Pay Compression and a Three Percent Merit Pool
A 600-employee software company has set a 3% merit budget for the year. Market data shows software engineers paid near the 50th percentile, but new engineering hires have been coming in near the 65th percentile because of hiring pressure. Voluntary turnover in engineering is 12% against 7% company-wide, and five of nine engineering exit interviews cite pay. Two senior engineers with eight years of tenure have just learned that a new hire with two years less experience earns $12,000 more in base. Their manager has submitted an off-cycle adjustment request for both. Engineering is roughly 25% of total payroll, the bonus pool is funded at 8% of payroll, and the CFO has said the 3% pool is the only compensation money available.
1. How should the 3% merit pool be allocated, and what is the trade-off in the allocation choice?
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The budget is fixed, so the decision is purely about distribution. Do the arithmetic out loud: engineering is about 25% of payroll, so giving engineering the entire pool would fund roughly a 12% increase for engineers and a 0% increase for everyone else. Any meaningful engineering allocation therefore has to be carved out of other functions, which is a political decision the CHRO must own openly rather than bury inside manager discretion.
Recommended structure:
- Carve out an explicit market and equity reserve (for example 0.5 to 0.75 of a percentage point of payroll) held centrally and released only against documented criteria: range penetration, verified market position, and internal inversion.
- Distribute the remainder through calibrated manager allocations weighted by range position and performance, with a hard rule that no one above range maximum receives a base increase and no one below minimum receives less than a defined amount.
- Do not fund the equity reserve through a flat across-the-board reduction that managers then quietly reverse for favorites; centralize the reserve precisely to keep the criteria visible.
The trade-off: concentrating the pool in engineering buys retention where turnover is 12% and exit data cites pay, but it signals to the rest of the company that market pressure, not contribution, drives reward, and it creates a recurring cost that must be funded again next year. One-time payments preserve future flexibility but do not fix compression, because compression is a base-pay problem.
2. Two senior engineers have learned a new hire with less experience earns $12,000 more. How should HR respond?
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Treat this as an equity audit, not a complaint to be managed.
- Verify the facts against offer letters, range placement, and documented experience. Internal rumor frequently inflates or misstates the gap.
- Audit the whole team, not just the two who complained. Run inversion analysis across all engineering incumbents against tenure, performance, and range position. Adjusting only the loudest employees rewards information leakage and creates a new inequity the next time someone compares notes.
- Decide the criterion in advance. If the company will pay for market scarcity, say so, and then apply it consistently by re-examining the ranges rather than granting individual exceptions. If pay should reflect scope and performance, the new hire is mispositioned and the fix belongs in the offer process going forward.
- Address the off-cycle request on a deadline with written rationale. Silence is read as evasion and accelerates the exit risk that generated the request.
Two legal and policy cautions: in locations with pay range disclosure requirements, the posted range is now effectively public to the workforce, so internal positioning must be defensible against it; and for non-supervisory employees, conversation about pay is protected concerted activity, so any manager who suggests the two engineers were out of line is creating legal exposure.
3. Should the company keep hiring new engineers at the 65th percentile while paying incumbents at the 50th? Advise.
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No. That combination is not a compensation strategy; it is two strategies running in parallel, and the cost is paid in compression and turnover.
Frame it as a portfolio decision. The company can lead, match, or lag by job family, and each choice has a price. If engineering is genuinely scarce and critical, move the engineering ranges to reflect the 65th percentile and fund it by lagging in non-critical functions, then state that in the compensation philosophy so managers can explain it. If the company cannot fund that, it should stop hiring at the 65th percentile and accept longer time-to-fill or a different candidate profile rather than importing compression with every hire.
Consider total compensation before moving base. With an 8% bonus pool, part of the market gap can be closed through variable pay or a one-time signing component that does not compound into base. That is a legitimate lever, but only if employees understand and value it; if exit interviews cite base pay specifically, variable pay will not resolve the complaint.
Guard against the silent middle. The most expensive outcome is the current one: ranges that describe the 50th percentile, offers made at the 65th, and incumbents discovering the gap. That erodes trust in the range system itself, which is harder to repair than any individual adjustment.
Sequence: fix the range and the offer guideline first, then run the inversion audit, then spend the reserve. Doing the adjustments before the guideline changes guarantees the gaps reopen next quarter.