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Pay Compression: What It Is and How to Avoid It

Pay compression can creep up on any enterprise, small or large. Many small businesses don’t understand how it’s happening until they’re dealing with disgruntled employees. Extreme cases may lead to legal action due to a violation of equal pay laws.

Here’s a primer on pay compression and ways to remedy it.

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What is pay compression?

Pay compression happens when differences in compensation among employees don’t reflect their experience, skills or responsibilities. Also called salary or wage compression, pay compression can occur in various groups of employees including:

  • New hires and tenured employees: Paying new hires at compensation levels equal to or above those of employees with more experience in the same position.
  • Recently promoted workers and peers: Paying newly promoted employees more than their counterparts.
  • Supervisors and subordinates: When nonexempt employees earn more than their superiors who work comparable hours without overtime pay.

How does pay compression happen?

Pay compression isn’t a deliberate practice in most cases. External factors beyond the control of a business often create pay inequity. However, a company’s internal pay structure can also contribute to compression pay.

State- or federal-enacted minimum wage increases

Increases in minimum wage rates affects the entire company’s pay scale, and compensation levels may coincide over time.

Overtime threshold increases

The DOL sets the overtime threshold, the wage level to qualify for overtime compensation. When it raises this threshold, resulting compression pay can cause hourly workers to earn as much as or more than nonexempt employees when they work overtime.

Increase in market rate for starting salaries

A tight labor market can force a company to offer competitive pay to high-demand professionals. Going rates may rise faster than businesses can increase pay for existing workers. Consequently, new hires may start with compensation that’s close to or higher than what current employees in comparable positions earn.

Inconsistent pay practices

Creating confusing job families and ranks can foster pay inequities. This happens when one job family or rank has distinct levels and responsibilities, but everyone is paid using the same compensation range. Wage compression can also arise from pay discrimination based on gender, race or disability, which is unlawful but still common.

Pay compression may also stem from:

  • Increased employee awareness
  • Pay structures that fail to keep pace with inflation

How can pay compression hurt your business?

Pay compression could make tenured workers feel undervalued. Employees who become aware of pay inequities are more likely to lose motivation and become less productive. Worse, they may seek employment elsewhere.

Wage compression can also deter potential hires if your job’s salary range doesn’t match market rates.

How can small businesses prevent or correct pay compression?

Preventing or mitigating pay compression calls for extensive planning and continual assessments. It won’t be quick or easy, but acting now will be less costly than ignoring the issues in the long run. You may need to phase in some changes to manage costs.

Human resource experts recommend the follow options to counter pay compression:

Establish and review compensation control points

Define your company’s compensation philosophy, which will guide your pay policies. Set pay grades and salary ranges accordingly. Ensure that your company’s compensation procedures consistently align with your plan’s control points.

A business can choose to lag, match or lead the market with compensation packages. Lagging the market typically makes it harder to recruit and retain high-quality talent. On the other hand, leading the market can attract talent and keep current workers motivated.

Review your compensation plan at least every 3 to 5 years.

Clarify job descriptions

Analyze the responsibilities of each job, as well as the qualifications required for performing the roles. It may be helpful to delineate evolving jobs with new or refined scopes of work. Consider converting some hourly positions to salaried status.

Other methods to reduce or eliminate compression salary issues include:

  • Hire more hourly workers to reduce required overtime
  • Offer sign-on bonuses for new hires
  • Make base salary adjustments
  • Make off-cycle, midyear adjustments to equalize current and new employees’ pay
  • Set higher merit budgets for high-performing workers
  • Implement cash bonus awards such as on-target earnings
  • Offer additional paid time off

FAQs about pay compression

What are some noncash ways to reduce compression salary issues?

The adjustments needed to fix pay compression may be too much for some budgets. Fortunately, there are a few nonmonetary options:

  • Stock options
  • Career development coaching to prepare tenured workers for promotion
  • New job titles
  • Free snacks
  • Remote work options
  • More flexible hours

How can you help employees understand that you’re trying to be fair with wages?

Be transparent about the business’s compensation philosophy and actions so your workers understand how their pay is set. Clear communication can help avoid perceptions of unfair compression wages. Bear in mind that employers may restrict workers from discussing their pay.

What should the compensation gap be between employees and their direct supervisors?

HR experts suggest that direct reports should be earning no more than 90% of their supervisor’s salary. However, some circumstances may require a deviation from this:

  • You need to hire a specialist for a short-term project who will ask for a higher wage than your current workers.
  • Sales reps and other commission-based employees might earn more than their superiors.
  • Your company may have to adjust the salaries of employees who live in a more expensive city or region.
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