What is Pay Compression?

By: Don Lustenberger

At DCI, we’ve been tracking increased attention on the topic of pay compression. So, let’s talk about what it is, how it comes about, how it might pose a risk for your organization, and how to potentially remedy it. 

What is pay compression? 

Pay compression (aka wage or salary compression) refers to when the earnings of new hires are close to the earnings of current employees in the same job, who may have the same or even more experience in that job. (We refer to the special situation when the earnings of new hires exceed the earnings of current employees as “inversion.”) At the same time, pay compression can also describe a situation where the pay for entry-level jobs grows increasingly closer to the pay of jobs immediately above them in the pay structure.  

How does pay compression come about? 

There are several factors or conditions that can lead to pay compression, the most obvious of which involves new hires simply obtaining higher starting salaries. But why might this happen?  

When it’s a job seekers’ market (like we’re experiencing now with low unemployment), employers may have to offer higher starting salaries than they previously had to successfully attract and hire new talent. Consequently, these new employees may end up earning more than those who were previously hired into the same jobs.  

At the same time, incumbents may be less likely than job candidates to negotiate their earnings (e.g., ask for pay raises or larger merit increases). With little or no desire to enter the job market themselves, incumbents don’t have the same leverage that applicants do. Because of this, employers may be less likely (or less incentivized) to upwardly adjust the earnings of their current employees. As a result, the growth of an existing employee’s earnings may not always match that of the labor market, and so new employees enter organizations earning nearly as much, as much, or more than incumbents. 

Perhaps a less obvious contributing factor involves employees who have been in their roles for a longer period. It is not uncommon for employees with longer job tenure to receive more modest increases in salary over time. These employees may in some cases be consistent, but not the highest, performers, and the merit increases they receive may not be as large as the increases that others (who may eventually move up and out of those roles) receive. Additionally, employees who have been in the same role for a longer time may begin to reach the upper range of their pay scales and, in turn, begin to see smaller and smaller merit increases year over year until they are no longer eligible to receive increases. There may also be a point where additional job experience no longer translates into greater earnings—at least with respect to a particular role. 

In other cases, as with academic faculty members, contracts signed years ago may outline starting salaries and maximum annual increases, which, over time, fail to keep up with the labor market. In those scenarios, more experienced employees may find themselves earning the same as or less than what new hires coming into those roles are making. Additionally, increases in the minimum wage may create a situation where the earnings of employees within one job start to grow closer to the earnings of employees in a job immediately above it. When this happens, the pay of employees with additional experience, greater skill sets, and more responsibilities starts to look more like the pay of employees with less. 

What can make an organization more susceptible to pay compression? 

In many cases the causes of pay compression may be driven by the labor market or by the nature of pay scales, contracts, and laws. But there also are some factors that can exacerbate pay compression within an organization. Companies without sound practices for establishing starting salaries (and adhering to them) may be more susceptible to candidates negotiating higher starting pay.  

When organizations have sound pay scales based on market data but fail to update those scales or seek to attract higher caliber talent than what those pay scales were designed to target, they may find themselves needing to offer new employees higher starting salaries. At the same time, these organizations may end up neglecting to raise the earnings of their current workforce. Under these situations, pay compression can be more pronounced. 

What risks might pay compression pose? 

When new employees with less experience enter a job earning the same or more than their peers, there is, of course, the risk that those peers discover this information and perceive the inequities as unjust. These perceptions can certainly have negative effects in terms of morale and even retention. Beyond this very real concern, there are also potential legal risks that pay compression can have for organizations. These are tied to employment discrimination statutes designed to protect members of various demographic subgroups.  

For starters, there is some evidence that men may be more likely to initiate negotiations¹ and receive better negotiation outcomes than women.² To the extent that conditions are ripe for pay compression within an organization and pay compression is being driven by men negotiating higher starting salaries, companies may be at risk of violating Title VII of the Civil Rights Act of 1964. The statute prohibits discrimination in employment settings and covers employee compensation. In this situation, men in a certain job (or set of jobs) may be earning more on average than women, when their experience may be on par with or less than that of women. 

As another example, older workers typically tend to earn more than younger workers because they are more experienced. Rarely are claims of age discrimination brought forth in compensation, and this is especially true of base pay. However, pay compression can create situations in which employees of age 40 or older, whose compensation is protected by the Age Discrimination Act of 1967, are paid less (or less than would otherwise be predicted based on their experience) than younger employees, despite their additional experience.  

How can pay compression be mitigated? 

Although organizations can do little on their own to control the labor market and laws concerning minimum wage, there are things they can do help mitigate pay compression: 

• Organizations should stay in tune with the labor market and update their pay scales, starting salary guidelines, and merit increases to ensure new employees coming onboard with less experience don’t out-earn their peers with more experience.  
• Organizations should also limit the amount of discretion hiring managers have when setting starting salary. Added discretion can invite more negotiation, which can lead to potential gender inequities in pay. If top applicants are consistently turning down offers, companies can elect to offer one-time hiring or sign-on bonuses that can keep base pay rates down and allow the organization to be more equitable with incumbents. Or, again, organizations may opt to re-evaluate where they are in the labor market with respect to pay. 
• Organizations should also regularly conduct pay equity studies to evaluate whether any of their jobs may be experiencing compression and the risks associated with it. Pay equity analyses that examine compensation for those working in similar roles can uncover pay compression and potential pay disparities attributable to gender, race, ethnicity, or even age. 

DCI continues to follow the trends and remain up to date on all things pay related, so be sure to follow along.

References

¹ Kugler, K. G., Reif, J. A., Kaschner, T., & Brodbeck, F. C. (2018). Gender differences in the initiation of negotiations: A meta-analysis. Psychological Bulletin, 144, 198–222.

² Mazei, J., Hüffmeier, J., Freund, P. A., Stuhlmacher, A. F., Bilke, L., & Hertel, G. (2015). A meta-analysis on gender differences in negotiation outcomes and their moderators. Psychological Bulletin, 141, 85–104.