The competitive labor market has impacted compensation in a variety of ways. Minimum wage has increased, and talent wars have driven up new-hire pay rates as companies choose to extend select offers above their typical hiring pay to stand out in a limited pool of job seekers. This problem is challenging for most employers but is even more of an obstacle for organizations with a significant hourly workforce.

What is pay compression?

Pay compression is when there is a small difference in pay between employees who have different levels of experience or skills. It occurs when new employees are hired at higher salaries than existing employees who have been with the company for a longer period of time. Pay compression can happen due to various reasons, such as changes in the job market, inflation, or the need to attract and retain new talent.

When pay compression occurs, the expected pay differences based on the organization’s identified compensation drivers (which often include experience and performance) are not followed due to recruitment and retention pressures.

Identifying pay compression and how it happens

Several different things can result in pay compression. Recent changes to minimum wages in 20 states has certainly created instances of compression within jobs. These changes in minimum pay compress existing pay differences between employees (mostly for those lower wage roles that are affected by the increased minimum wage).

Compression within a job can happen if hiring pressures, such as a real (or perceived) limited supply of candidates, cause organizations to bring in new hires at pay rates equal to or sometimes even higher than more experienced, high-performing employees.

Compression between jobs can happen if high pay rates for certain “hot jobs” cause unintentional pay compression between managers and their direct reports, between peer jobs within an organization, and/or between job levels within a progression (e.g., Accountant I, II, III).

Pay compression and compensation drivers

Finding and mitigating pay compression issues starts by ensuring the organization has a clear understanding and agreement on the compensation drivers at play and how they should be influencing pay. These compensation drivers are the factors that influence where a job is positioned in a pay structure (i.e., grade or range) or where an employee is positioned within a pay range.

Factors that influence where a job is positioned include:

• Grade: Pay grade is typically the most important factor in driving pay, especially in companies with a well-established grade/level structure.
• Job characteristics: Some organizations prioritize pay differences between job families as the responsibilities, skillsets, and requirements (e.g., education, certifications, etc.) vary.
• Work location: Pay differentials by geography reflect differences in external labor market conditions (e.g., labor costs and cost of living).

On the other hand, where an employee is positioned in a pay range is typically decided by:

• Experience: Many organizations reward general experience, but the extent to which firm-specific experience (tenure) is rewarded varies.
• Performance: Pay-for-performance companies tend to show stronger associations between performance ratings and pay. Performance and ratings may drive differentiation for short- and long-term incentives more than base salary.

Impact of Pay Compression on Pay Transparency

With pay transparency becoming more of a must than a nice to do in both the US and Canada, what happens when compression exists and pay ranges are revealed to employees?

Pay compression can create a perception of unfairness among employees. When individuals with different levels of experience or skills are compensated similarly, it can be seen as undervaluing the contributions of more experienced or skilled employees.

Whether it's an overstated understanding of performance or a genuine correlation between experience and salary range penetration, there is usually not a single answer as to why an employee is positioned where they are in a salary range. And let's be real, in many cases, especially with pay compression, they are not in the appropriate position within the pay range.

Another issue arises when employees start discussing their pay with their co-workers. This initiates internal (and sometimes external) dialogue regarding who is a better performer or more experienced. When employees perceive that their skills and experience are not being adequately recognized or rewarded, it can lead to demotivation and a decrease in productivity. This can wreak havoc on employee morale and company culture.

Pay compression can have a significant impact on pay transparency within an organization. Addressing pay compression and ensuring a fair and transparent compensation system are essential to maintain trust and transparency in pay practices.

How to fix pay compression issues

Get ahead of it — right now. If you do not know where your pay compression problems are, make that a priority. Every company has compression problems. It’s something we’ve all put on our “To Do” lists to manage over time. But pay transparency is pushing compression to the top of the priority list.

There are many ways to approach identifying and handling pay compression, but here are some general steps to take:

1. Get clear on your compensation and rewards philosophy. What are you paying for and what are the drivers of pay? How are individuals rewarded and how do you establish hiring pay rates? Make sure leaders are on board and that the philosophy is embedded in your administration of pay as it stands today.
2. Find pay compression instances. Spreadsheets are your friend in this situation. Resist the urge to address one-offs because there’s usually a ripple effect. Instead, document your pay drivers and expected pay differences in a consistent manner.
3. Model resolution approaches. Identify where like actions should be taken and formulas applied and calculate the total financial impact.
4. Prepare an implementation approach that considers timing, scope of financial impact, and communication planning. Be sure to obtain approval and buy-in from leadership.
5. Communicate and then communicate again. Develop a communication strategy that engages management by educating them on the organization’s compensation drivers and gives them confidence to explain the changes.

Engage a partner

The size and scope of a company-wide pay compression project, particularly with the current state of the workforce and employee/employer contract, is complex and of critical importance. It’s not necessarily something you should feel you have to manage internally. Perhaps, having a third party with vast experience in handling pay compression to partner with you would not only provide you with much-needed capacity but also lend some additional credibility and impartiality to such an important activity.

Mercer is ready to partner with you and create a custom approach that can meet the needs of your unique organization. Contact us at 855-286-5302 or surveys@mercer.com.