Of all the challenges People professionals face today, getting compensation right is near the top. That’s because HR must strive to meet the fluctuating demands of the market for new hires while working within the constraints of compensation strategies, and ensuring fair compensation for existing employees. When things go right, you end up as an organization that’s well-respected for your comp and benefits, and with a reputation of being a fair employer. When things go wrong, you can end up with wage compression.
What Is Wage Compression?
Wage compression, also known as salary or pay compression, occurs when newly hired, less experienced employees earn close to what current employees make.
For example, say an employee hired 10 years ago was offered a starting salary commensurate with the market rate. Over time, they’ve gone on to earn standard raises, in line with your company’s pay matrix, all the while deepening their knowledge and gaining experience in their role. In a situation of wage compression, an incoming employee may still be offered a starting salary close to what the older employee is currently earning because the market rate outpaces your company’s salary-increase practices.
“The new employee will have a higher salary relative to the experience of already established workers,” explained Robert Bird, JD, MBA, Professor of Business Law at the School of Business at University of Connecticut.
In some cases, this can even result in wage inversion, whereby new employees are earning more than older, more experienced ones. Wage inversation decimates morale and can create legal issues.
“Wage inversion really opens up the door for a discrimination claim,” said Matthew Burr, SPHR, SHRM-SCP, MBA, an HR consultant and Associate Professor of Business Administration at Elmira College. Especially if the individual earning less than the new hire is part of a protected class of worker based on gender, race, sexual orientation, age, or other underrepresented group, the employee has an opportuinty to claim pay discrimination. Companies with salary compression are likely to experience low productivity and high turnover, too.
What Causes Wage Compression?
Wage compression can be the result of external factors, like minimum wage increases, or internal issues, such as a failure to keep pace on fair market pay. Here are some of the top causes of wage compression.
1. Minimum Wage Increases
Wage compression can occur when the federal or state minimum wage gets a bump. This mainly affects companies with hourly employees. For instance, say a recent increase of your state’s minimum wage elevated it from $10.50 per hour to $12.00 per hour. Perhaps an employee with three years of tenure at your company is currently earning $12.07 per hour, while new hires are earning $12.00 per hour. This is wage compression.
2. Tight Labor Market
In a tight labor market, wage compression can result as companies, vying for talent, offer elevated starting salaries to candidates in an attempt to secure the individual for the role.
“What happens is that new talent is even more expensive than new talent was a few short years ago,” said Bird. “And that talent comes at a premium at the expense of the salaries of those [who] are already established, accelerating wage compression.”
3. Arbitrary Pay Increase Systems
Without standardized pay structures, wage compression is bound to occur. Bird explained that this happens for a few reasons: “Sometimes it’s a ‘the squeaky wheel is the one that gets greased,’ situation,” he said — meaning that employees willing to demand specific starting salaries or raises may be more likely to receive a bump in pay, while others fall to the bottom of the salary range for their labor, escalating the opportunity for compression. “Men tend to argue and negotiate more readily for pay increases, so women have a higher chance of falling further behind,” he added.
The Negative Impacts of Wage Compression
Little variance in pay between experienced workers and those newer to the job can leave employees feeling frustrated, taken advantage of, and just plain mad. There are legal implications to consider, too. Here are three of the main ways wage compression can negatively impact your employees, leadership, and organization.
1. It hurts culture.
“The cultural implications of salary compression are huge,” said Cassandra Faurote, compensation expert and President of Total Reward Solutions, an HR consultancy specializing in compensation and rewards. She noted that the generational shifts in the workforce and the willingness of younger employees to discuss pay with colleagues can accelerate the consequences of wage compression. Learning that a colleague with less experience or less tenure is earning close to or as much as a more senior or experienced individual promotes a sense of unfairness at work, which may lead to an employee’s decision to leave the company or view the pay discrepancy as discriminatory.
2. It encourages turnover and affects human capital.
Imagine that you’ve been working for your current employer for 12 years. You were hired in 2009 in the midst of the recession as a marketing associate, and your starting salary reflected the economic downturn. You’ve done well at your job, been promoted, and specialized in product marketing. You’ve received a number of raises, sometimes even biannually, and are now a senior product marketing manager. You have no direct reports as you wanted to remain an individual contributor, but you’re a more tenured employee and certainly one of the most senior marketing professionals at your organization.
Now, say your company is growing and has recently hired two mid-level product marketing managers. Through the grapevine, you learn that these new employees, hired into less senior positions, are earning close to what you’re currently earning — after 12 years on the job and a lot of hard-earned experience. It’s probable that these new hires are simply commanding the current market rate in a tight labor market. But nonetheless, you feel frustrated, angry, and undervalued, and you decide to leave the company.
“Wage compression can lead an enterprise to lose long-standing employees, who are often some of their best employees,” Bird said.
3. It poses legal challenges.
While wage compression or wage inversion are not illegal per se, the act of paying one individual more than another for performing similar work can create grounds for a discrimination lawsuit, warned Bird. “If there's a situation where two employees perform similar work and one is being paid significantly more than the other, it will lead the underpaid employee to believe that the reason [the discrepancy] exists is because [of] some unfair reason,” he cautioned. “[They could think that] it could be because of their race, gender, et cetera.”
Bird pointed out that legal battles are difficult to win. The burden of proof would fall on the plaintiff to prove, which is challenging. “But even the perception of unequal pay or discrimination can be harmful to an enterprise,” he said. “And it also erodes morale in the company because other employees will realize, ‘Oh, this person filed a claim. Maybe I shouldn't trust my employer,’ or, ‘This person filed a claim, maybe I should, too.’ So there are those concerns.”
How to Prevent Wage Compression
Wage compression is a situation where an ounce of prevention is worth a pound of cure. Human Resources departments and People teams fare better working to avoid wage compression at their organization rather than having to remedy it. Keeping that in mind, here are some tactics to do both.
1. Consistently keep track of market rate, and match it if you can.
It’s hard to pay your employees fair market value for their role and experience if you don’t know what that is, so HR departments need compensation plans that include keeping tabs on the fair market value for positions across the organization. To do so, companies can employ methods that range from using free or inexpensive resources like Salary.com, Glassdoor, and PayScale, to purchasing survey results or reports from large, established HR consulting firms specializing in this area.
2. Conduct pay equity reviews and make adjustments as needed.
Much like Human Resources must keep track of what other organizations are paying for a given role to avoid wage compression, HR needs to know how their own company is compensating employees, too. Faurote recommended conducting pay equity reviews, or pay reviews, annually.
“Do so to ensure your employees are appropriately placed in the pay range based on their education, previous related experience, time in job, [and] pay relative to others in the same job,” she said. If large pay inequities are discovered, Faurote said businesses can provide equity adjustments, or raises, every six months until they’ve remedied the issue.
3. Consider non-financial compensation.
Say your HR team conducts a pay equity review and finds big pay discrepancies, but there’s no budget to offer raises. Burr said companies won’t always be able to increase employee pay, but bulking up other benefits is a good incentive strategy.
“There are lots of options, [like] a four-day work week, an extra week of PTO, or a student loan benefit,” Burr said. He noted that businesses will be most effective in buffering a wage compression issue with additional benefits if the company is providing a benefit the employees actually want.
“Ask the workforce what’s important for them,” he advised. “If you have a younger workforce, a premium health program may not be the most attractive [option], but other things may. You need to ask those questions.” Anonymous employee surveys would be an effective way for HR teams to gather this information.
It can be easy to view wage compression as a byproduct of outside forces: The labor market has grown tight, talent is scarce, and starting annual salaries are up — what is your organization to do? But this ignores the responsibility an employer has to adjust its compensation strategy as the market changes. Companies that do so will reap the benefits of a positive workplace culture and healthier retention rate. Beyond these benefits, fair pay practices protect employers from would-be legal challenges, while helping to support fair pay for all.