Pay compression is the situation in which an organization has negligible differences in pay between people who have differing skill sets and/or experience levels. It often happens when current employee pay raises don’t keep up with increases in the market pay rate—resulting in a situation in which new hires are hired in at levels similar to employees who have been with the organization for many years.  Pay compression is the situation in which an organization has negligible differences in pay between people who have differing skill sets and/or experience levels. It often happens when current employee pay raises don’t keep up with increases in the market pay rate—resulting in a situation in which new hires are hired in at levels similar to employees who have been with the organization for many years. Pay compression can also occur when there is some type of disconnect in how the pay structure is designed and how it works in reality. For example, if a sales team has a high level of pay that is at-risk and is meant to be rewarded only when specific goals are met, on paper this should result in pay variability in which those with the most expertise and skill will be paid more than those with less. But in some cases, these types of incentive pay structures don’t result in much pay variability at all, regardless of the skill level and years of experience for the individuals on the team. This can be a form of pay compression. Problems with Pay Compression Pay compression can cause problems for employers. For example, it can lead to turnover if employees feel they’re being undervalued by not getting paid much more than new hires. This is especially troublesome when it’s the best employees who decide to jump ship. Pay compression can also cause employees to lose motivation, even if they’re not actively looking for a new job. This can translate to productivity losses in some cases. Pay compression can also hamper recruiting efforts. This happens when there is a disconnect in the organization about what the appropriate pay rates for a given level of experience might be versus what the market is really paying. If a current employee with x years of experience has not been receiving pay raises commensurate with market rates, then the organization may try to hire a new person at that experience level at the same rate as the current employee—only to discover that a new hire may not be willing to come on board at that rate. How to Address Pay Compression in Your Organization Pay compression is a major issue, and solving it is not simple. But there are steps that employers can take to first determine what pay rates are more appropriate and then move toward better pay equity. Here are some steps to take to start the process of getting back on track:
After the entire pay structure has been assessed, work out a plan to bring employee pay and benefits in alignment with the market and with organizational goals. This plan may take time to implement. Once it is corrected, take steps to avoid pay compression in the future by monitoring market pay rates and keeping current employees at appropriate levels. One more tip to remember: Be careful not to actively discourage employees from discussing pay. Doing so could actually be a violation of employee rights. Under the National Labor Relations Act, employees have the right to discuss working conditions—which includes pay rates. A unique instance of compressed pay levels occurs when organizations are operating in markets in which there is high demand for skilled employees and these organizations are forced to raise the pay rates of newcomers in order to attract them. When companies are designing a pay system, they may simultaneously use both external market surveys, in which supply and demand pressures are used to establish pay rates, along with internal job evaluation systems, in which the worth of a given position is determined in relation to organizational strategy and design. Research has found that pay compression may be an outcome when organizations focus more heavily on these external market pressures, via an external equity strategy, than on internal job evaluations or job equity analyses, both internal equity strategies, when determining wage rates. The greater demand for qualified employees makes employers willing to pay more for skilled workers, thus directing their efforts toward an external equity strategy. To attract the best employees, companies may ignore internal pay equity and pay the market value for workers instead. However, such actions produce pay compression by narrowing the pay ratios between newcomers to the organization and current members. In recent years, the problem of pay compression has been particularly prevalent in high-growth industries and in occupations where market forces push starting salaries for new hires to increasingly higher levels in an attempt to stay competitive in the recruitment of new employees. As a result, wages increase faster in the external labor market than in the internal company structure. For example, recent studies have found that internal pay rates grow, on average, 3.4 to 3.7 percent per year. However, in the external labor market, wages might increase in the range of 10 to 15 percent per year. Accommodation of these external pay rates when recruiting and selecting organizational newcomers will then narrow the pay gap between employees of differing levels of organizational experience. Currently, pay compression is argued to be endemic across pay systems inside a vast majority of private, public, and not-for-profit organizations and across all major industry types. Some have argued that changes in the economy, the use of outsourcing, and general economic and managerial control policies are leading this new wave of pay (both wage and salary) compression well beyond what has traditionally been experienced. As pay rates become more restricted inside organizations, for whatever reason, these pay rates do not tend to recover at the pace of those newly hired by organizations. It could be argued that organizations are not only ignoring the experience and loyalty factors of their workforces but are failing to respect the external wage and salary market unless new talent is needed from outside the organization. It is important to realize the negative ramifications that can be associated with pay compression. Multiple streams of research have shown that the amount of pay an employee receives strongly influences key attitudes and behaviors such as job performance, organizational commitment, job satisfaction, and intentions to leave an organization. The level of pay also impacts an individual’s feelings of self-worth and the perception of their value to the organization. In addition, organizations and managers should be aware that individuals are not only concerned with the absolute amount of money they make but also how that level of pay compares to that of other individuals in the organization. Employees frequently compare their pay against that of their coworkers in an attempt to determine their personal value and status in the organization. Variations in pay rates among employees are justifiable and, therefore, deserved if the relative worth and contribution of those employees differ. Under such conditions, pay differentials are viewed as equitable and fair. However, problems arise when the pay differentials between individuals are not as wide as employees believe they should or could be. In conditions of pay compression, individuals of differing levels of experience are receiving similar pay rates. As a result, a perception of unfairness, or inequity, can be created as the more experienced employee does not feel that their pay level is reflective of their performance, loyalty, and commitment to the organization. Less tenured employees are receiving similar pay as longer tenured employees because the external labor market created an opportunity for them to demand a higher starting salary, not because their relative contributions are similar. Because pay compression occurs across groups of differing experience, it will likely be viewed as unfair and be detrimental to employee performance and organizational outcomes. Limited variance in pay levels between individuals in a relative group, such as those with similar levels of experience, is desirable. However, to guard against perceptions of unfairness, differentials must be present across individuals of differing levels of experience. When pay compression occurs, these differentials are eroded. As a result, those longer-tenured employees will likely feel that their pay is unfair and begin to look outside the organization for opportunities to resolve this inequity. In addition, their commitment to the organization will suffer and their performance levels may fall. These individuals may perceive that their value to the organization is unrecognized, and as a result, their self-esteem, satisfaction, attachment, and motivation can suffer. Such negative outcomes suggest that organizations must be aware of the potential danger of allowing external market strategies to overtake internal equity and stimulate pay compression within their pay structures. Each new generation of employees seemingly demands greater attention to fairness of rewards in the workplace. Understanding this reality will position the issue of pay compression as increasingly salient to organizations in the future. See also:
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What is pay compression most likely to develop?
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