Does Pay Transparency Lead To Salary Compression? (And How to Avoid It)

Does Pay Transparency Lead To Salary Compression? (And How to Avoid It)

Over the past few years, companies around the world have increasingly been adopting transparent policies around pay.

This radical new approach can help employers build a culture of trust within their organisations. It can boost employee morale and productivity, and help employers to attract and retain the best talent. There’s even evidence that pay transparency could be the key to ending the gender pay gap.

But today, we’re here to talk about the dark side of pay transparency. Because if they’re not handled correctly, transparent pay policies can have a lot of unintended consequences. In particular, we’re going to dive into the link between pay transparency and salary compression.

Let’s start with some simple definitions to make sure we’re all on the same page.

What is pay transparency?

Pay transparency is a company policy that involves being open and honest about the salaries it pays its employees. It’s also a spectrum: not all companies are 100% transparent or 100% secretive about pay.

There are also a few different types of pay transparency that companies can adopt:

• Process transparency: Being open about the way decisions about pay are made.
• Outcome transparency: Openly sharing the actual salaries or pay ranges for groups of employees or individuals.
• Communication transparency: Allowing or encouraging employees to openly discuss their pay with colleagues.
• Jobseeker pay transparency: Giving jobseekers information about the starting rate or range for advertised roles before they apply (usually on job adverts).

What is salary compression?

Salary compression is when employees are paid the same or similar amounts despite differences in their experience, job level, performance or tenure.

Here’s an example: a company hiring software engineers in 2024 may have to offer a high starting salary to those engineers due to the tight job market. But that means those new employees may end up being paid a similar salary to software engineers who already work for the company, despite their additional experience.

Another form of salary compression is when employees are paid similarly despite big differences in their performance — even when the company is supposedly operating a pay-for-performance model.

Basically, salary compression is what it sounds like: employees’ salaries getting closer together. And there’s some evidence that pay transparency could be making it worse.

The link between pay transparency and salary compression

First of all, one obvious effect of pay transparency is that it brings salary compression out into the open. A few years ago, if a company paid a new employee more than existing employees performing the same role, no one would be any the wiser.

But as companies get more transparent about pay, that’s no longer the case. Plus, many states, countries and municipalities, including New York City, California and Illinois, now require employers to share salary information on the job ads they publish. And, as we’ve talked about, the EU’s 27 member states will soon follow suit.

That means existing employees can see what their employer is prepared to pay a new hire, even if they’re not transparent about pay in any other way.

And there’s also evidence that pay transparency can actually lead to salary compression. According to one study, when the government of California made salaries transparent in 2010, this caused average pay to drop by 7% in two years. Another study of 100,000 academics between 19997 and 2017 confirmed the same thing: pay transparency = salary compression.

So, what’s going on? Part of the problem is that managers are afraid of salary transparency — and those same managers are responsible for making decisions about individual employee pay.

Let’s use an example to help us understand:

Imagine you’re a manager of two employees in the same role, Jane and Jill. When performance review season rolls around, you need to give each employee a performance rating that will determine how much of a pay rise they receive.

Now, you know that Jill’s performance is much better than Jane’s. But you also know that your company recently adopted a transparent policy towards pay. That means if Jill gets paid more, Jane will know about it.

To avoid any problems, some managers give employees more similar ratings than they really deserve — leading to pay compression.

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What can we do about it?

So, how can organisations keep things fair and avoid salary compression, all while adopting transparent policies around pay?

Here are a few ideas:

1. Rethink your reward system

Every company has a set of specific factors that it considers when making pay decisions. For example, some companies allocate a portion of their salary increase budget to performance-based raises. And others give rewards based on tenure.

The point is, if you’re seeing salary compression at your company, you may be rewarding the wrong things. To correct the situation, you’ll need to take a close look at your pay practices to make sure they’re still in line with your compensation philosophy.

You should also make sure that your policies are being consistently applied — which might mean limiting manager discretion in salary decisions.

2. Review all salaries regularly

One big driver of salary compression is when new employees are engaged at a similar (or higher) rate to existing ones due to changes in the market.

Even if this is genuinely the market rate that these new employees command, it’s easy to see why this is frustrating for people who have been with you for a long time. And, let’s face it: all it does is tell them that if they want more money, they need to go elsewhere.

The easiest way around this is to review every single salary regularly — at least once a year. When you do this, it’s a good idea to take salary benchmarking data into account. That way, you can ensure that your existing employees are still being paid an appropriate rate that’s in line with today’s market.

3. Make performance measures objective and clear

Salary transparency puts a lot of pressure on managers to defend their pay decisions. As we’ve seen, this can lead some of them to take a self-protective approach, ranking employees similarly so as not to cause disputes. In other words, this leads to salary compression.

To avoid this, you should make sure the criteria your company uses to assess performance are fair and objective. For example, consider linking performance ratings to concrete, measurable achievements — rather than relying on the manager’s subjective opinion.

This will help managers feel more confident in the decisions they make — and help employees understand the reasons behind them.

4. Train managers to communicate about pay

Employees’ direct managers usually have no say in their organisation’s overall approach to pay. They may not even fully understand it. But those same managers are the ones who have to justify pay decisions to employees — and face their wrath if they don’t like what they hear.

This is the sort of thing that leads managers to try and reduce the differences in pay between employees on the same level, simply to avoid friction between employees.

So, what’s the solution? Simple: give managers thorough training on the organisation’s pay policies, how they’re enforced and how to communicate that information to employees.

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The key to fair and competitive compensation in 2024

Coming up with a pay structure that feels fair to everyone can be tricky. You need to offer salaries that are high enough to attract the best new candidates — especially for hard-to-fill positions. But you also need to avoid angering or alienating existing employees who may feel their pay isn’t fair in comparison.

And the increasing move towards pay transparency from employers and governments around the world makes this even more complicated.

Thankfully, Figures can help. We can help you to create a custom, flexible salary grid that’s in line with your compensation philosophy. You can tailor your salary bands to your desired market position, and make adjustments for performance, tenure, experience and anything else you think is fair.

Plus, our salary benchmarking tool gives you access to accurate, real-time salary data from over 1000 companies across Europe. That means you can easily find out if you’re paying your employees in line with what the market demands.

Want to learn more? Read about our salary bands or benchmarking capabilities, or sign up for a demo to see it in action.