What is Pay Compression and Why Does it Happen?
Pay compression is a relatively new term, seeing that the market’s current focus is on grabbing talent at any cost. Relative to a feeding frenzy, there is no time to even look left or right- snatching the food that will help one survive is the only choice one has. The enticing salaries on offer come at a price to the company- not only because they need to afford these salaries, but it may lead to performance losses from the employees already there. Why? This will be discussed further on. Let’s start by undressing the term ‘pay compression’.
Salary or pay compression refers to the situation in which the pay of one employee varies only slightly to the pay of another employee, despite differences in skills or experience. Inverted pay differences may even occur between brand new hires and those with decades of experience and dedication.
Let’s look at an example. Generation X, Marty, who is 51 and working as a remuneration consultant with 23 years experience at a company earns a decent salary attributed to his skill, knowledge and tenure. 28 year old Millennial, Rose, with two years work experience is fresh in the market. However, she is “talent”. She is exactly what the company needs for a competitive advantage. The demand for Rose ultimately leads to inflated salary offers, with the highest bidder winning. However, this bid has pushed her starting salary so high, that Marty – who has brought a whole lot more to the company-, is sitting on the same pay range, having been shoved aside and treated with internal inequity.
Imagine being a supervisor and earning round about the same salary as a person you are supervising in a lower-level job.
Same job categories with different tenures receiving same pay is one form of pay compression.
Another form of pay compression makes itself known when different job grades are paid within the same pay range.
So what causes pay compression?
- Misalignment in Pay Schedules
There are several underlying causes of pay compression. In the example above, the employee in the lower level may have had lengthier tenure and an extra degree. These variables are fair. Pay compression only really has a negative effect when it is seen as unfair. In this same instance, the supervisor may have been paid less than the subordinate due to different pay schedules governing the pay of each of these parties or pay schedules and adjustments aren’t aligned. Furthermore, some companies have differing pay for different departments or divisions. Some departments and divisions may be more generous with promotions, salary increases and market adjustments when others are tight. This misalignment causing the supervisor to earn less than the subordinate may be viewed by the supervisor as unfair. This will be discussed further on but for now, let us continue to look at other causes of pay compression.
- Failing to reorganise properly
This point I linked to the point above. A common error that companies make is the failure to re-organise every aspect of the company when reorganising. As a general rule of thumb, when a single organisational process or function changes, the rest of the organisation processes or functions need to be adapted accordingly. After reorganisations, companies neglect to re-evaluate jobs. The new structure may lead to misalignment in pay and thereafter pay compressions. This is also the case when mergers or acquisitions occur.
As discussed above, talent demands result in inflated salaries. Employer’s have a tendency to ignore their pay regulation policies when talent acquisition is the point of focus. In addition to this, the immediate need for talent means that employers don’t have the time to cultivate it. As such, rather than hiring potential and developing it, a quick fix in the form of an employee who already has the experience is the go-to.
Pay compression therefore seems to arise when the company is in a hurry and other factors are neglected. These factors are re-evaluation, alignments and the remaining employees’ perceptions of fairness.
This leads us to an important question:
How Does Pay Compression Affect Performance?
Pay Compression and perceptions of being unfairly treated commonly go hand-in-hand. Art Markman, a psychology professor at the University of Texas, commented, “Once you see your workplace as unfair, it can begin to make you feel bad about every aspect of your work”. Perceptions of pay being distributed unfairly can make employees feel dull and start viewing their work in a negative light. What is the point of years and years of hard work, dedication and loyalty to the company, when person X who is new to the company, has not even lifted a finger yet, but earns the same salary? Surely employees will begin to believe their efforts are wasted because no matter how hard they try, they are “no one” to the company.
Pay compression ultimately leads employees to feel demoralised, dissatisfied and less motivated. Thus, performance will suffer, and the overall dampened mood will affect turnover.
Then again, this looks like a better prospective for employees since if they quit and get re-hired by the competitor, they’ll get an immediate pay increase.
It seems then, that pay compression is a problem that needs to be addressed … for the sake of organisational performance, for the sake of decreased employee turnover, and most importantly, for the sake of Marty who has dedicated decades to the organisation but had his loyalty, commitment, hard work and actual love for the organisation, thrown back in his face. How can this situation be prevented?
How to spot and stop Pay Compression in its tracks
As the saying goes, prevention is better than cure. It is important to spot pay compression occurrences before they even make their mark. What you should do:
- Assess supervisor salaries in relation to their report salaries
An annual pay compression analysis should be conducted. Companies that are merging, acquisitioning, reorganising, have high employee turnover rates or continuously hire, should conduct a pay compression analysis every six months. Where direct report salaries are over 95% of supervisor salaries, caution should be taken.
- Re-evaluate each compa-ratio in each pay grade by employee tenure in the position
One of a few variables that pushes an employee through a pay range is tenure in a position. To test for compression, one can start within a specific pay grade. A problem will present itself when third and fourth quartiles comprise employees with shorter tenure at the company and those with longer tenure are sitting in the first and second quartiles. Any problems found, should result in a job re-evaluation.
- Jobs need to be positioned on a unanimous internal hierarchy and priced together.
The prevention policy for eliminating pay compression before it makes its mark is to “look from within”. Promoting someone within the organisation shows employees that their options and growth in the organisation are potentially unlimited. This can serve as a motivator and simultaneously knock out pay compression injustices.
If the internal market is insufficient, and candidates have to be sourced from the external market, several other measures can be taken to hinder pay compression:
- Pay should be controlled within the budget and within the HR policy. Free from pay constraints, managers tend to opt for candidates that come at a ‘hire price’.
- Put a cap on the point in a range at which a new hire can be paid. This is a generally ignored rule since most company’s want to hire only the best talent. So the options are most likely ‘to hire the best talent’ or ‘to retain the most seasoned employees’.
- Source talent who are seeking a promotion and will view the hire as such. This also relieves the company from paying a hire premium
- Equity adjustments should be reviewed if talent is hired at a higher salary. Managers are then also forced to reconsider the importance of tenure and experience in a job.
- Organisational process and policy should be aligned. As previously discussed, misalignment between departments can cause pay compression. To align various departments’ pay policies, transparency must be implemented across units. Transparency can lead to decisions to be made with greater consideration. Calibration should also be employed across all units. By managers sharing pay plans with one another, greater insight and approval can be sought. The numerous levels of approval also act as an extra eye for arising inequalities.
Pay compression arises from ‘mistakes’ in the organisation.
Often policies, procedures and decisions have not been given enough attention and pay compression slips in. This can have an impact on the employees that have proven their loyalties to the organisation and affect their performance and dedication to the company.
As such, it is best to prevent pay compression before it occurs, either by hiring within, or by giving more attention to pay decisions and pay structures.