SECTION FOUR: PAY CONCERNS AND PAY RAISES
1) INTERNAL vs. EXTERNAL EQUITY
Definition: Internal equity exists when employees at a company perceive that they are being rewarded fairly according to the relative value of their jobs. External equity exists when a company’s pay rates are equal to the average rates in the organization’s market or sector.
Why it matters: How employees perceive their pay compared to their coworkers and others doing similar work at other companies can have a huge impact on retention, job satisfaction, and morale. Internal inequities can have legal ramifications for the company so it’s a good idea to evaluate internal pay practices within and between departments on a regular basis to identify any large, unexplainable disparities. If you have external inequities and find your pay is low compared to market, you likely have flight risks, higher turnover, and difficulty recruiting. If the external inequity is due to internal pay being higher than market, then you likely have a compensation budget problem. And while turnover may be low, the employees sticking around might be doing so for the wrong reasons.
2) COMPRESSION
Definition: Wage compression is the phenomenon that occurs when a new hire is paid the same as or more than employees with more seniority in the same job.
Why it matters: Compression is one of the more challenging issues in compensation. A common culprit is the “hot job,” where candidates start asking for rates that exceed those of your current employees in that same job. Due to supply and demand of talent, the rate being sought by candidates is likely fair given the current market conditions. That said, paying new employees at the same rate (or higher) than incumbents can cause some real and ongoing compensation problems, including morale issues. The best strategy to avoid compression is to be proactive rather than reactive to market changes. Listen to candidates and recruiters as that can indicate a need to market price a job out of cycle. Review internal pay spreads – jobs with multiple incumbents who are all paid the same (or similarly) can indicate compression issues.
3) RED-CIRCLED and GREEN-CIRCLED
Definition: A red-circled employee is one whose pay has exceeded the maximum of the range for their job. A green-circled employee is one whose pay is below the minimum of the range for their job.
Why it matters: Employees who are paid outside of range can indicate a misalignment between the company’s pay practices and pay structure. In general, employees should be paid somewhere between the minimum and the maximum of their range. Outliers are common when rolling out a compensation plan for the first time – without a structure to guide your pay practices, it is likely you will have employees who are paid above the maximum or below the minimum of your new created ranges. Make a plan to address outliers at implementation of the plan as well as create a policy around handling outliers on an ongoing basis. Red-circled employees are common in companies where a standard 3% across the board increase is given every year, with little attention to a job’s market value or the pay range (if established). Green-circled employees are common in companies where pay has been frozen for several years due to budget cuts and now the market has outpaced employee wage growth. It is important to identify outliers and develop a plan to bring them in range. Freezing pay for red-circled employees and offering a performance-based bonus will help retain top performers without compounding your problem. Allocating budget to bring green-circled employees up to the minimum of the range is recommended, though if the cost is too high to increase everyone at once, consider spreading the increases over several budget cycles.
4) COLA:
Definition: Cost of Living Adjustments. An across-the-board salary increase or supplemental payment intended to bring pay in line with inflation in a geographical area.
Why it matters: Many companies will go through the process of adjusting employee pay based on the Consumer Price Index and the cost of living in their given area. Want to really impress the CEO with your compensation savvy? Educate executives on why COLA is a thing of the past and what you should really be focusing on is Cost of Labor. Cost of Living is what consumers pay for a basket of goods (milk, gas, clothing, etc.) whereas Cost of Labor is what a company pays employees to do a job/produce work for said company. What’s the connection? The only connection is that both track supply and demand – Cost of Living tracks goods and Cost of Labor tracks people. The key here is that trying to pay Cost of Living could put the company at risk of over or underpaying employees relative to competitors in the area. Cost of Labor, on the other hand, ensures your rates remain competitive with the going rate for that type of work. Before budgeting for COLA increases, ask yourself, are you intending to reimburse employees for their living expenses (Cost of Living) or are you intending to pay employees competitive to the local market (Cost of Labor)?
5) MERIT INCREASES vs. MARKET ADJUSTMENTS
Definition: A merit increase is a performance-based raise to an employee’s pay. A market adjustment is an increase to the employee’s pay based on market movement.
Why it matters: It’s all about how you communicate the increase(s) to the employee. A market study may reveal that some employees are paid well below the market value for their job and are potential flight risks. When that is the case, some companies will opt to adjust the base pay up for those employees as way to achieve better market alignment. This increase is and should be treated differently than a merit increase. Why? Because if an employee receives both a market adjustment and a merit increase, without distinguishing between the two, the employee may expect the same amount next year. For example, if the market adjustment brings the employee up 5% and you are allocating a 3% increase on top of that, you don’t want the employee to conflate the two and expect an 8% increase next year.
6) MERIT MATRIX
Definition: A pay-for-performance tool used to determine pay increases for individuals based on their performance and position in range (or range penetration).
Why it matters: The merit matrix is a straight forward way of allocating your budget across your employee population. Merit matrices support pay-for-performance by accelerating high performers’ movement through their range and slowing or halting the movement of pay for poor performers. In a merit matrix, performance ratings are plotted along the vertical side of the matrix and the position-in-range options along the horizontal side. For more information on building a merit matrix, see our post on 5 Steps to Creating a Merit Matrix.
There you have it, our ‘comp’lete comp glossary! Now that you know a few key comp terms in your vocab go out and dazzle the party with your advanced jargon! It’s not too ‘comp’licated to be a great icebreaker.
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Hi – great article! I have a question for you however – can you explain why a geographical differential could be viewed as a negative? For instance, my friend moved from Texas to CA and his pay range increased 10% as a result. Doesn’t this essentially move his current pay “down” farther from the midpoint as a result? Thanks!