Why You Need to Address Pay Compression

The US tight labor market is requiring companies across several industries to raise pay to attract new, experienced workers. This strategy creates pay compression for existing workers — meaning, they are now underpaid  — and leaves them deeply dissatisfied. To prevent this problem, companies need to address their pay compression issues before employee turnover spirals out of control. Research frequently shows that turnover (as we will discuss below), not raising wages to maintain market pay competitiveness, is the real driver of rising business costs and loss of productivity.

Pay compression occurs when companies give higher-than-normal wages and salaries to new hires, often during times of labor shortage, but do not pass on similar pay increases to their current employees. The increase in wages to new workers closes the pay difference between them and similarly qualified employees hired in the previous months and years.

According to ADP’s Q2 2021 Workforce Vitality Report, US wage growth among job switchers (those who left their employer for higher pay with a new employer) increased by 5.8 percent since June of 2020. The rate for job holders (people who stayed with the same employer) rose 3.1 percent for the same period, creating wage compression. According to the US Bureau of Labor Statistics, the quit rate in May, 2021, was 2.5 percent, down slightly from the previous month, but still high.

ADP reports that wages for job switchers increased year-over-year very differently depending on the industry. The industry with the highest job-switcher rate is listed below, along with the increased pay rate for job holders:

  • Resources and mining job-switcher rate increased by 11.81 percent. Job-holders’ pay increased by 6.06 percent.
  • Information Services job-switcher rate increased by 9.75 percent. Job-holders’ pay increased by 3.74 percent.
  • Professional and Business Services job-switcher rate increased by 9.59 percent. Job-holders’ by 4.72 percent.
  • Finance and Real Estate job-switcher rate increased by 7.84 percent. Job-holders’ by 3.89 percent
  • Manufacturing job-switcher rate increased by 6.73 percent. Job-holders’ by 3.36 percent.

ADP is not the only source reporting increased overall wages for job switchers. The US Labor Department reported that US private sector ages were up 7.9 percent in May from February 2020.

The trend is up, and it won’t change soon, according to analysis by The Conference Board. The US labor shortage is a long-term problem. It is caused by an aging workforce, low birth rates, difficulties women have finding day-care after the COVID19 endemic began, and the difficulty with automating professional services roles. In addition, worries about catching COVID-19 during the fourth surge of the endemic may keep some unemployed people from returning to work in factories, retail, and restaurants.

Many executives like to assume their employees will not catch on to the higher wages or bonuses paid to new hires. There is an adage that applies here. When more than three people know a secret, it will no longer remain a secret. This principle is especially true for pay. The only safe assumption is that employees will hear of it and compare new hires’ pay to their own pay. If pay compression is not addressed, your higher-performing employees will leave for employers who will pay them more unless you are able to provide equity the other employers cannot. These equities can be stock in the company or work from home, three to four days a week.

Employers cannot legally discipline employees for talking about pay or other working conditions.  Employees are legally protected by the National Labor Relations Act (NLRA) to talk about what they earn. According to the National Law Review, “The National Labor Relations Board (NLRB) has taken the position over the years that employees have the right under the National Labor Relations Act (NLRA) to discuss their “terms and conditions of employment” with one another, including their wages, benefits, etc. This right applies in both union and non-union settings. Accordingly, the labor board routinely finds companies who prescribe rules that forbid employees from discussing their rates of pay or similar issues to have violated the NLRA.”

It is the cost of turnover, not keeping wages current to market pay or preventing pay compression, that is the real damaging cost to a business. Gallup estimated that voluntary employee turnover costs US businesses $1 trillion a year.

According to Gallup, here’s how it breaks down for an individual organization:

  • The annual overall turnover rate in the U.S. in 2017 was 26.3%, based on the Bureau of Labor Statistics.
  • The cost of replacing an individual employee can range from one-half to two times the employee’s annual salary — and that’s a conservative estimate.
  • So, a 100-person organization that provides an average salary of $50,000 could have turnover and replacement costs of approximately $660,000 to $2.6 million per year.

Often your recruiters will be the first to indicate pay compression is occurring because of the demands for higher pay made by your job applicants and rising rejections of job offers. Then complaints will come in from managers and employees to HR. Tracking data such as ADP or the BLS will help you understand general trends, but you need to have accurate and current salary information for your region of the country. Salary surveys where you have benchmarked your key jobs for each job family (such as software engineers) will also indicate if you have a pay compression problem, but salary survey data is often lagging indicator, and the problem will manifest before you receive the latest salary survey data.

There are two major ways to address pay equity. One is to maintain differences between the bands of your salary structure. The other is to have a pay-to-market strategy.

An example of the first approach was published in yesterday’s The Wall Street Journal. Chipotle Mexican Grill Inc. said in May that it was lifting its pay for hourly positions to an average of $15 an hour, amounting to an average raise of around $2 for front-line workers. Months before making the announcement, the company completed an analysis of how the change for entry-level crew members would affect the pay for other roles, from hourly kitchen and service managers to the salaried general managers who oversee a store’s operations. The chain made sure the raises included a premium for experienced employees within each role and gave raises that averaged around $2 an hour to hourly managers and commensurate raises to salaried managers. To pay for the extra labor expenses associated with the raises, Chipotle raised its menu prices by 3.5 percent to 4 percent this year.

A pay-to-market strategy ideally requires statistically reliable and representative salary surveys, not what you commonly find if you Google pay for a job title in the city where your office is located. This crowd-sourced information often may not have a large enough number of participants to be reliable or the jobs may be poorly identified and not matched to your jobs — meaning the data is not accurate.  The reliable pay-to-market surveys are usually conducted every six months and require participants to align their jobs to the jobs in the salary survey, based on established criteria to make sure the survey is gathering data on jobs that are truly similar and comparable. In this approach, companies look for pay changes not for the whole system as an average but discretely for every benchmark job they have in a job family, like accountants,  software engineers, and marketing specialists.

In the example above, Chipotle is looking to match the $2 an hour increases for entry level workers across its pay system for restaurants (not office workers). With pay to market, you are looking to match the rising pay levels of discrete jobs in job families, such as entry level cooks and experienced cooks, to the market pay for inexperienced cooks to market cooks and service managers to service managers. In this approach not everyone may get the $2 increase. The pay for experienced cooks in the external market may be rising faster, such as $4 an hour, requiring you to raise your experienced cook salary by $4 an hour to retain these valuable employees.

The labor shortage in the US will not go away soon. Executive teams and HR leaders will need to adjust their strategies and tactics in a world of labor shortages, rising turnover and pay – and the changing expectation for hybrid working and the wants of America’s young workers, Generation Z.

Victor Assad is the CEO of Victor Assad Strategic Human Resources Consulting, managing partner of InnovationOne, and Sales Advisor to MeBeBot. He works with companies to transform HR, implement remote work, recruit executives, and develop extraordinary leaders, teams, and innovation cultures. He is the author of the highly acclaimed book, Hack Recruiting: the Best of Empirical Research, Method and Process, and Digitization. Subscribe to his weekly blogs at www.VictorHRConsultant.com. 

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