Pay Compression

Pay compression occurs whenever a companys pay spread between newly hired or less qualified
employees, and more qualified job incumbent is small.
The minimum pay rate for a range usually is the lowest pay rate that the company will pay for the
jobs that fall within that particular pay grade. In theory, newly hired employees receive pay that is at
or near the minimum. In practice, new employees often receive well above minimum pay rates,
sometimes only slightly below or even higher than the pay moderately tenured employees receive.
Two situations result in pay compression. The first is a companys failure to raise pay range
minimums and maximums. Companies that retain set range maximums over time limit increase
amounts. For example, let us assume that the entry-level starting salaries for newly minted certified
public accountants have increased 7% annually for the last 5 years. Tax-It, a small accounting firm,
did not increase its pay range minimums and maximums for entry-level accountants during the
same period because of lacklustre profits. Nevertheless, Tax-It hired several new accountants at the
prevailing market rate. Failure to pay competitive pay rates would hinder Tax-Its ability to recruit
talented accountants. As a result, many of the Tax-It accountants with 5 or fewer years experience
have lower salaries (or slightly higher salaries at best) than newly hired accountants without work
experience. The second situation that results in pay compression is a scarcity of qualified candidates
for particular jobs. When the supply of such candidates falls behind a companys demand, wages for
newly hired employees rise, reflecting a bidding process among companies for qualified candidates.
Pay compression can threaten companies competitive advantage. Dysfunctional employee turnover
is a likely consequence of pay compression. Dysfunctional employee turnover represents high
performing employees voluntary termination of employment. High performing employees will
probably perceive their pay as inequitable because they are receiving lower pay relative to their
positive contributions (i.e. experience and demonstrated performance) than newly hired employees
who are receiving similar pay.
How can companies minimize pay compression? Maximum pay rates represent the most that a
company is willing to pay an individual for jobs that fall in that particular range. Maximum pay
rates should be set close to the maximum paid by other companies in the labour market for similar
jobs. Setting competitive maximum rates enables a company to raise pay rates for high-quality
employees who may consider employment opportunities with a competitor; however, maximum
rates should not exceed maximum rates offered by competitors for comparable jobs because high
maximums represent costs to the company over and above what are needed to be competitive.