By David Anderson, Margret V. Bjarnadottir, and David Gaddis Ross
In the past few years, addressing systemic pay inequities has been a goal for many companies. Not only does improving equity protect companies from legal liability, but it also helps build a better, fairer workplace. How to achieve pay equity, however, isn’t always obvious. When we present our research on pay equity analysis to business leaders, we’re often asked for advice on how to identify and address the gaps, especially when resources are limited.
The answer may not be as obvious as you might expect and depends on the organization’s motivation when considering closing gaps. Does the company want to build an equitable workplace, minimize regulatory risk, or both?
Start With a Pay Equity Analysis
The first step is to run a pay equity analysis. This is a systematic analysis of employees’ compensation to determine whether one or more demographic groups (e.g., women or a racial minority) are underpaid. A pay equity analysis gives us a measure of a pay gap after accounting for pay drivers like job roles and qualifications.
Once you’ve identified the pay gaps, you have to figure out what to do about them. The size of the gap is just one consideration. Companies must also weigh their specific regulatory environment and how important gaps are to their stakeholders when deciding how to address pay gaps.
Understanding Regulatory Risk
Companies concerned about reducing their legal liability should focus, at least initially, on their pay gaps’ statistical significance — that’s often what courts and regulators look at to determine potential discrimination or inequity.
Statistical significance denotes the likelihood that something (like a pay gap) happened by chance. Companies whose gaps are deemed statistically significant are likely discriminating against a group of employees in the eyes of the court.
If you conduct a pay equity analysis, one of the outputs — in addition to the size of the gaps — will be your gap’s statistical significance. This figure is influenced by a number of factors, including the size of your organization and your firm’s pay structure.
The more employees there are, the more confident you can be about whether a pay gap happened by chance. To see why, imagine flipping a coin. If it comes up heads three times out of four, you might attribute that to chance. If it comes up heads 30 times out of 40, you would be more convinced the coin was weighted toward heads.
For similar reasons, the more regimented a firm’s salary structure — that is, the more precisely an employee’s job and qualifications determine their pay — the more likely it is that a pay gap of a given size will be considered significant to a court.
The Size of Gaps Matter to Stakeholders
Statistical significance isn’t the only type of significance that counts. The average employee, investor or manager is much more likely to focus on economic significance, which is simply the size of the measured pay gap.
For example, at a small firm, a 4% pay gap between employees of different demographic backgrounds may be economically significant but statistically insignificant. That does not mean this gap should not be closed. The economic size of the gap is thus an important consideration for firms weighing stakeholder expectations and their own pay equity philosophy.
How to Close Gaps — and Keep Them Closed
- Take stock of values and the regulatory environment to set goals
First, firms should see where they fall along the spectrum of internal and regulatory pressures to set a pay gap goal. At one end of the spectrum, we have firms whose stakeholders do not care intensely about pay equity and who face minimal regulatory pressure to address pay gaps. Organizations at this end of the spectrum may, at their discretion, take action to correct any obvious inequity, but may not do much beyond that.
At the opposite end of the spectrum are firms whose values and brand are inconsistent with having pay gaps and that face intense regulatory scrutiny and legal liability in relation to pay equity. Such firms should seek to close their pay gaps to zero and keep them there, as zero is an easy and impactful figure to communicate to employees, external stakeholders, and regulators.
Between these poles, there are firms that may face little regulatory pressure regarding pay equity but hold values inconsistent with having pay gaps. Such a firm should establish a tolerance threshold of acceptability for its economic pay gaps (e.g., 1%) and manage the gaps below this level, ideally close to zero.
- Close or Reduce Existing Gaps
Once an organization has clarified its pay gap goals, it’s time to close the gap. First, the pay gap needs to be reduced to below its internal threshold (which can be based on statistical significance or economic significance).
If a firm’s pay equity analysis reveals a pay gap, and that gap is over the firm’s threshold, the firm will need to give raises to employees of the underpaid demographic(s) the sum of which would be determined by what it would take to pull the gap within the firm’s acceptable threshold.
- Build Thresholds Into Compensation Practices
Once a pay gap is closed, pay equity needs to be integrated into the organization’s compensation processes to prevent the gap from reappearing. This is because every compensation decision that a manager makes — hiring, firing, or ad hoc salary adjustments — affects the pay gap. Unless an organization is unusually static, such decisions happen on a rolling basis.
As a result, an organization’s pay gap is a dynamic metric. A firm thus needs to build in a tolerance margin around its target pay gaps.
- Pratice Proactive Pay Equity Management
Get before future pay gaps by ensuring that new hires (and internal promotions) get unbiased starting salaries (which can be evaluated based on a firm’s pay equity model). A proactive approach also includes monitoring pay equity in real time and accounting for the changes in the workforce as they happen. Finally, it includes making ad hoc adjustments in a data-informed manner that ensures internal consistency with similarly situated employees. These days, sophisticated but user-friendly software exists to help with this process.
Pay equity presents both consequences and opportunities for firms. On the one hand, firms must ensure their pay gaps do not call down the wrath of stakeholders or regulatory authorities. On the other hand, firms that define clear pay equity goals and adhere to them set themselves apart as good places to work, and their employees are less likely to leave. We strongly encourage firms to take a proactive approach to pay equity, whether to minimize regulatory risk, ensure minimal equal pay gaps, or both.
David Anderson is an associate professor of Analytics at the Villanova School of Business. Margrét V. Bjarnadóttir is an associate professor of management science and statistics at the Robert H. Smith School of Business at the University of Maryland. David Gaddis Ross is the R. Perry Frankland Professor at the University of Florida’s Warrington College of Business Administration.
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