Wage compression, also known as pay compression or salary compression, refers to a situation in which employees at a company are paid similarly even if they have widely differing skill sets or experience levels.
Wage compression may be happening if long-time employees are being paid the same as new employees or if managers are being paid the same as their direct reports. In extreme situations, wage inversions can develop. Wage inversion occurs when a new hire is paid more than a veteran employee.
Companies typically try to avoid wage compression because it can lead to poor employee morale and high employee turnover. Highly skilled or veteran employees have little incentive to stay with a company if their skills or experience are not compensated appropriately.
Why Does Wage Compression Happen?
Wage compression is a situation that typically develops over many years. There are a few common causes of wage compression.
Minimum wage increases
When the federal or state minimum wage increases, companies may be forced to increase the pay of their lowest-level employees. However, companies don’t always increase the base wage rate of mid-level employees at the same time. Over time, as the minimum wage is raised successively, mid-level employees who were once making much more than this may end up being paid roughly the minimum wage.
Starting salary increases
Companies typically adjust the starting salaries for new employees upwards in response to rising costs of living or competition for talent. If these upward adjustments happen faster than the rate at which a company offers raises to existing employees, new employees can end up making as much or more than veteran employees in similar positions
Companies that don’t have a well-thought-out system for offering compensation packages to employees can end up with wage compression or inversion. For example, a company may end up offering a higher salary to a new employee because they negotiated for it or because a manager felt strongly about that candidate. That can lead to wage compression relative to veteran employees in similar positions.
Critical job roles
Over time, the market-average salaries of certain job positions can increase as a result of scarcity. For example, if software engineers are in high demand among many companies, companies may need to offer higher salaries to be competitive with peers if they want to hire an additional engineer.
If companies do decide to pay higher rates for critical job roles in these cases, they will often have to pay higher salaries to their current employees in that same position. Otherwise, their current employees may look for higher-paying jobs at competing companies.
Raising pay for multiple employees in critical roles can have a ripple effect across a company’s budget. A company may not be able to offer planned raises to employees in other positions, exacerbating other factors that contribute to wage compression.
Why Wage Compression Matters
There are several areas in which wage compression can have a major impact on companies:
If long-time employees discover that new employees are making just as much as they are, it sends a signal that their experience is not valued highly and will be detrimental to morale. Those veteran employees will then be strongly incentivized to look for another job that will compensate them according to their experience. The same is true for managers who discover that they are making little more than the lower-level employees they’re supervising.
Wage compression can also hamper recruiting efforts. If potential recruits see that veteran employees and managers are leaving a company in large numbers, they are likely to wonder why. In addition, if candidates ask about a company’s system for raises, they may be turned away by pay scales that are not competitive in the current market.
Another consequence is that wage compression can raise questions about discrimination. While it’s not illegal to pay employees who do similar jobs different amounts, it is illegal to discriminate based on age, sex, disability, race, or religion. Even if there is no intentional discrimination involved in pay disparities, wage compression can lead to discrimination lawsuits. These lawsuits can be costly and damaging to a company’s reputation regardless of the outcome.
Wage compression is most acutely problematic when veteran employees or managers find out that it’s happening. It’s important to keep in mind that companies cannot restrict employees from discussing pay, as doing so would violate the National Labor Relations Act.
If pay compression is happening at your company, employees will likely find out about it sooner or later. It’s typically much better for companies to address the problem head-on than to try to hide pay compression problems, which could lead to an exodus of veteran employees down the line.
How Can Companies Fight Wage Compression?
Pay compression usually creeps in slowly, giving companies time to fight it before it gets out of control. Here are a few ways that companies can avoid wage compression altogether or adjust if wage compression is occurring.
Conduct pay reviews
Conducting annual or biennial pay reviews is one of the most effective ways to identify whether wage compression is occurring and to prevent it from getting out of control. It involves reviewing the compensation packages of each of your company’s employees as well as the compensation for similar positions across the labor market.
As a good rule of thumb, if employees make more than 90% as much as their direct supervisor, then wage compression may be occurring. You can apply a similar principle when comparing new employees to veteran employees in the same position.
A pay review also offers a chance to compare wages across employees at the same level in different departments or divisions of your company. If employees in one division make significantly more than employees in another division when those employees perform similar work, then you may need to adjust pay.
Your company may also find that specific jobs, such as roles that are in high demand, have higher market values. In that case, your company should consider creating different pay ranges for different types of jobs.
Researching what competitors in your area pay for similar jobs is a good way to benchmark pay adjustments if you find that wage compression is occurring. For example, if you need to raise the basic salary of a manager, you can use the salaries paid by competitors for that position as a guideline.
Offer incentive pay or promotions
Another way to combat salary compression is to offer incentive pay or other variable goal-based compensation. Goal-based compensation is effective because it rewards skilled and highly productive employees for their achievements. It provides employee incentives and rewards veteran employees who do their jobs well.
Grooming veteran employees for promotions can also work to offset wage compression. Promotions not only come with greater compensation for skilled and veteran employees but also give them a chance to grow within your company and take on new responsibilities.
Offer non-monetary benefits
Compensation doesn’t have to be monetary in nature. In fact, providing non-monetary forms of compensation can be an effective strategy to fight wage compression if your company doesn’t have an unlimited budget for payroll.
Consider offering veteran employees or managers benefits such as flexible work hours, remote or hybrid work arrangements, or extra paid time off. When offering non-monetary benefits, be sure to ask employees what types of benefits are most important to them.
Communicate with employees
If wage compression is a problem at your company, it’s often a good idea to own up to it. Be honest with employees that wage compression is an issue and let them know that your company is working on it. This can go a long way towards showing long-time employees who may feel underappreciated that your company cares and wants to do right by them.
Of course, it’s important not to over-promise and to follow through on any promises you do make when communicating with employees about salary compression. Failing to deliver on solutions can lead to a sharp decline in morale and an exodus of talent.
Develop a compensation strategy
The above approaches to combat wage compression should be integrated into a broader compensation strategy for your company. A compensation strategy developed cooperatively by your HR, finance, and management teams can provide a guide for how compensation should evolve in the face of market salary changes, business growth, scarcity of critical job roles, and more.
In this way, a compensation strategy can help your company deal with wage compression and prevent it from developing in the first place.
Wage compression occurs when new hires receive roughly the same compensation as veteran employees or when managers are paid the same as the employees they oversee. It can be caused by rising minimum wages, increases in starting pay, or inconsistent pay practices.
Pay compression can be highly detrimental to employee morale and make it harder to recruit new talent. Companies can combat this by conducting frequent pay reviews or by offering bonus pay or non-monetary forms of compensation to veteran employees.