Pay Compression: What it is and How to Address It

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Looking back over the last four years since COVID-19 first appeared, 2024 has been a markedly different year for employee compensation. Since 2020, salaries have skyrocketed, leveled out, gone up again, pressured budgets, and influenced some of the largest resignation and employee shuffles in recent years. Significant challenges are still present for employers who are trying to maintain a competitive and consistent approach to rewarding their employees. This has caused internal pressure on pay ranges and salary bands for many employers in all industries with varying effects and unintended consequences.

Often, pay compression sneaks up on organizations, and, without a direct complaint being filed by an employee, it may go on for much longer than it should.

What is Pay Compression?

Pay compression is not one-size-fits-all and shows up in various situations. For example, pay compression can exist when: there is little to no difference between a new hire’s and a tenured employee’s salary in the same role; a manager is making only a little bit more than their direct report; or similar situations. In general, employers collectively don't want their employees to pay a “loyalty tax,” or be negatively rewarded for their loyalty and tenure without it being reflected in their compensation. Similar but different, if a manager's direct report is receiving a higher wage than their manager, this would be called pay inversion.

Many scenarios can combine to create pay compression within your organization.

For example:

• Increasing minimum wages and competition (therefore compensation) for entry-level roles may have caused your organization to hire new employees at the same or similar rates of more tenured employees, causing very little to no difference in wages despite differences in tenure.
• Organizations that follow a pay-for-performance strategy may not have enough differentiation in their merit increases for high-performers and low-performers, making a negligible difference in salaries even with differentiated performance levels.
• Mis-calibration of managers or supervisors making incongruent decisions for employees in similar groupings may cause some employees to move up faster in a pay range than another team of employees who are managed by a different supervisor.

Various combinations of factors can create, contribute to, and/or exacerbate pay compression in an organization. This often comes up as an unintended consequence of an inconsistent compensation strategy/process, but not always.

How to Find Pay Compression?

Finding pay compression requires a deep dive into your employees' pay data—most importantly, as viewed through the lens of your compensation philosophy and strategy.

Here are three simple steps to help you get started on identifying internal pay compression:

1. Identify your current employees' pay and where they fall within their pay ranges.
2. Look at the actual salaries of individual contributor employees and consider their salaries in concert with tenure.
   1. Spot check: are any higher-tenured employees making less than their less-tenured counterparts in the same job?
      1. If the answer is yes—an instance of pay compression has been discovered and brought an opportunity to correct this situation.
3. Look at managers' salaries and how they relate to the individuals they manage. Spot check: are any managers making less than someone they supervise? If so, investigate why this is the case and if this is in alignment with your compensation strategy & philosophy.

How to Address Pay Compression?

Refer to your compensation philosophy and strategy. What are your compensable factors? Is it a combination of skills, experience, and tenure, a combination of other compensable factors, or something else entirely within legal constraints?

It can be helpful to decide what percentage of distance between salaries you feel is fair and reasonable for your organization. This could be anywhere from 10-25% depending on your organization size, industry, complexity, and other factors. Then, track salaries for pay compression. For example, if you decide there should, on average, be a 15% difference between a manager salary and their highest-paid direct report, ensure that is the case.

Setting milestones or regular point-in-time salary reviews can help maintain the preferred distance between salaries when additional pay actions are being considered, such as promotions, merit increases, determining an offer for a new employee, etc.

It is a best practice to set a repeatable, scalable process for determining starting wages and to commit to regularly reviewing salaries from the perspective of maintaining reasonable differentiation between salaries, especially if you are a pay-for-performance organization.

Unaddressed pay compression can turn into a serious morale issue, impacting the employee experience, customer experience and overall satisfaction, productivity and revenue, and other byproducts.

How to Prevent Pay Compression?

Active management of employee salaries with a consistent application of the organization’s compensation strategy is the only way to address pay compression proactively. Many organizations do not track pay compression or monitor for potential issues. This can open the organization to risk and liability for complaints by employees who may feel they are being paid differently due to a protected class characteristic (e.g. sex, gender, race, age, sexual orientation, nationality, religion, etc.) rather than simply due to poor alignment of internal compensation practices (in some cases).

If being proactive in addressing pay compression sounds daunting, consider what it would take to integrate more pre-emptive actions within your compensation strategy and internal practices. Diagnose your present state—Is it a willingness issue or an education issue? Do you need additional support from leadership? Is more internal education needed for leaders and/or managers to make consistent pay action decisions for all employees?

Conducting pay equity analyses at regular intervals is an excellent way to identify, correct and prevent future pay compression and pay inequity issues. We strongly encourage employers to conduct a pay equity analysis for their organization at least annually to determine compliance with Oregon’s Pay Equity Law.

We Can Help!

Struggling with addressing and correcting pay compression in your organization? We'd be honored to support you on this journey of implementing proactive practices for future success. Contact our Compensation team for a conversation.