As Minimum Wages Rise, Prepare for Pay Compression Issues

Pressure to increase wages for the lowest-paid employees, driven by the need to attract workers and to stay ahead of rising local, state and federal minimum wage mandates, is "a red-hot compensation topic right now," according to a panel of pay authorities who spoke at WorldatWork's 2021 Total Rewards Conference, held virtually in October.

Raising minimum pay levels can require revisiting pay ranges throughout the compensation structure, the panelists noted. As a related issue, many benefits costs, such as 401(k) matching contributions and incentive bonuses, are linked to employees' base pay and will become more expensive as wage rates trend higher.

These issues, they said, will arise whether through a higher pay threshold mandated by local law, as is often happening now; by an eventual upward adjustment in the federal minimum wage level; or simply in response to the tight labor market, especially for hourly workers.

"This is all a balancing act," said Heather Krechmer, a senior compensation consultant at PayScale, a Seattle-based compensation data and software firm. "Increasing minimum wages, whether mandated or not, is going to come with a cost." Those costs include "not only bringing employees up to a new minimum wage, but addressing potential pay compression issues affecting employees at higher pay levels."

"In hospitality, we have a number of [employees who] have jumped from hotel to hotel, primarily because of the higher wages that competitors have been posting," said Megan Surdo, senior director of compensation for Aimbridge Hospitality, a third-party hotel management company in Cummings, Ga. "On the flip side, even if we're able to bring a new associate into our hotel at a higher rate, we have to struggle through the compression concerns that we have with internal pay rates for our associates who have been tenured for a long period of time."

Addressing Wage Compression

For many employers, "their biggest concern [regarding raising minimum pay levels] is making sure that they're still able to differentiate pay for people who aren't in minimum wage positions, and how they're going to pay to do that," Krechmer said.

Greg Stoskopf, managing director at Deloitte Consulting in New York City, explained that "employers are looking at the cost of correcting compression, and are taking employees who are already above the new minimum and adjusting their pay accordingly so that some of the differentials previously in place between those at the lowest level of pay and those above them are kept in place."

Employers may make that adjustment all at one time, he noted, or they may look at a phased approach "where the compression is addressed over time due to the cost involved."

Often, Krechmer said, there are multiple levels of positions within an organization that are falling below $15 an hour, and employers "need to create a structure that's going to allow flexibility and also allow for pay to be differentiated." For example, "if you have a cashier, a lead cashier and a senior lead cashier, you want to make sure that you differentiate pay for experience as well as for performance, and allow for career progression. For organizations that are moving from, say, $8 an hour to $15 an hour for the lowest-paying positions, there are many levels that are being impacted by compression."

Some employers are responding by merging multiple job-position levels into one or two, Krechmer added. But "within the pay structure, it's important to keep levels in place, as part of employees' career track, keeping people engaged by showing them how they can progress within the organization."

Surdo concurred, saying, "People want to feel like they're growing, they want to feel like there's movement through their career path, and narrowing different levels into a single pay rate can eliminate the opportunity to proceed through that career range."

Implications Beyond Base Pay

"Incentives are typically driven off of base pay," Krechmer said. "In its simplest form, as base pay increases, so will the size of incentive payouts."

For employers, "this is an increase to the bottom line that needs to be budgeted for and planned for accordingly," she said.

Unemployment compensation is similarly linked with base pay, Krechmer noted. "As the minimum wage base rises, so does the size of the required payment for unemployment insurance."

Employers' Social Security, Medicare and retirement plan contributions will also go up as low-end pay increases, Stoskopf pointed out. "As wages rise, employers will be required to pay more into these social safety nets, as well as potentially higher profit sharing and bigger matches in 401(k) programs."

Employees should also be informed that, as they earn more, the change in their tax rate could potentially lead to lost eligibility for certain tax credits, he observed.

These consequences "may be hidden inside the wrapper of the increasing minimum wage," Stoskopf said.

Companies that may be offering some short-term incentives for low-wage workers "could think about moving some of that variable pay over to base pay," Krechmer advised. "Often, employees who are making $15 an hour would much rather have more fixed pay as opposed to a variable component." She suggested that employers consider "how you can leverage the pay budget in the most strategic way."

As a recent example, when Walmart increased hourly wages for hundreds of thousands of its lowest-earning employees at the end of September—raising its starting wage to $12 from the $11 floor established in 2018—it also announced it was phasing out its quarterly bonuses for store workers, ending a decades-old practice.

Planning Ahead

When preparing to factor pay-range adjustments into compensation budgets, "plan now for what you anticipate will happen down the road," Krechmer advised.

The panelist recommended the following steps to prepare for minimum wage increases:

Discuss with leadership when and why the minimum wage should be raised to remain competitive or in response to government mandates.

Run a general census to get an idea of how many people fall below $15 an hour.

Model a revised pay structure for raising the minimum wage, with a goal such as increasing the lowest wage to $15 an hour over the next two to three years.

Assess the impact of rising wages for new hires against the wages of more tenured employees by analyzing how much employees make compared to one another and their managers.