Wage compression (or salary compression) is the term used to describe the scenario when the difference in pay between employees at a company decreases regardless of relative knowledge, skills, ability or experience.

There are a few key reasons that wage compression is an issue. Among the most prominent concerns are:

Wage compression could be caused by several different variables. We will discuss a few of the more common causes below.

Many companies choose to provide annual increases. This looks different for different types of organizations but it essentially refers to having a preset schedule (typically once a year) for the company to evaluate their employees performance, rate them and provide an increase to their wage. This increase should take into account multiple factors, including the local cost of living, the individual employee’s performance and the company’s performance over the course of the year leading up to the raise. Wage compression can appear in this situation if the increase given to existing employees is lower than what the market indicates and if the increases are low enough that the wages of new employees encroach on the wages of existing employees.

Occasionally market factors may lead to scarcity of certain skills or jobs. When this happens, it drives up the wage that’s acceptable for that job, which in turn requires organizations to pay more for that talent. It is important for employers to take this into consideration because it could impact their business in ways beyond wage compression. For example, Company Z has a robotics engineer that they are paying $60k annually. They recently took on a new project and now they need a second. However, since hiring their first robotics engineer, the market for someone with that skill set has spiked due to increased demand and limited resources. Now the cost to hire a robotics engineer is $90k. The company only budgeted another $60k to hire someone, they have a deadline to meet on their new project and now they also need to be concerned about the retention of their current engineer. By not being aware of the market value for this critical role, the company will most likely not be able to fill that role. They may not meet their deadline on a project they recently took on, which could have long-term consequences for the company or they may not get the best person for that role. If you aren’t willing or able to pay market value for a role, there is always potential that the only candidates available are those who are underskilled or underqualified with training needs that could possibly be beyond what the company is capable of providing. If the company chooses to pay the additional money to attain a new employee at the higher rate despite not having created the budget for it, it could force them to make sacrifices, such as no annual increases, closing down parts of business or locations, reducing workforce in other departments, etc.

When there is a mandate to increase minimum wage for lower level and entry level workers, employers will do so out of obligation. A common pitfall that employers fall into is failing to adjust higher-level/tenured employees’ wages in response to the minimum wage increase. Failure to adjust those employees’ wages over time will eventually lead to decreasing gaps in pay between entry level and experienced employees. Think about it this way — by increasing the minimum wage you are decreasing the value of the wage paid to tenured employees as the cost of goods, services and the general cost of living go up with inflation. Be sure to evaluate existing, experienced employees salaries at least once a year and as minimum wage is increased to ensure that they are still being compensated fairly for their knowledge, skills, ability and tenure. Doing this maintains employee morale and decreases turnover because employees will feel more valued for their contributions.

When we consider the potential risks of unchecked processes over time, it becomes abundantly clear how important it is to establish proactive solutions. Some tips for handling wage compression are listed here.

Review the wages of the existing employee base regularly. See how these wages align to the market and consider what adjustments may be needed. Consider any minimum wage changes that may affect your organization. During this review, look at supervisors compared to their reports, employees in the same or similar jobs and the entire organization. Actively seek out ways to adjust compensation to avoid shrinking differences in wages.

Building a compensation plan requires collaboration between HR and the finance team. Ultimately, a compensation plan can help the company prepare for how they want to handle salary compression, gaps in employee development, and employee benefits and incentives. HR should evaluate what is important to the employees because your employees create your culture and should influence where the company chooses to focus their resources. This could include flexible work arrangements, more PTO, healthcare benefits, telemedicine, advancement opportunities, training, family or child care, financial wellness planning, etc. The company should also consider what specific needs could arise over time, such as scarcity of a critical role, company growth plans or a high percentage of employees nearing retirement. Employers can create their compensation strategy to address whether there are certain jobs that have higher market value than others and create pay ranges for different job families. They can also budget for other non-monetary benefits that their employees have expressed interest in. Having a plan for how they will deal with market-based wage changes and keep employees engaged helps a company adjust quickly when the need arises and avoid the low morale that accompanies wage compression.

Regular increases, formal compensation structures or bonuses aren’t always conducive to the company’s budget restrictions. Companies could consider non-monetary rewards, financial equity plans, formal succession planning, flexible work arrangements or a combination of different pay structures that work within their unique limitations. Ultimately, when handling wage compression, the most important thing a company can do is to evaluate their pay structure and be willing to adjust to the market to be able to attract new candidates and retain current employees.