Why addressing wage compression is a retention tool

When new talent joins an organization, there’s always a shift or a change. 

The new hire needs to learn the ins and outs of a company. There’s the onboarding process, ramping up in the role, and acclimating to the team and company culture.

But one thing might also occur when new hires join your organization that many organizations encounter: wage compression. In fact, according to a 2022 survey, 56% of organizations experienced pay or wage compression in the last year. And with rising inflation rates, salaries for incoming candidates might be rising, too. 

But what does that mean for employees who joined in similar or comparable roles earlier at lower pay? Well, according to the data cited above, it’s likely that some employees are making the same or less than new hires joining the company in comparable roles. 

The challenge of wage compression is a major issue for human resources. On one hand, it's important for a company to attract new talent. But, this should not warrant unfair compensation to existing, competent employees. So, how do organizations work to balance attracting top talent while equitably taking care of their own? What can your organization do to balance the scales and keep salaries fair, equitable, and attractive? 

This guide will examine the methods of calculating wage compression within an organization. To understand how this issue emerges, we’ll look into causes — and the impact of the issue. We’ll also explore different ways organizations can address pay compensation imbalance. After all, wage compression isn’t just an HR issue. And it isn’t just a benefits and compensation issue. It’s also a retention strategy.

What is wage compression? 

Let’s better understand what we mean by wage or pay compression before we dig into how to fix it. 

Otherwise known as pay or salary compression, wage compression risks causing rifts in your workforce. It leaves your existing employees asking, “what about us?” 

Because wage compression doesn’t account for skill level, experience, or seniority, it can often skew pay equity efforts. After all, skill level, experience, or seniority are all necessary barometers for determining fair compensation. Instead, new employees and experienced employees earn within the same salary or compensation range. And, as you may feel in your own workforce, the scales shift. Especially with bubbling unpredictability and an economy growing more expensive, it can rattle your current employees. 

Wage compression doesn’t just happen with peer-to-peer relationships. Wage compression may also occur where managers and individual contributors receive similar wages. As you can imagine, if a hiring manager makes a job offer to a candidate with a salary range close to their own, it can cause tension and dissatisfaction. 

In other cases, wage inversion may take place. Here, new workers earn higher wages than tenured staff members, even if the new worker is less experienced. 

Calculating salary compression

Pay compression can lead to increased turnover, and discontent among workers. To stay ahead of pay discontent, a set formula exists to calculate wage compression.

How to calculate salary compression

To calculate pay compression, it’s important to assess the salary range of the department. For example, salaries can range from $35,000 to $100,000 USD in the marketing department.

Within this department, achieving compression requires adding both ranges and dividing by two. That means finding the sum of $35,000 and $100,000 to arrive at the midpoint. 

In this instance, $67,500 is the mean salary for this position. Salary.com explains that salary compression may be calculated as the actual salary of an employee divided by the midpoint of the salary range. This number is then multiplied by 100 to get the compensation range percentage.

         Actual salary               x 100

     Midpoint of the salary range

Say an employee in the marketing department earns $55,000. Using this calculation, said employee makes around 81% of the midpoint of the salary range. But what does this mean?

Organizations may use this calculation to determine where an employee falls in the salary range. New employees or newly promoted workers will place around 80% of the range midpoint. Long-term or outstanding employees are entitled to more. They will usually earn around 120% of the midpoint heading towards the extremes of the pay range.

A worker may qualify for an income above the midpoint but earn below it. These employees should be considered for a pay raise to avoid discontent. We can calculate wage compression by examining the wage structure between managers and subordinates. 

Common causes of wage compression

Salary compression is often the result of different factors. Companies aiming to fix pay gaps should take a close look at the gap they’re seeing and identify their causes.

Minimum wage increases

It is common for the minimum wage to be raised by law. Organizations ought to ensure that they review and benchmark salary ranges in line with this raise. But, organizations may consider an across-the-board increase too extensive to attempt.

As a result, budget constraints may limit minimum wage raises to new, less experienced employees. This leaves tenured workers earning their usual pay. The disparity in wage increases can lead to wage compression.

Mergers and acquisitions

Companies merging without properly integrating employees can lead to pay compression.

One company can have a different approach to compensation strategy. The other may have less-experienced workers earning wages that are greater than those of more tenured employees in the other organization. Where provisions aren’t made to properly combine both workforces, this can lead to wage compression. 

Demand for new talent

To remain competitive in the job market, companies can raise starting salaries.

But while top talent is drawn to the high pay, current employees might experience a dip in morale.

Businesses may fail to adjust earnings across the company to reflect the raise for new talent. This can lead to wage suppression where new workers earn around the same amount as more tenured staff.

Poor compensation strategy

If a company fails to map out compensation plans for its workers, can lead to pay compression. 

Likewise, when pay strategy fails to meet the current market rate, this can lead to compression. This is true where going rates for a position have risen, yet current employees receive outdated salaries.

Unequal additional pay

Organizations may encourage wage suppression where additional pay is provided in unequal amounts. In these cases, a direct report can earn around the same as a manager. This exists where pay practices permit overtime, stipends, and bonuses without proper control.

The impact of wage compression

Companies with compression may keep a pay structure due to the cost of adjustments. But while this approach provides temporary relief, it can be damaging. Employees, managers, and the business itself may suffer when pay compression remains unaddressed.

Wage suppression impacts work culture

When younger, less qualified, employees earn close to a tenured worker, it can be frustrating for any worker to learn. When wage compression happens, it can fuel feelings of unfairness in the workplace and, if things escalate, it can cause a hostile work environment. It can lead to questions about the culture, company values, and the value and contributions an employee brings to the company.

Senior staff members may report low morale. They can be unwilling to welcome new members to the team knowing they are peers in earnings.Wage suppression can lead to strong feelings of dissatisfaction at work. It can act as the spark to encourage a departure from the organization.

It can worsen turnover

Using skills, knowledge, and experience—workers add to the economic value of a company.

In particular, long-term workers are entitled to fair payment for their services. These workers have contributed considerable time and skill towards the company's goals.

Wage suppression can impact employee retention. A worker can feel under-appreciated when they feel their services aren't fairly compensated. This is often seen where less-experienced workers earn similar pay to long-term staff. In such cases, the employee may leave for a workplace that offers fair compensation.

This practice can prompt legal action

When two employees perform similar roles, it's expected that they earn similar pay. In cases where one earns more than the other — this can appear discriminatory.

Workers may believe they are being cheated because of race, gender, religion, sexual orientation, or another unfair reason.

Pay compression is not an expressly illegal practice. Yet, this activity at the workplace can open up legal grounds for a worker to sue for discrimination.

Wage compression can affect a company’s reputation

When a company has pay inequities, this can damage their position in the labor market and their employer branding.

Word can spread fast that workers are not well compensated within the organization.

This practice can also affect recruitment efforts. New talent may avoid a company where tenured staff do not receive competitive pay.

4 tips to address wage compression

Without the right measures to correct pay differentials, wage compression can lead to worker dissatisfaction, poor company reputation, and a possible threat of legal action. 

It is, however, possible to address this practice in the workplace. If you notice wage compression in you organization, try the below measure to address the situation.

1. Examine current pay practices

Where salary compression exists in a company, the first step is to assess the situation.

This process may begin by first examining current market standards for pay rates. Present managerial wages, expected salaries for direct reports, and new hires’ salaries should also be reviewed. By going through this exercise, you’re essentially auditing the market in parallel to your own pay practices. 

These evaluations help the organization decide what current expectations are for different positions. Where the minimum wage is raised, employers should ensure this reflects in salaries across the board.

When disparities are discovered, address them. All employees should be fairly compensated. And while it may come at an incremental cost to the bottom line of your business, it’s a worthy investment in your people.

2. Provide equity adjustments

Any disparities and pay need to be assessed and adjusted. When disparities in pay are uncovered, it’s important to adjust any inequities immediately. 

Pay should be reflective of the skillset, experience, and duties of an employee. Earnings should be distributed more equitably towards long-term or high-performing workers.

Wage suppression can be contained by limiting overtime claims by a direct report. This will reduce the chances of out-earning a manager or other supervisor.

Where policy permits, merit increases may be considered in favor of pay raises. This is to ensure unbiased payment. Also, a mix of base, variable, or incentive-based bonus pay can provide fair compensation in the workplace.

3. Introduce additional rewards

In special cases, salary increases alone may not work to reduce differences in the pay gap. In these cases, wage compression affecting tenured staff can be corrected using bonuses or more paid time off. 

If you’re looking to introduce additional rewards, revisit your compensation and benefits strategy. How does your organization approach its total rewards strategy? Are there stock and equity options? Are there programs like unlimited PTO already in place? What additional rewards can you offer to balance the pay equity scale? 

4. Carefully monitor salary ranges

Companies should always look out for salary midpoints when deciding on pay. In particular, companies where wage suppression occurs should adopt this.

Tenured workers should not fall within the range kept for less experienced employees. If they do, compensation restructuring becomes important.

How to prevent wage compression

Because of the negative impact of wage compression, it’s important to put measures to avoid this system in the workplace. Take the following steps to prevent salary inequity in an organization:

Adopt a transparent stance

Where employees are unclear about their compensation within the workplace, this can impact morale. Employees may feel under-appreciated or rewarded, leaving it to company heads to clarify pay structure.

Your HR, internal communication, and leadership teams should work together to explain the full or partial benefits that workers can expect in their respective positions. Transparency in compensation structure should be the watchword. Employees across departments and throughout the organization should have clear pay expectations at the end of every week, month, year, or other timeframe within the organization.

It is recommended for organizations to review salary structure every three years. The maximum time for structure review should be five years to avoid backdated payment practices.

Where possible, this timeframe may be adjusted to 18 months to ensure any inequalities in payment are caught early.

Establish a pay cap

Human resources and relevant departments in the office can set a pay ceiling for new hires. This can limit the risk of paying new talent more than what the company offers to experienced staff.

A salary cap can prevent dissatisfaction from experienced workers. When new hires receive fair packages, this can serve as a push to work toward earning higher pay.

Routinely compare wages

In large or small businesses, it’s easy for a leader or manager to earn around same the wages as direct reports. This can be avoided when an organization makes deliberate efforts to compare salaries.

Plan ahead

Another effective way to prevent wage compression is to plan against it. Organizations may use relevant software to keep track of pay trends for talent.

Likewise, companies can follow market surveys. They may also assess salary information to glean what applies across positions.

Hire a compensation manager

Human capital management is an investment in your people. If you’re serious about addressing wage compression, consider creating a role where a dedicated person addresses (and prevents) wage compression. Not only can this person help avoid cases of wage compression, they can help prevent it.

You might be hesitant to add headcount, especially with looming uncertainty ahead. But as we know in today’s job market, it’s critical to retain and develop your top talent. You’ll need to keep your employee morale high, your employer brand reputable, and your employees engaged and satisfied.

The result? Employee retention. With many human capital management systems, it’s possible to pair up with finance to provide solutions to wage compression. Through a carefully planned compensation strategy, salaries can be equitably distributed.

This strategy may involve annual adjustments for market changes. The strategy should be paired with earning transparency and open communication to employees.

Where compression is managed in an organization, it can boost its profile in the job market. A reputation for fair and equitable compensation is always an asset for a company's brand. But more importantly, fair and equitable compensation is an asset for your people (and your bottom line).

Build future-mindedness as a skill

At BetterUp, we look at future-mindedness as a skill for any leader to develop. Part of being future-minded means your organization is looking ahead with pragmatism and optimism. 

With this perspective shift, future-mindedness can actually help your organization better prepare for those “worst-case scenarios,” like any issues with wage compression. It can also help you build the skills and resiliency needed to navigate uncertainty and change, especially with an ever-changing workforce. 

Consider how BetterUp can help build a sense of future-mindedness with your leaders. Especially with HR and people managers busier than ever, how are you supporting your people to reach their full potential? In what ways can you empower their success? 

With virtual coaching, you can help your workforce build its future-minded muscle. And so when change does strike (because it will), you’ll be better equipped to come out on top.