The United States is in the midst of a historically tight labor market. As we emerge from the pandemic, employers are signaling they are eager to hire. The number of open positions has nearly doubled since the beginning of the year and far exceeds candidate demand. To attract candidates in this fierce job market, companies are increasing pay. This sets a precedent that may inadvertently result in future salary compression.

What is salary compression?

Salary compression— also referred to as pay compression or wage compression—is a compensation issue that develops over time. It occurs when there are slight pay differences between your employees and large differences in their knowledge, skillsets, experience, and tenure. It occurs when an organization raises the starting salary to recruit a candidate and the new employee is compensated at a higher rate than the company’s tenured employees. It can also occur when a manager is paid only slightly more than and his or her direct reports. Wage compression is not illegal but is often accompanied by pay inequities that could violate equal pay laws.

Why is salary compression a problem?

• Lost productivity: When long-time employees discover that they are paid less than new hires, they often feel undervalued and harbor resentment. Unhappy and actively disengaged employees are less motivated and productive and cost U.S. companies $450 to $550 billion in lost productivity per year.
• Higher turnover rates: Today’s candidate-driven market is the perfect time for unhappy and disengaged professionals to advance their careers and shop their worth.
• Recruiting obstacles: When there is a large difference in an organization’s internal pay rate and what the market indicates is acceptable, a job can be posted with an inappropriate salary range. When this occurs, your organization may fail to attract a top candidate for the position.  Later in the recruiting process— when it’s time to discuss compensation with a candidate— your offer may be rejected if you benchmarked using an antiquated pay scale.

How is salary compression caused?

The main causes of salary compression are as follows:

• The minimum wage increases: When lower-level employees receive a federally mandated pay increase, the pay scale for your entire company can become misaligned and pay levels may converge over time.
• Demand exceeds supply: In a tight labor market when supply and demand are out of sync, companies offer competitive salaries to lure in high-demand professionals such as nurses or software developers. A new hire is brought in with a starting salary or hourly wage that is close to, or higher than, what the new employee’s manager or more experienced co-workers are earning.
• Misalignment with market data: When a company fails to analyze market rates, its internal compensation structure can become misaligned and can inadvertently create wage compression.
• Broad pay grades: Salary compression can occur in organizations that have job families with multiple levels of a job function.  A company with three distinct levels of software developers should have a unique salary range for each level.  If all three levels are compensated the same—regardless of tenure and experience— pay compression can result in and cause disengagement among more senior employees.

How can salary compression be addressed?

Salary compression is a significant issue, and resolving it isn’t simple. Here are ways to get back on track:

• Assess your current compensation structure: HR and finance professionals must work together, leveraging salary analysis tools, to assess and determine compensation structure. Pay adjustments must be accounted for in a company’s budget so it’s important to have a firm understanding of your organization’s economic restraints when starting the process.
• Compare the salaries of managers and their direct reports and review job description changes to ensure pay adjustments have kept up with responsibilities. Review the compensation ratios within each salary grade based on the employee’s time in the position. It’s best to have a unique pay range for each proficiency level within each job category. Don’t promote employees to the next tier until they have the required experience and tenure.
• Consult with legal counsel: While assessing your organization’s pay structure, watch for discrepancies that may have evolved that could appear as discriminatory, such as gender-based pay differences. Determine the root cause of any identified discrepancies to address them going forward.  If you discover evidence of discriminatory compensation practices, consult with legal counsel.
• Communicate the new policy: Your revised compensation policy should be communicated throughout your organization. Encourage managers and senior leaders to routinely have salary compensation discussions with their staff.
• Focus on talent retention: One of the most effective ways to control your overall workforce costs is by retaining your talent. Global Workplace Analytics found that losing a valued employee can cost an employer $10,000 to $30,000. Look for ways to booster morale within your organization beyond pay, such as adopting a hybrid work model or offering professional development opportunities. A recent survey on the future of work found that 83% of employees prefer a hybrid work model.

Once the entire compensation structure has been assessed and communicated, take steps to avoid future pay compression problems. Perform salary benchmarking annually to monitor market rates and employ unique pay ranges for each level of proficiency within the role. To avoid salary compression, increasing pay should be used as a last resort to attract workers in today’s tight labor market.

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