draw regulatory scrutiny or legal litigation. As a result, potential business partners and customers might opt to look for alternatives.

How to Identify Pay Compression?

Identifying pay compression early is important for maintaining fair pay and a positive workplace environment. Here are several ways to find out if pay compression is occurring in an organization:

Compare New Hire Compensation to Existing Employees

Assess the salaries offered to new hires compared to those of existing employees in similar positions to identify possible compression points.

Calculating Compa-Ratios

A compa-ratio compares an employee’s actual salary to the midpoint of their salary range. When compa-ratios are consistently lower for highly tenured employees than for new hires, it indicates that service compensation has fallen behind the market.

For instance, if experienced employees have a ratio of 0.80 while new hires have a ratio of 0.90, there’s likely pay compression.

Track Employee Retention and Turnover

Pay compression and employee retention are closely interconnected. To identify pay compression, track employee retention, and turnover rates, compare salaries for similar positions, and assess pay raise histories.

What to do about Pay Compression?

Once pay compression is identified, Human Resources teams are better off prioritizing its prevention rather than trying to resolve it later. Here are some effective strategies to include:

Regularly Conduct Compensation Reviews & Market Benchmarking

• Wage compression frequently occurs when businesses fail to align salary increases for existing employees with the market rates offered to new hires. To avoid this and stay competitive, companies should regularly review their compensation structures.
• Performing annual salary benchmarking against industry standards and proactively adjusting pay based on market trends helps ensure wages remain competitive. Over 60% of US companies claim to conduct pay equity reviews, but most approach these reviews as periodic exercises or as a response to a crisis.
• Regularly schedule equity reviews to identify the disparity between salaries and roles.

Adjust Pay Structures and Salary Bands

• According to an organization’s salary bands, revise existing salaries as needed to achieve market parity and ensure fair pay. Develop a procedure to implement changes that allow for transparent communication of the underlying reasons.
• At the same time, update pay policies and train managers on how to maintain consistency and equitable pay decisions.

Improve Pay Transparency and Communication

• HR usually handles the communication of pay policies and practices to employees. Sharing insights from pay analyses—highlighting key findings and plans—helps create transparency across the organization.
• The organization should also reinforce its commitment to fair and competitive compensation. Consider organizing information sessions to address employees’ questions. Clear and honest communication plays a crucial role in rebuilding trust when employees feel undervalued.

Develop Clear Promotion and Raise Policies

• A fair and competitive pay structure can attract and retain top talent. The revised compensation policy should outline the payment structure for new hires, the remuneration for promotions, and merit increases, as well as address other relevant compensation topics. It should also be easy to understand, consistently referenced, and utilized.
• This anticipatory approach helps maintain a stable and motivated workforce while preventing the outcomes of underpaying employees.

Conclusion

Pay compression is a complex matter that requires continuous attention and strategic management. By identifying the root causes of pay compression, understanding its impacts, and implementing effective solutions, organizations can create equitable pay systems that improve employee satisfaction, increase retention, and drive overall organizational success.

The workplace is evolving; keeping up with remuneration trends and regularly reviewing pay structures is very important for addressing pay compression and maintaining a competitive edge in the talent market. With factoHR’s payroll software, automate the entire payroll process and eliminate manual errors. Experience fast, accurate salary calculations, automatic tax deductions, and on-time payments every cycle

FAQs

Which Tools Can HR Teams Use to Manage Pay Compression?

HR teams can manage pay compression through internal pay audits, compensation management software, and market salary surveys. These tools support features like pay benchmarking, pay equity analysis, and the creation of salary bands to prevent and resolve pay compression.

Is Pay Compression against the Law?

No, pay compression is not against the law. However, it can become a legal issue if it leads to unfair pay differences based on things like gender or race. That kind of discrimination is against the law, such as the Equal Pay Act, and could lead to legal trouble for the company.

Does Pay Compression Happen Only in Big Companies?

No, pay compression can happen in big or small companies. It occurs because of external factors like minimum wage hikes, a competitive job market, and internal factors like outdated pay structures that cause a small pay difference between new and experienced workers.

What Happens if a Company Ignores Pay Compression?

If a company ignores pay compression, it can lose experienced employees, lower team morale and engagement, face hiring challenges, and even risk legal issues if the pay gaps are unfair or discriminatory.

How does Transparency Help in Solving Pay Compression?

Transparency helps solve pay compression by clearly communicating how pay decisions are made. When companies share their compensation strategy, pay structure, and commitment to fair pay, it builds trust. Clear pay policies that reward employees based on their skills and contributions help reduce unfair pay gaps and promote equal pay for all employees.

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