What is a compensation philosophy?
A compensation philosophy determines the “why” behind pay.
It is a formal written statement that explains your company’s approach to how you pay your employees, based on your business strategy and company culture.
But it is more than a static document. It is the source of truth that guides your future pay decisions.
And it articulates your employee value proposition: the unique set of benefits, rewards, and advantages that make people want to work for your organization.
Why do you need a compensation philosophy?
Ultimately, the purpose of any philosophy or strategy around pay is to attract high-caliber candidates, as well as engage and retain your employees.
Whether or not you’ve written it down, you are already making decisions about pay that form your compensation philosophy in action.
Documenting and standardizing these decisions helps you ensure that your pay practices are fair and competitive.
In this context, fair pay means that pay should be perceived as equitable across your organization. (In case you missed it: equitable pay is not the same thing as equal pay.) A statement of commitment and action items around pay equity are important sections to include in your compensation philosophy.
Competitive pay is a little more complicated. It doesn’t necessarily mean paying the highest salaries around. It means that your compensation philosophy should build out a total rewards package that offers value when compared with the market.
What is “the market” anyway?
The market is shorthand for the labor market or the cost of labor, where the “going rate” of pay for a job is determined by how much your competitors pay.
In this context, we’re not talking about the competitors that you position your product or service against. Rather, it’s who you compete with for talent: when candidates choose a job offer with another company, where are they going? That could mean companies in the same industry, but it could also mean companies that are similar to yours in location, size, stage of growth, and recruiting for similar roles.
For example: an advertising agency trying to hire a social media coordinator competes with other ad agencies, but also with consumer brands, non-profits, and any company that runs their own social media team in-house.
In an increasingly remote world, your competitive set might also include organizations that you’ve never considered before - like tech companies in another country - whose increased hiring reach may be shifting your local salaries.
With so much competition in the market, a well articulated and strategic compensation philosophy helps you define the unique employee value proposition, the special sauce, that makes you stand out from the crowd.
So how do you win in your market?
When setting your pay relative to your competitors, there are three approaches you can take: you can meet the market, lead the market, or lag the market.
Each strategy has a use case, but it all depends on your company’s unique situation and on how you leverage your total rewards offering.
Here comes the world’s tiniest refresher on total rewards! An employee’s overall compensation has a couple of different components:
- Base Pay (the salary)
- Short-Term Incentive Pay or Variable Pay (like bonuses and commision)
- Long-Term Incentive Pay (like stock options and RSUs)
- Benefits Programs (like health and dental)
- Relational Benefits (like working for a good cause or achieving career growth)
Each of these has a role to play in making your compensation competitive.
1. Meet the market
The most common strategy is to match the midpoint of the range of pay that your competitors offer. This means you offer a fair and competitive wage, but not “top dollar”.
With average pay, you might choose to allocate budget towards something else to differentiate yourself from all the other companies. You can offer a generous vacation program, or a learning & development budget, or even bump up bonuses during boom times. A common example: early stage startups often lean more on “at-risk” pay or long-term incentives such as stock options.
This approach may make it harder for you to hire critical, in-demand roles and also risks that your superstar employees are more susceptible to leaving for a better offer.
But overall this strategy is a safe bet, especially if you aren’t suffering from any particular hiring or attrition problems. It also works well when your employee value proposition aligns with the interests of your team, such as an airline that offers awesome travel perks.
2. Lead the market
Leading the market means that you are purposely setting salary rates above your competitors to improve recruitment and retention.
You are establishing your company as the one to beat when competing for top talent. Paying extremely well usually has a positive impact on employee morale and can boost productivity. Companies that choose this approach often go all-in with excellent benefits as well.
This tactic comes with high payroll costs, and often high pressure revenue goals and performance expectations to match. It might be right for a company in a very competitive industry, for organizations that are highly profitable or well-funded, or for companies with aggressive growth goals.
If you have the deep pockets for this expensive strategy, it just might pay off.
3. Lag the market
Lagging the market means that an organization pays less than the market midpoint.
This is the least common strategy because lower pay can result in difficulty hiring, higher than average turnover, and lower team performance.
However, this philosophy can work well in the public sector or non-profit world, where factors like robust benefits and strong value-driven work balance out lower pay.
This is a perfect example of the power of the other parts of the total rewards package. Not everyone is motivated by a higher salary. It also highlights the importance of the overall employee value proposition. If your organization offers the opportunity for meaningful work, incredible work/life balance, cool industry perks, or rocket ship career growth, then lagging the market can still be a winning strategy for you.
+1. Mix it up!
I said there were 3 ways to structure a winning compensation philosophy, but since we’re talking about unique and unexpected differentiators - surprise! Here’s 1 more way to mix up your secret sauce.
Many organizations benefit from a combination of meet-lead-lag approaches.
For example, you might choose to lead the market only on positions that are very difficult to fill or critical to company operations. You may choose to lag the market in geographic areas where there is an oversupply of a certain kind of talent.
There are infinite ways to tailor the right mix and drive results, which is why a good compensation philosophy and a well-designed rewards program can be an absolutely vital pillar of a winning business strategy.
If you go this route, just make sure that you are paying consistently for repeatable or substantially similar roles to avoid creating pay inequities.
Does your compensation philosophy pass the test?
As your company grows and the market changes, your compensation philosophy will naturally need to evolve with it.
According to the Society for Human Resources Management, an effective compensation philosophy should pass the following quality test:
- Is the overall program equitable?
- Is the overall program defensible and perceived by employees as fair?
- Is the overall program fiscally sensitive?
- Are the programs included in the compensation philosophy and policy legally compliant?
- Can the organization effectively communicate the philosophy, policy, and overall programs to employees?
- Are the programs the organization offers fair, competitive, and in line with the compensation philosophy and policies?
With these thoughtful principles documented in a compensation philosophy, you are well on your way to making better pay decisions that help your company win.