Pay Compression: How and Why to Recognize and Avoid It

What is pay compression? Imagine you’ve just hired someone. You’re paying them nearly the same amount that you give longer-service employees for the same position. By doing this, you’re likely engaging in pay compression.

Pay compression happens when new employees are paid nearly the same or more than longer-service employees in the same roles. For instance, new employees with little experience earn more (for the same job) than experienced tenured workers. Or, new hires and tenured workers have similar skills, but the new hires’ pay is only slightly less than that of the longer-term workers.

Pay compression also occurs if a lower-level employee earns nearly the same as or more than their manager or supervisor. For example, an exempt salaried manager (who does not qualify for overtime) ends up earning less than a nonexempt hourly direct report (who does qualify for overtime pay).

Causes of pay compression

Pay compression occurs when outdated pay practices do not reflect current labor market conditions. For example, the market rate for the position has risen, and you’ve set the new hire’s salary to align with that increase. However, existing workers in the same job are still receiving the old market rate. The following are other common causes of pay compression.

• Improper promotion practices. For example, a tenured employee is promoted and therefore takes on extra responsibilities, including leadership duties. Despite the promotion, they earn less than some of their direct reports or a new hire in a similar role.
• Minimum wage increases. These may cause a new hire to receive the same wage as tenured employees.
• Pressure to secure candidates with in-demand skills, especially in a tight labor market. To attract top talent, the employer offers higher pay, ignoring the potential impact on current employees in the same job.
• Economic downturn that results in pay freezes. Once the economy bounces back, candidates may request higher pay that outpaces existing employees’ frozen salaries.
• Merger or acquisition, such as when the companies involved have different approaches to employee compensation.
• Disproportionately providing additional pay, such as in the form of overtime wages, stipends, and bonuses. Excessive overtime, for example, may cause nonexempt hourly workers to out-earn their managers.

While pay compression can be intentional, in many cases, it is unintentional. Regardless, the practice can be damaging to the organization.

Consequences of pay compression

The detrimental results of pay compression can be far-ranging. It causes low morale among longer-service employees, which often leads to disengagement. Other negative results include:

• Employees view your pay practices as unfair.
• Loss of employee trust in your company.
• Difficulty recruiting from within, as employees may not see any value in accepting a promotion.
• Increased employee turnover, as employees jump ship for greener pastures.
• Newly departed employees “spreading the word” about your unfair pay practices. This not only impacts the business’s reputation but may also hinder your ability to attract qualified candidates.
• Employees filing lawsuits or complaining to the federal or state labor department, alleging unfair pay practices. Or they may lodge a complaint with the Equal Employment Opportunity Commission (EEOC), citing pay inequity.

You might be wondering how existing employees would know what new hires in similar roles are earning. Remember that, except in limited cases, employees are allowed to discuss their pay with coworkers. Plus, “news” about pay tends to travel fast in the workplace.

How to address pay compression

On the upside, pay compression can be fixed — and the sooner the better. To ensure fair compensation, the first place to start is with an analysis of the salary ranges for each position. By comparing them to the current job market rates, you’ll spot pay inequities that need to be adjusted. Your pay structure must consistently align with market rates.

It’s also important to compare employees’ job descriptions with their actual responsibilities. See whether the descriptions need to be rewritten and whether pay ranges should be modified to avoid wage compression.

The ultimate goal is to develop and consistently follow a comprehensive employee compensation strategy. A compensation plan should include verification that employees are being paid according to their responsibilities, performance, and experience.

Other tips for handling pay compression

• Make equity adjustments. Increase pay for longer-service, high-performing workers.
• Offer longer-service employees other types of rewards if you can’t close the pay gap through salary increases. Some options include cash bonus awards or additional paid time off.
• Stop or lower pay increases for overpaid employees, until their pay becomes equitable.
• Find ways to control overtime. For example, if an employee out-earns their manager due to overtime, you can hire another employee to decrease per-worker overtime.
• Compare managers’ salaries to direct reports’ pay. If the numbers are too close (e.g., a lower-level employee making more than 90% of their manager’s salary), then wage compression is likely present.
• Pay attention to your salary range midpoints, as this is where new hire salaries typically start. If a new hire’s pay falls in the 3rd or 4th quartile of the salary range, and a longer-service employee in the same job remains at the midpoint, that might be salary compression.

It’s critical to pinpoint the root causes of pay compression and then promptly correct them. If outdated HR processes are a factor, it may be time to modernize your HR system.

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