The Impact of Pay Compression on Pay Equity

The U.S. labor market has been on a roller coaster ride, from massive job losses at the start of the COVID-19 pandemic to unprecedented growth in last year.

According to the Economic Policy Institute, the labor market lost 22 million jobs in spring 2020.  In the past 12 months, however, the economy added 6.6 million jobs and is on track to return to pre-pandemic labor market conditions before the end of 2022. Unfortunately, there are not enough people looking for work to fill available positions. According to the Bureau of Labor Statistics, nearly 5 million people, who left the workforce at the start of the pandemic, have not returned and are not looking for work. 

In December 2021, the Society of Human Resource Management projected that labor shortages would continue through 2022 with wage growth topping 4%. Because of the tight labor market, employers are driven to offer higher starting pay to attract qualified talent to fill critical roles. When employers fail to take into account the impact of higher starting salaries on compensation levels of existing employees in comparable or more experienced roles, they inadvertently create a pay compression problem.

Pay compression occurs when there is little difference in pay between employees with different levels of skill, responsibility and/or qualifications. The current race for talent has created pay inequities between newly hired and long-term experienced employees and between subordinates and their supervisors. 

Offering higher starting pay addresses employers’ current labor shortage problem. But the resulting pay compression inevitably leads to increased turnover among the more senior and/or highest performing employees. Pay compression also negatively impacts pay equity exposing employers to significant legal risk and reputational harm.

Pay Inequity: An Unintended By-Product of Pay Compression

Pay compression often results in co-workers performing the same or similar jobs being paid differently with the most recent hire earning more than a long-term employee. Countless articles have been published on the impact of pay compression on employee morale and turnover rates.  However, very little has been reported on the effect of pay compression on pay equity and related legal risks. This is surprising given that current labor market conditions create the perfect storm for creating pay inequities.

To minimize the risk of biased decision-making, employers manage pay equity and legal risk by implementing a comprehensive compensation policy that guides pay decisions, assigning positions to pay ranges based on market drivers, and employing a system of checks and balances to prevent bias. However, when faced with challenging labor market conditions, policies and guardrails are often pushed aside in an effort to attract much needed talent and fill critical roles quickly at any cost. The result may be similarly situated employees who are paid differently, which may allow for the inference of biased decision-making. 

Discussions related to pay equity focus almost entirely on the impact on women and employees of color. However, where pay compression is the driving force behind the pay inequity, employers should not overlook the risk of adversely affecting older employees with more company seniority who may be paid less than younger, newly hired workers. 

Role of Pay Transparency

The idea that pay rates for any role are confidential is an antiquated notion. Indeed, the current buzzword in pay equity circles is “pay transparency.” Twenty states and the District of Columbia have passed legislation prohibiting employers from taking adverse action against employees who discuss their pay.

On the federal level, the National Labor Relations Act gives employees the right to communicate with other employees at their workplace about their wages. Similarly, federal contractors subject to the jurisdiction of the Office of Federal Contract Compliance Programs are prohibited from firing or discriminating against employees for discussing, disclosing or inquiring about their own pay or the pay of their coworkers.

The most recent trend in the push for pay transparency is at the state level. There is a proliferation of state and local laws and proposed bills requiring employers to provide salary range information to applicants for posted positions either when requested or at specific points in the hiring process. Colorado is the most progressive, requiring pay ranges be included in job postings. New York City passed a similar bill in December 2021 requiring employers to state the minimum and maximum salary in all posting for an open posting, promotion or transfer opportunity.

Minimizing Negative Impact on Pay Equity and Managing Legal Risk

Pay compression can lead to an unintended impact on employees based on gender, race, ethnicity or age.  Further, as discussed above, the heightened transparency around pay makes it more likely that employees will become aware of the fact that they are paid less than recently hired colleagues. There are steps employers can take to minimize legal risk and preserve or even enhance their pay equity status. 

• Continue to conduct annual companywide pay equity analyses under attorney/client privilege. In addition, during this period of rapid competitive hiring, periodically review pay differences between employees in the same or similar jobs for equity imbalance. Make adjustments where necessary.
  
• Review current pay grades against current market trends. Adjust grades where necessary, ensuring appropriate pay differentials between each level. Also, consider whether certain ranges for hard-to-fill roles need to be expanded to allow more differentiation between employees. Identify any current employees who are not paid in-line with the current market rate for their role. Implement a plan for raising the pay of employees who are out of line with the rate for their roles.
  
• Maintain contemporaneous documentation of the legitimate, non-discriminatory reasons for offering new hires starting wages close to or more than their comparators.  Documentation is critical to defending against pay discrimination claims.
  
• Consider offering new hires a one-time signing bonus rather than a base pay rate that exceeds the pay rate of current employees in similarly situated roles.    
  

Implementing a compensation program that eliminates and minimizes the risk for gender and race/ethnicity-based wage gaps is time and resource intensive. It can take multiple years to achieve pay equity. It takes almost no time to undo all the work that went into developing and implementing a fair compensation program. 

Thoughtful decision-making, monitoring compensation decisions and implementing adjustments where necessary is critical.