When Managerial Discretion about Compensation Brings Lower Pay

Real median pay for non-college-educated U.S. workers stagnated or even fell during the late 1970s and the 1980s—a  circumstance that limited economic mobility for many workers and helped cause growing economic inequality.   A number of factors have been identified as contributing to that wage stagnation, including increasing global competition that put pressure on wages for U.S. factory workers, technological change, a federal minimum wage that decreased in real value during the period, and declining labor union power.

In an interesting article published earlier this year in the journal American Economic Journal: Applied Economics, Maxim Massenkoff and Nathan Wilmers identify a less-well known factor that also played a part in the wage stagnation blue-collar workers faced during this period: changes in the way that employers set their pay. Specifically, Massenkoff and Wilmers document that, starting in the 1970s, there was a significant trend away from standardized pay rates—where pay is predictably determined by job title, often in conjunction with years of service—to compensation methods that give managers more discretion in setting pay. The research found in their study that this switch often coincided with lower wages for blue-collar workers—particularly for the lowest-paid workers.

Massenkoff is an assistant professor at the U.S. Naval Postgraduate School in Monterey, California, and Wilmers is the Sarofim Family Career Development Associate Professor and an associate professor of Work and Organization Studies at the MIT Sloan School of Management, where he is a member of the core faculty of the MIT Institute for Work and Employment Research (IWER) and is also affiliated with the Economic Sociology group.

Using data from an annual survey of pay in the private sector for various types of blue-collar jobs that was conducted by the U.S. Department of Defense (and used to set pay for similar jobs in the military), Massenkoff and Wilmers found that, during the period between 1974 and 1991, there was a substantial shift away from standardized pay rates for blue-collar jobs in U.S. businesses. Moreover, that shift away from standardized pay rates was associated with lower real median wages for workers. “Even comparing workers in the same occupation, industry, and labor market, those [blue-collar workers] without standardized pay rates receive 8 percent lower wages,” during this time, the authors write in their article titled “Wage Stagnation and the Decline of Standardized Pay Rates, 1974-1991.”

Further analysis by the researchers showed that, in businesses that shifted away from standardized pay rates, real wages for blue-collar workers were relatively steady before the shift in compensation policy. However, in the year after the change there was “an immediate and sustained reduction in real wages of around 1 percent,” Massenkoff and Wilmers write. “The sharpness of the change suggests that standardized pay rates are not abandoned during a time of already-declining wages, but instead the move away from standardized pay rates permits a subsequent within-job drop in real wages.”

The researchers observe that their findings “suggest that employers abandoned standardized pay rates and cut real wages simultaneously….When employers switched to merit-based and other pay schemes that allowed managerial discretion, they were able to reduce blue-collar workers’ pay….During a period of declining bargaining power for blue-collar workers, more flexible pay-setting practices allowed employers to adjust real wages for these jobs downward.”

The shift toward flexible and merit-based pay setting, the authors note, did increase wages slightly for some blue-collar workers at the top of the pay scale. However, that increase was dwarfed by the decrease in real wages for the lowest-paid workers, who are often those most recently hired. The authors note that, to avoid alienating existing employees, companies seeking to decrease compensation costs sometimes introduce a two-tier system, with new hires starting at a lower wage than incumbent ones did.  While the survey data the researchers analyzed does not include characteristics of the individual workers at different pay levels, patterns Massenkoff and Wilmers saw in the data are consistent with a scenario in which companies paid new hires lower real wages after abandoning standardized pay rates—in that the timing of the shift away from standardized pay rates for a particular job was associated with employment growth in that position.  

“Switching to more flexible pay setting allowed lower pay for some workers, opening a new second tier of lower wages, likely for new hires,” Massenkoff and Wilmers conclude. What’s more, the effects of lower starting pay can be lasting. “Employers using flexible pay setting are less likely to give pay increases in response to cost of living changes  and more likely to make pay adjustments only for individual workers,”  the researchers observe.