The case against pay inversion.

In the competition for new employees, companies sometimes will offer a higher salary to the new hire than they are currently paying to better-qualified current employees in similar positions. In short, their pay scale is inverted. While various rationales are offered for this practice, such as market pressures or a dearth of suitable prospects, firms should be aware of potentially harmful fallout. This may include higher direct and indirect costs, low employee morale, negative effects on society, and questions about management's ethics and competency.

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Mary, a health care employee, joined the firm 10 years ago and has become a highly skilled employee. She has always received high performance evaluations and is viewed as one of the best employees on the staff. Another member of the department retired, and Mary's manager went outside for a replacement. They hired a new employee who had just graduated from a program no better than the one Mary attended. The new person's job duties were identical to Mary's, but the new person wasn't as proficient as Mary, so Mary was asked to train and mentor her. Nonetheless, this new employee was offered a salary 10% higher than Mary's.

This example describes an ever-growing phenomenon, pay inversion. This is different from salary compression because the less-qualified new hire is making more than a more qualified current employee. In a 2002 study, the Institute of Management and Administration asked HR professionals to list their top compensation problems ("How to handle," 2002). Salary compression was mentioned most often (25%), followed by retention and recruiting (18%), hot skills (15%), and offering competitive pay (15%). Since these last three issues may also be linked to pay inversion, the problem may be greater than the compression figure (25%) alone suggests.

Although the difference between compression and inversion may be a few hundred dollars, it is not unreasonable to expect current employees to react much more negatively to pay inversion because they are going from "earning more" to "earning less" than the less-qualified new hire. Inversion is expected to have a much greater negative impact on employees than compression because it is likely to be seen as being more unfair. While employees may be able to shrug off compression, they may have much greater difficulty ignoring inversion.

Labor shortages resulting from baby boomer retirements will further exasperate the pay inversion problem. Horrigan (2004) cites statistics showing that as the 76.4 million baby boomers start reaching age 65 in 2011, fewer workers will be available to take their place. Jones (2002), Reinhardt (2003), and Hoffman (1999) believe construction, engineering, health care, and fast food will all be affected. Even before the baby boomers start to retire, the Bureau of Labor Statistics' projections show the U.S. could have a shortage of more than 10 million skilled workers by 2010 (Greenwald, 2003). Greene (2003) reported that some firms such as P&G, Home Depot, and Eli Lilly are already experiencing the problem.

Pay inversion is defined here as the hiring of new employees for a specific job who have fewer credentials or lower overall job performance, or both, at a higher compensation level than that of current employees. This definition acknowledges that new employees for a specific job may be more competent and have better credentials than current ones and, hence, their higher pay would not constitute pay inversion as defined above. This definition also takes a broad view of compensation and recognizes that pay is only one aspect of total compensation. Various perks such as stock options, meal allowances, vacation schedules, office choice, and a company car are all part of compensation. Also, while older employees may be more likely to be affected by pay inversion, younger workers may also be affected. As such, the term "current employee" is used rather than "older employee" unless age is a specific issue.

This article discusses the typical reasons given for pay inversion, analyzes the arguments against it, and offers several ways of addressing the problems it creates.

Why Firms Engage in Pay Inversion

A typical explanation for why firms practice pay inversion is that the "market" demands it. Basic economics says that when employees are in short supply, an employer must pay more to attract an applicant. As a result of labor shortages, organizations feel they have no choice but to invert pay to hire well-qualified people.

In addition, a firm may invert pay because it sees two different markets, one for current and one for new employees. As Gomez-Mejia and Balkin (1987) note, pay levels at "entry ports" must be tied to external markets and set high enough to attract new entrants. However, current employees often have limited mobility so they can be retained despite paying them less.

In addition to the market argument, firms often justify pay inversion on the basis of business necessity (Bravin, 2005). They cannot afford to raise the salaries of current employees to market rates due to budget constraints, and may also believe the cost of doing so would keep the firm from being competitive.

Firms also feel justified in practicing pay inversion because they believe it is legal. Even though inversion may disadvantage older employees, it maybe legal under the Age Discrimination in Employment Act (ADEA). Although the Supreme Court recently ruled that a case could be filed if pay policies have a disparate impact on older employees, it said that "business necessity" is a legitimate defense (Clark, 2005). Therefore, it is still difficult for older employees to gain relief under ADEA.

In addition to justifying inversion based on market conditions, business necessity, and legal considerations, companies may also feel there are no ethical prohibitions against it. This is because most firms implicitly or explicitly use utilitarianism as an ethical guidepost, according to Berkowitz, Kerin, Hartley, and Rudelius (2000). Utilitarianism looks at the benefits and costs of a decision in the hope of arriving at one that helps the most while harming the fewest. This theory makes it easy for management to justify inversion by arguing that the benefits to the firm outweigh the costs. The benefit may include lower recruiting costs, a better candidate, improved morale or productivity of current employees as staffing levels increase, and better customer service. The perceived costs may include higher turnover and, as discussed in next, lower morale or productivity. Since the perceived benefits are more tangible and immediate while the perceived costs are less tangible, more uncertain, and more likely to occur in the future, it is easy for management to justify pay inversion under utilitarianism.

A final argument in support of inversion is that managers may believe it has little effect on the motivation and morale of current employees. They may believe current employees will still work hard out of a sense of responsibility to their boss and co-workers and, in some situations, a commitment to the profession. Even if there are morale-related costs, management may believe the costs will be "at the margin" and have little impact on overall productivity.

Arguments Against Pay Inversion

In the previous section, a case was made for practicing pay inversion, while this section examines the arguments against it.

* Increased costs. One inevitable outcome of a seller's market and the resulting pay inversion is increased payroll costs as employees job-hop to receive better compensation. In addition to payroll costs, firms will have costs related to recruiting, hiring, and training the new employees. Lavelle (2003) cited a study conducted by the Hay group showing these costs can be quite high. The Hay Group estimates the replacement costs for professional employees can be equal to 18 months pay, not including lost sales and productivity. Admittedly, these costs are likely to be less than raising the salary of all, more qualified, current employees.

In addition to these direct costs, numerous indirect costs stemming from lower motivation and job satisfaction are likely. According to Adams' (1963) Theory of Equity, workers determine if they are being treated fairly by comparing their contributions to the firm (inputs) against their rewards from the firm (outcomes) in relationship to another worker's inputs and outcomes. If an individual believes the two ratios are equal, then the situation is considered fair, and motivation and job satisfaction should be high. If the two ratios are not perceived as equal, then the situation is unfair, and motivation and job satisfaction should drop. Likewise, discrepancy theory views worker perceptions of pay satisfaction as a function of the perceived amount of compensation one receives versus the amount one feels is deserved (Heneman and Judge, 2000). Most workers would see salary inversion as unfair based on equity theory and discrepancy theory since the new hire's inputs (credentials, job skills, productivity) are less and the outcomes (salary and perks) are more.

Another management theory related to fairness, based on the work of Rousseau and Parks (1992), is psychological contract theory. It argues that employment offers and acceptances are based on mutual understandings. During the hiring process, the employee and the firm reach an implicit understanding regarding what each will give and receive in return. This agreement serves as an unofficial contract between the two parties and is subject to change, but only by mutual consent. When a firm unilaterally changes the rules and breaks its promise, it breaches the psychological contract. Based on pay practices at the time they were hired, older employees would reasonably expect their psychological contract to include the provision that they would be paid more than less-competent new hires. This is less likely to be true for younger workers hired under a pay inversion environment.

Some may believe it is acceptable to break the psychological contract if it allows the firm to remain competitive. Although it is unlikely airline employees ever expected their salaries and benefits to be cut so dramatically, most have accepted the cuts (and the implicit breaking of the psychological contract), if grudgingly, since most recognize the cuts are required for survival. However, unless employees believe the firm's survival is at stake, they may not respond favorably to a breach in the psychological contract. Employees may question how hiring a less qualified employee at a higher salary makes the firm more competitive.

According to fairness-based management theories, employees who feel they have been unfairly treated will take action to achieve equity and restore the perception of fairness. Some of the best may respond to inequity by leaving, a less than desirable outcome in an era of worker shortages. Another response may be to work only at a reduced or minimum level, the reverse of what the firm wants. Likewise, employees may reduce what Dennis Organ (1994) calls discretionary organizational citizenship behaviors, e.g., no longer providing extra help to the firm or co-workers or not volunteering for new assignments. When employees attempt to achieve fairness by reducing their work efforts, other employees may be affected. If one of those co-workers is the new hire, his or her potential may never be reached, making it harder to justify the high salary. Even worse, current employees may take out their frustration on the new employee, or they may bad-mouth the firm to the new hire to restore a perception of equity. Either way, the new hire's chances of success are hampered.

Many firms today are stressing the importance of teamwork and want all employees to work effectively as a unit. Pay inversion may reduce an employee's desire to have a commitment to the group. In fact, it may even cause one to sabotage group efforts or the acceptance of a new hire into a pre-existing group. Bohl (1999) cited a study done by the editors of the Compensation and Benefits Review where 65% of the firms reported that the special treatment afforded hot-talent workers created tension with other employees, reducing the likelihood of group commitment. Although difficult to measure, the indirect costs of inversion may be huge, far exceeding direct costs.

* Harms society. Pay inversion harms society in a number of ways. First, it may reduce an employee's sense of commitment to the firm and the community (Bridges and Harrison, 2003). Under pay inversion, employees quickly learn that if they want a higher salary, they must move. Is constant mobility best for society? Does society want a nation of "owners" who develop a sense of loyalty to their employer and community, or of "renters" who see themselves as temporary employees with no attachment to either? From a public policy perspective, people should be encouraged to get involved in their firm and community. Policies that create a nation of transient and uninvolved people should be discouraged.

Second, inversion harms society by lowering the self-esteem of current employees, especially older ones. Since pay is a form of recognition and status, inversion connotes to current employees that they are not as valued as newer ones. While pay inversion may increase the person's desire to leave, the negative psychological impact of inversion may keep him or her from doing so. The result is, according to Snape and Redman (2003), the older worker feels trapped and becomes more likely to take retirement as soon as the option becomes available. In an age of worker shortages, this is not desirable. Third, pay inversion harms society by perpetuating two age stereotypes. The first stereotype holds that older workers are loyal and dedicated to their employer (Erwin, 2003). Unfortunately, while positive, this stereotype fosters pay inversion by reinforcing the idea that the older employee's sense of loyalty and dedication to the firm will overcome any negative feelings about being paid less. The more negative stereotype of older workers is that they have poorer health and inflexible attitudes, resist change, and lack the ability to be trained, according to Chiu, Chan, Snape, and Redman (2001). As O'Boyle (2001) noted, this view makes "credible the stereotype of the older, longer-service employees as inferior to the younger, newly-hired workers, thereby reinforcing the vicious circle of discrimination against the older worker."

Fourth, pay inversion may encourage older employees to retire early or to retire-in-place until retirement, thereby wasting human capital (Lavigna, 2005). If older employees retire early, society loses because it no longer benefits from the older employee's skills, experience, and knowledge of organizational history. On the other hand, if older employees retire-in-place until retirement, society also loses because firms become less competitive. Firms may not realize that the reason some current employees, especially older ones, act like deadwood is because they killed the tree!

Finally, anything that encourages retirement harms society by putting additional pressures on Social Security and Medicare. Many articles have addressed the upcoming problems faced by these programs (e.g., Savings, 2004). The longer baby boomers wait to retire, the more they pay into Social Security and Medicare, thereby lessening the problem.

* Raises management competence issues. In addition to increased costs and harm to society, a third argument against pay inversion has to do with how it affects employee perceptions of management competence. If employees don't accept management's arguments for inversion they are likely to question the competence of management in dealing with pay and perhaps other issues. As it is, only 51% of employees have confidence in senior management (Sager, 2005). Unless the issue is handled properly, this is likely to drop. Employees may question management's competence if they do not believe the market-necessitates-it argument, believing that when someone says the market starting salary for a particular job is $X, the person is typically referring to an average based on a range of salaries. So, employees may believe management should be able to hire new workers at a wage point more in line with that of current employees if it were more skilled at recruiting.

Likewise, some workers might also believe salary inversion is not a result of business necessity but of management incompetence, selfishness, or laziness. This is likely if employees don't believe that increasing the pay of productive current employees would seriously harm the firm's competitiveness. It is also likely to be true if the firm has a lavish corporate headquarters or gives executives extravagant pay, benefits, and perks. They may believe management is throwing money at new hires to make the process easier for them and using company funds to enrich themselves at the expense of current employees. Therefore, to the extent management can't or doesn't present convincing arguments as to why pay inversion is necessary, employees may question the ability of management to deal with pay and hiring issues. Because pay is so important to employees, the perceived failure to address inversion may encourage them to question management's competence in other areas as well.

* Raises ethical issues. Finally, Glassman and McAfee (2005) show how pay inversion could be considered unethical according to a number of theories. Boatright (2003) states that Aristotle, in Book V of the Nicomachean Ethics, expressed the idea that equals should be treated equally. This concept, distributive justice, suggests that people who perform similarly should be given similar rewards. Salary inversion violates this principle. Similarly, Boatwright (2003) suggests under Kant's approach to ethical behavior, people should be treated with respect and only as they have freely consented to be treated. It is unlikely that most current, productive employees would freely consent to pay inversion except in the rarest of circumstances. It is also unlikely they would feel pay inversion treats them with respect. Finally, one could argue that pay inversion is unethical because it doesn't provide employees with a logical set of rules for determining their compensation (Boatright, 2003). It also contradicts the societal notion that pay should be based on job performance. It is unlikely most employees would consider it ethical to base pay grades for all jobs on when one was hired and the market at the time rather than on job performance.

Are There Solutions?

There is no perfect solution to the pay inversion problem, and no single approach will fit every situation. Nonetheless, there are at least three alternatives firms could consider to minimize eliminate the problem or mitigate its negative effects.

First, firms could simply refuse to invert pay because they believe it is morally wrong. These firms compete for workers on the basis of their nonsalary strengths such as location, work environment, team orientation, flexible work schedules, etc. They can also present their policy of treating employees fairly, particularly with respect to pay, as an indicator of high ethical standards. By competing on these strengths, firms may be able to attract employees who have either experienced pay inversion, believe rewards should be performance-based, have a strong need for fairness in the workplace, or have a long-term orientation and do not want to be a victim of future inversion.

Second, firms can try to minimize the inequity caused by inversion by providing a combination of monetary and nonmonetary compensation (choice of work schedules, overtime, vacation, office location, parking, etc.) based on job performance. Here, compensation means more than money and includes tangible services and benefits (Hornsby and Kuratko, 2002). One approach would be to divide victims of inversion into three productivity-based categories. The first, consisting of those few who are truly outstanding, would be given primarily monetary compensation to ensure they stay. Those in the middle group, which most likely represents the majority of those affected, could be given primarily nonmonetary compensation based on productivity. The cost of providing nonmonetary compensation should be significantly less than raising salaries yet gives productive current employees concrete evidence that the firm is trying to address the issue and restore equity. The third group, which should be relatively small, represents those whose performance is only slightly better than the new hire. These people could be given little, if any, nonmonetary compensation. It should be made clear to all that these actions are designed to compensate for salary inversion.

Third, firms could take a utilitarian approach and not grant new employees normal pay increases until the wages of current productive employees have caught up. Under this philosophy, management believes the benefits of giving the new employee's raise dollars to productive long-term employees outweighs any costs to the firm of having an unhappy new employee. This practice is consistent with Gomez-Mejia and Balkin's (1987) distinction between internal and external markets. Specifically, once hired the new employee is now a viewed as a current employee. As such, the employee is now part of the internal market and can be retained for a lower wage because of the costs of searching for a new job and possible limited mobility.

During the new employee's first salary review (which might be delayed beyond the normal time frame), it could be made clear to the new hire that the firm believes in pay for performance, and since the new hire's salary is greater and the level of performance is lower than that of current employees, normal raises should not be expected until performance increases to a level commensurate with the salary. Productive current employees, during their salary review, could be told they are getting an inversion adjustment over and above their normal raise. This approach makes it clear to all employees that the firm is aware of inversion-caused inequity and is making a good faith attempt to address it.

Many articles present "how-to" tips for dealing with inversion. For example, a recent issue of HR Focus ("How to avoid," 2004) suggests additional overtime for current employees, more frequent salary reviews for present employees, and the creation of new, higher-paying job categories for them.

The important point is that when management evaluates potential solutions, it must select one consistent with the firm's philosophy, culture, and ethical values. This is true whether the solution is a "how-to" tip or is theory-based. For example, on its Web site, GE says it has a performance meritocracy culture ("Employee relations," 2005). Based on this statement, GE must select a solution consistent with a meritocracy culture if it wants to maintain credibility among employees. Alternately, Kroger's mission states that it will treat associates with respect, openness, honesty, and fairness ("Corporate news," 2005). Therefore, it would want to select a solution consistent with these values. No matter what method is used, management must tell employees the costs and benefits of pay inversion and how they are addressing the issue, even if nothing is being done. This is consistent with the literature on procedural justice that suggests employees judge not only compensation decision outcomes but also the process used to make those decisions. As part of this discussion, top management must honestly and convincingly present a strong case for inversion, how it will benefit the firm and the employees, and what the firm intends to do about inversion in the future. The extent to which management follows these suggestions will determine whether or not pay inversion is a major or minor problem.

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R. Bruce McAfee, Old Dominion University 

Myron Glassman, Old Dominion University

Dr. Glassman, a professor of marketing, has published over 50 refereed journal articles. Dr. McAfee's teaching and research interests center on employee motivation and employee relations. He has published numerous articles and 10 books, including Applications in Human Resource Management (5th).