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What is Wage or Pay Compression? How Can You Address It?

Key Takeaways

1. Pay compression occurs when there is a narrow pay range between employees with different levels of experience, skills, or qualifications. This can lead to decreased productivity, morale, and increased turnover rates.

2. Understanding the various factors that contribute to pay compression, such as inconsistent compensation practices and inflation, is key to preventing it from arising. 

3. Employers should be aware of the potential for pay compression and take proactive steps to address it. This might involve conducting an internal review of compensation structures and monitoring market data to identify pay disparities.

4. An effective way to address pay compression is to implement a standardized and transparent pay structure that accounts for factors such as skills, experience, and education, helping ensure employees are being compensated fairly and equitably. 

In today’s rapidly changing labor market, it is essential for organizations to offer competitive compensation packages that not only attract but also retain the best talent. However, ensuring that compensation is both attractive and equitable is not always an easy task, and pay compression can become a significant challenge for many companies. 

When this occurs, it can lead to decreased job satisfaction and motivation, increased turnover, and ultimately, difficulty for organizations in retaining their top talent. Addressing pay compression is, therefore, crucial for any employer looking to remain competitive as well as recruit and retain a diverse workforce.

This article takes a closer look at pay compression, including its underlying causes and the most effective strategies for organizations to manage it.

What is pay compression?

Pay compression, also referred to as salary or wage compression, occurs when there is little differential in pay between employees, irrespective of factors such as employee experience, skills, seniority, or length of service. 

Examples of pay compression include situations where new hires are offered salaries comparable to those of long-standing employees or when employees in higher positions receive salaries similar to those of less experienced employees who report to them. As a result, employees in more senior positions may feel undervalued and, therefore, more likely to leave their organization in search of better compensation from companies offering market-competitive rates for their skills and expertise. 

Pay compression can also lead to a decline in staff morale, decreased productivity, and increased turnover rates making it difficult for employers to attract and retain talent. 

What causes pay compression?

Understanding the various factors that contribute to pay compression is key to preventing it from arising. Some of the most common causes of pay compression include the following:

  • Scarcity of talent
  • A shortage of skilled workers in a particular field can cause demand for qualified candidates to outstrip supply, leading organisations to offer higher salaries to attract talent in a bid to entice them away from their rivals. If current employees fail to receive commensurate salary increases, it can result in pay compression, as new hires end up earning similar salaries to more experienced employees.
  • Minimum wage increases
  • Mandated minimum wage increases may lead to hourly paid workers receiving a salary boost while others in the organization remain at their current pay levels, creating a potential disturbance in a company’s salary structure. In an ideal scenario, every employee in the organization would receive a proportional wage increase in accordance with increases in the minimum wage. However, in reality, it is not always feasible to achieve this due to budget restraints, leading to pay compression.
  • Inconsistent compensation levels
  • Inconsistent pay practices within an organization can cause pay compression, particularly where different stakeholders take varying approaches to compensation decisions. For instance, a company director in location A may be more liberal with pay raises compared to another director, in location B, who takes a more conservative approach. As a result, employees with less experience in location A could end up earning similar salaries to more skilled employees in location B, resulting in pay compression.
  • Inflation
  • Inflation can cause pay compression as salaries fail to keep pace with the increasing cost of living. In this situation, new hires may be offered higher salaries as an incentive to join an organization, while the salaries of existing employees fail to be adjusted accordingly, causing a compression in pay between different levels of experience and seniority. 

What are the best ways of managing pay compression?

By addressing pay compression, companies can ensure their employees are fairly compensated for their skills and experience, promoting morale, retention, and overall business success.

Below are some steps organizations can take to manage pay compression:

  • Review compensation structures
  • A regular review of the pay structure within an organization can help to identify any areas where pay compression exists, allowing for necessary adjustments to be made. The analysis should include market research and the monitoring of market data to determine the appropriate compensation for each job level, considering factors such as the industry, location, size, and employee skills and experience.
  • HR and finance collaboration
  • By working together, these departments can ensure compensation structures are fair and aligned with the company’s financial goals. HR can determine appropriate salary ranges by analyzing employee performance and skill sets, while finance can provide data on budget and financial constraints. Together, HR and finance can design compensation packages that are aligned with the company’s financial objectives and ensure a fair and equitable pay differential between different levels of employees.
  • Offer non-financial incentives
  • Benefits are becoming one of the most important factors employees consider today when deciding to join or stay with a company. Rather than higher salaries, non-financial incentives such as flexible work arrangements, training and development opportunities, and other perks can be used to strengthen an organization’s employee value proposition (EVP), helping to attract and retain top talent and reduce the likelihood of pay compression occurring. 
  • Implement standardized and transparent pay structures
  • Establishing clear guidelines for compensation that take into account employees’ skills, experience, and education can prevent pay inequalities from arising, mitigating pay compression in an organization. By setting pay ranges for each job level and defining salary increments based on objective criteria, such as market adjustments or years of service, organizations can ensure their employees are paid fairly and equitably. This approach also provides transparency in pay structures within an organization, helping to foster trust and engagement among employees.

Manage your global payroll — with Horizons

When it comes to ensuring accurate and on-time payments for your employees, Horizons’ expertise in over 180 countries and regions enable us to coordinate our clients’ global payroll cycles helping them streamline their payroll processes, while ensuring compliance with local laws worldwide. 

Whether you need guidance on harnessing payroll data or a trusted partner to handle your international payroll needs, contact us today to learn more about how we can help your organization.

To learn more about how Horizons can manage the payroll of your global workforce, get in touch

Frequently Asked Questions (FAQ)

An example of pay compression occurs when a new hire is offered a salary comparable to that of a long-standing employee. This can be due to a shortage of skilled workers in a particular field, leading to demand outstripping supply, prompting employers to offer higher salaries to secure new hires.

Although not inherently illegal, pay compression can give rise to discrimination claims since paying unequal salaries to employees with similar job descriptions can be deemed discriminatory. This is especially so where existing pay disparities disproportionately affect certain groups, such as women and minorities. Employers should therefore take steps to ensure that their compensation policies do not create or exacerbate pay inequalities or violate equal pay laws.

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