Pay compression is present when individuals with more years of experience receive pay rates nearly equal to (compression) or less than (inversion) individuals with fewer years of experience. Pay compression most commonly occurs when demands from the external labor market push the starting salaries of organizational newcomers to pay levels that are similar to those of existing employees. In other words, as job tenure with the organization increases, wage growth is stifled and the value of additional years of tenure declines over time. As a result, there is a narrowing of the pay differentials between employees with differing levels of experience. Pay compression typically results when the salaries or wages of organizational members do not grow at the same pace as external market wage rates and more recently hired employees are paid at rates similar to longer tenured employees. On an individual employee level, the degree of compression an individual experiences is determined by the relationship between an individual’s seniority, their salary level, and the salary of individuals with less experience. Therefore, an individual employee’s relative position within a pay structure is the key determinant of their experienced level of pay compression.
A unique instance of compressed pay levels occurs when organizations are operating in markets in which there is high demand for skilled employees and these organizations are forced to raise the pay rates of newcomers in order to attract them. When companies are designing a pay system, they may simultaneously use both external market surveys, in which supply and demand pressures are used to establish pay rates, along with internal job evaluation systems, in which the worth of a given position is determined in relation to organizational strategy and design. Research has found that pay compression may be an outcome when organizations focus more heavily on these external market pressures, via an external equity strategy, than on internal job evaluations or job equity analyses, both internal equity strategies, when determining wage rates. The greater demand for qualified employees makes employers willing to pay more for skilled workers, thus directing their efforts toward an external equity strategy. To attract the best employees, companies may ignore internal pay equity and pay the market value for workers instead. However, such actions produce pay compression by narrowing the pay ratios between newcomers to the organization and current members.
In recent years, the problem of pay compression has been particularly prevalent in high-growth industries and in occupations where market forces push starting salaries for new hires to increasingly higher levels in an attempt to stay competitive in the recruitment of new employees. As a result, wages increase faster in the external labor market than in the internal company structure. For example, recent studies have found that internal pay rates grow, on average, 3.4 to 3.7 percent per year. However, in the external labor market, wages might increase in the range of 10 to 15 percent per year. Accommodation of these external pay rates when recruiting and selecting organizational newcomers will then narrow the pay gap between employees of differing levels of organizational experience.
Currently, pay compression is argued to be endemic across pay systems inside a vast majority of private, public, and not-for-profit organizations and across all major industry types. Some have argued that changes in the economy, the use of outsourcing, and general economic and managerial control policies are leading this new wave of pay (both wage and salary) compression well beyond what has traditionally been experienced. As pay rates become more restricted inside organizations, for whatever reason, these pay rates do not tend to recover at the pace of those newly hired by organizations. It could be argued that organizations are not only ignoring the experience and loyalty factors of their workforces but are failing to respect the external wage and salary market unless new talent is needed from outside the organization.
It is important to realize the negative ramifications that can be associated with pay compression. Multiple streams of research have shown that the amount of pay an employee receives strongly influences key attitudes and behaviors such as job performance, organizational commitment, job satisfaction, and intentions to leave an organization. The level of pay also impacts an individual’s feelings of self-worth and the perception of their value to the organization. In addition, organizations and managers should be aware that individuals are not only concerned with the absolute amount of money they make but also how that level of pay compares to that of other individuals in the organization. Employees frequently compare their pay against that of their coworkers in an attempt to determine their personal value and status in the organization.
Variations in pay rates among employees are justifiable and, therefore, deserved if the relative worth and contribution of those employees differ. Under such conditions, pay differentials are viewed as equitable and fair. However, problems arise when the pay differentials between individuals are not as wide as employees believe they should or could be. In conditions of pay compression, individuals of differing levels of experience are receiving similar pay rates. As a result, a perception of unfairness, or inequity, can be created as the more experienced employee does not feel that their pay level is reflective of their performance, loyalty, and commitment to the organization. Less tenured employees are receiving similar pay as longer tenured employees because the external labor market created an opportunity for them to demand a higher starting salary, not because their relative contributions are similar.
Because pay compression occurs across groups of differing experience, it will likely be viewed as unfair and be detrimental to employee performance and organizational outcomes. Limited variance in pay levels between individuals in a relative group, such as those with similar levels of experience, is desirable. However, to guard against perceptions of unfairness, differentials must be present across individuals of differing levels of experience. When pay compression occurs, these differentials are eroded. As a result, those longer-tenured employees will likely feel that their pay is unfair and begin to look outside the organization for opportunities to resolve this inequity. In addition, their commitment to the organization will suffer and their performance levels may fall. These individuals may perceive that their value to the organization is unrecognized, and as a result, their self-esteem, satisfaction, attachment, and motivation can suffer. Such negative outcomes suggest that organizations must be aware of the potential danger of allowing external market strategies to overtake internal equity and stimulate pay compression within their pay structures. Each new generation of employees seemingly demands greater attention to fairness of rewards in the workplace. Understanding this reality will position the issue of pay compression as increasingly salient to organizations in the future.
- Bratsberg, B., Ragan, J. F. and Warren, J. T. 2003. “Negative Returns to Seniority: New Evidence in Academic Markets.” Industrial and Labor Relations Review 56:306-323.
- Brown, B. W. and Woodbury, S. A. 1998. “Seniority, External Labor Markets, and Faculty Pay.” Quarterly Review of Economics and Finance 38:771-798.
- Gerhart, B. and Rynes, S. L. 2003. Compensation. Thousand Oaks, CA: Sage.
- Gomez-Mejia, L. R. and Balkin, D. B. 1987. “Pay Compression in Business Schools: Causes and Consequences.” Compensation and Benefits Review 19:43-55.
- Lazear, E. P. 1989. “Pay Equality and Industrial Politics.” Journal of Political Economy 97:561-580.
- Pfeffer, J. and Langton, N. 1993. “The Effect of Wage Dispersion on Satisfaction, Productivity, and Working Collaboratively: Evidence from College and University Faculty.” Administrative Science Quarterly 38:382-407.