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Inflation everywhere: How to manage wage compression and inversion

 

In a job market with high wage growth, employers who bring in new talent externally are finding themselves paying ever-increasing salaries for new staff. Phill Brown, Practice Director, RWInsights at Robert Walters, breaks down two lesser-known by-products of inflation – wage compression and inversion. Read on to learn how to identify these issues, understand their potential impact, and create a strategy for prevention.

In many markets, the economic recovery from the impact of coronavirus has been swift – and in some, chaotic. Stock markets have risen rapidly. Growth is up, productivity is up too. However, the public expenditure that supported economies during the lockdowns and pandemic restrictions needs to be paid for, and this is largely being seen in increasing headline price inflation in many markets – which, in some cases, is reaching levels not seen for a generation or more. The price of everything – from petrol and diesel, to the food in your local supermarket – is noticeably going up.

The rising prices for raw materials, transport, and disrupted supply chains come as organisations are trying to recover in an environment with a record number of job vacancies, in what was an already highly competitive skills market. Add to that the release of pent-up worker mobility, suppressed by lockdowns – widely known as the great resignation – the response has been for organisations to increase the amount that they are prepared to pay to secure the talent that they need. The consequence of this has been increased wage inflation; at a level that has not been observed by most of the current workforce in their working experience.

Official wage inflation figures are high. The rates in the UK (7%) and the US (11.6%) are notable as the highest in the G20. In fact, the only two countries in the G20 that aren’t showing increased wage inflation are Germany and Russia. However, these figures don't reflect the whole economy. If reviewed by sector, they are often even higher, and for niche and in-demand skill sets, higher still. For example, in our own data, we have seen wage inflation of between 18.6% and 29% for high-level technical or highly specialised roles in the banking, finance and service sectors.

A key challenge for those in the C-suite is now competing financially for the talent their organisation needs to grow and develop. Gauging the right price to pay to attract and entice talent through your front door is a critical consideration. For many roles requiring niche or in-demand skills, there’s effectively a bidding war taking place.

Wage inflation is driving up the cost of doing business too. This is happening in all sectors, but it’s not affecting them equally. The impact of wage inflation is proportionate to the ratio of resource cost to output value or revenue. This disproportionately impacts professional and business service industries, where this ratio is over 45%. This area, along with the food and beverage service industry, recorded the two fastest increases in employment between January 2021 to January 2022. It’s easy to see how, with resource costs making up such a high proportion of operating costs, wage inflation will necessarily pass through into increased prices for the consumer.

It remains to be seen whether wage inflation will continue and whether it will further fuel price inflation, effectively creating a feedback loop with each pushing the other higher. A way out of this is through increased productivity. The more that processes and services can be automated and/or made more efficient offers a higher return against employee cost and means that higher wages can be accommodated without continued increase in overall resource costs.

Wage compression and wage inversion

Moving away from the effects on the economy and whole sectors, there are several effects that individual businesses will need to address. Hiring external talent in the current market can exacerbate challenges in other dynamics.

Wage inflation also brings with it two lesser-seen cousins that can be just as challenging: wage compression and wage inversion.

As organisations bring in new talent externally in a market with high wage growth, they find themselves paying ever increasing salaries for these new staff. As this trend progresses, the gap between their existing employees’ salary and new joiners in junior positions begins to narrow. This can mean that a manager hiring a new employee into their team may find that there’s only a small difference between their salary and what the market demands they pay for their new hire. This is wage compression. In extreme examples, managers may find that they must pay new hires more than their own salary. This is known as wage inversion.

Wage compression isn’t new. It can occur in organisations over time, typically it proceeds slowly enough that HR departments can identify and address it. It’s not just new hires on market inflated wages that cause this phenomenon either – increases in minimum wage, mergers and acquisitions and siloed compensation plans may all play an important role too, although these tend to cause compression over a longer period or in a more easily identifiable way.

Another cause of wage compression that has recently emerged is the increase in remote working. Organisations that previously operated a geographically based pay structure may have employees that have relocated to a lower pay area and retained their existing package. Wage compression can occur when that organisation then hires more senior employees into that area at the local, lower, geographical rate.

Wage inversion can also occur naturally, although more rarely. It is usually seen in highly specific hiring scenarios, such as hiring a highly skilled specialist for a particular task. Often these hires will be a contractor or on a fixed-term contract, which marks the scenario as a “special case” and provides some justification and legitimacy.

However, in highly inflationary markets, such as we have now, the rate of wage compression increases, and in turn, incidences of wage inversion can begin to occur more generally, and outside the realms of “special cases”.  The fact that many organisations may well be rationalising their own internal pay reviews due to headline inflation pressure on materials and resources only adds to the wage compression/Inversion risk.

The impact

It’s easy to see how wage compression can lead to problems for an organisation. A recent survey by Robert Half found that 56% of companies have experienced wage compression in the last 12 months. This scenario can cause several problems that negatively impact organisations on an individual and organisational level.

Individuals who find themselves on the wrong end of wage compression can become demoralised, disengaged, and decide to leave. At the organisational level, it can manifest in low morale, decreased productivity, increased sickness, and increased employee turnover.

For all these reasons, it can be an insidious danger to work culture as it damages the relationship between an organisation's values and their relationship to the value that individual employees bring to it. Because of the difference in the dynamic between internal and external salary increases, the impact is often disproportionately concentrated on those employees who have been with you the longest. The employees who you have invested the most in, and who are most knowledgeable about your business, your customers, and who are often likely to be delivering the most value.

Whilst wage compression itself is not illegal, it can unwittingly give rise to situations where fairness and equality can be called into question as grounds for discrimination due to race, gender, religion, sexual orientation, for example. As a result, there are many compelling reasons why organisations should be aware, understand, and have a strategy to mitigate the challenge.

Addressing the problem

How do organisations address the challenge of balancing attractive salaries for new talent, whilst providing equitable reward for their own?

Step one: Evaluate and be aware

Being aware of this issue and the possibility that it may be occurring in your organisation is an important first step. Many organisations are so focused on the external market and new talent coming in they reduce focus on their existing employees.

Step two: Measure it

There’s a standard formula for measuring and monitoring wage compression. We’ll take a fictional marketing department as an example.

  • Salaries in the marketing department range from £28,000 to £90,000, averaging at a midpoint of £59,000.
  • Ratioing individual salaries against this midpoint to calculate a percentage (actual salary/ department midpoint) x100.
  • Typically, new employees would join a company at around 75–80% of the midpoint. Longer serving or high performing employees would usually expect to be found at 120% of the midpoint or more.

Using this formula to plot all the salaries for the marketing team on a graph can illustrate the degree of wage compression that exists. This is known as a compa-ratio. It can be a useful tool for consistently evaluating wage compression in your organisation.

Step three: Decide on a strategy for prevention

There are many ways to address wage compression and the combination that you choose will depend upon the specific circumstances of your organisation. It will always be a balance of cost verses future benefit – but ensure that the full cost of replacing long-tenured, experienced employees is factored into any calculation.

Audit and optimise: Review your existing workforce and current practices. Where possible, formulate a plan for adjustments. This could be through direct wage increases, merit awards, bonus plans, paid leave, or additional rewards. Standardise an approver chain for compensation so it is monitored, and exceptions can be managed. Assess whether your role bandings are still relevant and appropriate to your organisation’s needs as it continues to evolve. Restructure your role bandings if necessary.

Monitor: Put in place a wage compression monitoring process and periodically review salary structure – reviews typically would be at a frequency of between 18 months and three years – more frequently in high inflationary periods, such as the one we are currently experiencing. HR software can also support in monitoring wages within an organisation and prevent the compression or inversion from occurring.  

Employee experience: Explore options for upskilling, training and developing your existing staff. Provide each team member with a clear career trajectory to help them understand their long-term progression and future earning potential. Decouple promotions from immediate salary increases. Promotions can be incentivised by future salary opportunity, especially if an individual is at the top or over the range in the current role.  

Candidate experience: Adjust your new hire strategy to focus on candidates who are looking to progress. Build “performance over time” incentives into the total package. Hiring just below the position that you’re looking for can avoid paying a premium for those who have already attained it. Consider alternative employment methods, fixed term or workforce consultancy engagements may cost more, but are time-bound or outcome-based. 

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