Every company has a unique compensation philosophy that drives the way they pay their team. Some companies intentionally focus on a specific compensation philosophy. Others follow one without really knowing it.
We live in a time when people want transparency and openness when it comes to compensation. It’s not your grandfather’s world anymore. Secrecy and wage gaps are becoming things of the past, but we’re not quite there yet. And sticking to a compensation philosophy can help your company lead the way toward a more equitable future.
There are really only three different compensation philosophies to choose from. But before we explain them, let’s take a closer look at what a compensation philosophy actually is.
What is a Compensation Philosophy?
A compensation philosophy is a blueprint that guides the way a company pays and rewards employees for their work.
Some companies write their philosophy down and weave it into their compensation policy. Others don’t articulate it at all. They might follow one of the three core philosophies without even knowing it.
But remember what we said earlier about leading the business world into a time of transparency instead of secrecy?
To do that, you must articulate your compensation philosophy if you haven’t already. It can guide the decisions you make as you recruit, interview, and hire new talent. It can also help you modify the compensation package you offer current employees to match what you offer new hires.
In short, a compensation philosophy unifies your comp strategy and helps you provide fair pay and benefits to everyone on your team.
The Only Three Compensation Philosophies
Leading the market, matching the market, and lagging the market.
These are the only three compensation philosophies that exist. Look at any company’s written comp philosophy and it’ll lead back to one of these concepts.
Keep in mind that in this context, the market doesn’t mean all industries everywhere. It means your industry and the corresponding market of people who purchase your goods or services.
For a restaurant owner, this would mean the hospitality sector—people who dine out, stay at hotels, and engage in tourism.
Content marketing agencies would fall under the marketing sector. Outpatient physical therapy centers would fit into the healthcare sector.
Think about where your company fits in as we dig into the meaning behind each of the three comp philosophies.
Leading the Market
With this compensation philosophy, you consciously pay your team more than the market average. If you pay your team a salary in the 75th percentile or higher for your market, you’re leading the pack. In other words, you pay your team more than 75 percent of the companies in your market pay their employees.
Say you’re an environmental law firm in the Salt Lake City area. Instead of paying attorneys a starting salary of $140,000 to $180,000, you’d start at $200,000 with excellent benefits.
Or, let’s imagine you own a restaurant in Anchorage, Alaska. Rather than pay your servers the typical hourly wage of $10-$15 an hour, you’d start new hires at $25 an hour with health insurance, PTO, dental insurance, and retirement benefits.
Obviously, leading the market comes with higher costs. Companies who adopt a lead-the-market philosophy must make sure they can afford to pay top wages and salaries. They have to aggressively keep pace with inflation, too, and make sure that the people they hire are worth the big compensation package.
So what are the advantages of this compensation philosophy?
It all boils down to this: great pay makes employees feel valued and cared for, as evidenced by a 2017 study published in the European Research Studies Journal.
This high morale drives employees to give the company their best effort. You can expect top levels of productivity and performance from highly paid employees. Plus, above-market compensation also motivates employees to stay with a company over the years.
But it’s also important to remember that employees are human. They need rest and relaxation outside of work, and they can’t function at 110% all the time. An above-average compensation philosophy can put enormous pressure on your team.
So, when does it make sense for you to implement a leading-the-market compensation philosophy?
- You’re a highly profitable company that can easily afford it
- You operate in a competitive industry where top talent is hard to find
- You want to recruit the best of the best
Just make sure you cultivate a workplace culture where rest and PTO are valued.
Matching the Market
Take a look at the median salaries for various roles in your industry. How does your compensation stack up? If you’re smack-dab in the middle, you’re matching the market.
Matching the market means paying your team at or near the 50th percentile. You’re not paying more than average, but you’re also not paying less than average. You’re in the comfy middle. It can feel like a safe place to be, especially if you’re a newer company and aren’t pulling in the profits you want just yet.
Under a meet-the-market philosophy, your employees can compare their salary to the median and find that it lines up. They won’t feel underpaid.
But they might also feel like they could make more elsewhere, which is one of the downfalls of this strategy.
And if you’re in a competitive field, you might struggle to attract and retain the best talent. That’s why the meeting-the-market philosophy is best if:
- You’re in a non-competitive industry
- You need to pay close to the median to avoid blowing your budget
Reassess your strategy year by year to make sure you keep up with the median salary. If things get competitive, consider inching up to somewhere between the middle and the lead, like the 55th, 60th, or 65th percentile.
Lagging the Market
There’s not a lot to love about this compensation philosophy. Lagging the market means you’re paying employees in the 25th percentile or below, which means that at least 75% of companies in your market pay better than you do.
If you aren’t already dealing with turnover and retention issues, you will soon enough. Employees who get paid less than the market average tend to feel undervalued. Unless you offer an outstanding company culture and great benefits, they’ll jump ship as soon as the opportunity arises.
And in some cases, even your cool benefits and healthy company culture won’t be enough to keep them around. Direct compensation is what employees care about the most.
So really, the only reason you’d follow a lag the market philosophy is out of necessity. Because sometimes you just don’t earn enough profit to pay above the 25th percentile.
If this describes your company, it’s time to sit down and take a good, hard look at the budget. Is there anywhere you can cut costs so you can pay employees more?
Or could you purchase a better health insurance plan without breaking the bank?
Look for ways to make up for your lagging-the-market philosophy. Inch up toward the mid-market pay range when you can.
Steps to Determine Compensation Philosophy
As you’ve probably realized by now, choosing a compensation philosophy is more complicated than just picking the one that sounds the best. There are several factors that play into the comp philosophy you can offer.
There’s also wiggle room within each strategy. If you adopt the lag-the-market philosophy but pay a salary that sits in the 35th percentile, you’re doing better than those in the 25th, 15th, or (yikes!) 10th percentile.
Are you trying to figure out what your current compensation philosophy is? Or are you actively choosing one before you start a business?
Either way, you’ll take these three steps to get started.
1. Define Your Target Market
Step back from your desk for a moment and take a look at your company. Ask some basic questions. What product or service do you sell? Who are your customers? What is your industry?
Do employees work remotely, on-site, or a combination of both? Where does your team live?
Your answers to these questions will help you figure out your market.
Let’s pretend you’ve recently opened a marketing agency. You live in the Denver area and you want to hire a few local employees to help run your business, which is booming.
Most of your clients are local breweries, ski resorts, farm-to-table restaurants, and boutique hotels. The post-pandemic world is hungry to enjoy Denver’s luxurious ski resorts and stunning views. And they have the cash to do it.
So even though you work in the advertising industry, you serve people in the hospitality sector. You’ve taken on more work than you can handle alone, which is why you’ve leased a 2,000-square-foot office in downtown Denver high-rise for $32 per square foot. This means you’ll pay $64,000 for a year’s worth of rent.
Now you need to have enough cash left over to pay the employees you’re currently recruiting. And while it’s not NYC, Denver is a moderately expensive place to live.
Rent costs $1,780 on average. Homes sell for a median price of $485,000. You plan to provide a good salary plus excellent benefits, including health and dental insurance, retirement, and childcare assistance.
You’ll offer 20 days of PTO per year and provide an office-wide lunch once a week. Oh, and you’re also bringing in a Nespresso machine to keep everyone well-caffeinated. No gas station-style coffee for your employees!
If you were this Colorado employer for real, you’d want to implement a strategy that lands between meeting the market and leading it.
2. Research Competitors
Before you can actually put your comp philosophy into words, you need to see what it would look like on paper.
To do this, research what your competitors pay their employees.
Look at job postings for similar roles in your area. Google the median income for people who work for companies like yours. Reach out to local organizations and trade associations to see if they’ve conducted salary surveys you can look at.
This research will give you a sense of the salary and benefits you need to supply for your desired comp philosophy.
In Denver, marketing agencies pay employees around $97,000 a year. You’d have to offer the same or higher to meet or lead the market.
3. Adopt a Realistic Compensation Philosophy
Now you know your market. You also know what it’s going to cost to hire in your market. It’s time to pick a philosophy that aligns with your budget and long-term goals.
Make sure you keep things realistic. Paying your employees well means staying within your means. If you can’t afford to pay three employees a salary that meets or leads the market, hire one or two employees instead. You can adjust as your company earns more profit.
Or, if you’re already an established business and you’ve realized your philosophy has been to lag the market so far, make a plan. Look at your payroll budget. Work toward meeting the middle instead.
Eventually, you might be able to lead the pack.
No matter which compensation philosophy fits your needs the most, outline it in a simple, clear, and honest way for your employees. Let them know where you currently stand and where you want to be when it comes to your comp strategy. Invite discussions and questions.
If you’re managing a larger company that’s been in business for a while, you might need to work on eliminating lingering pay gaps and less-than-transparent compensation practices.
Whatever you do, let your ideal comp philosophy guide the way.