How to Adjust the Compensation for Overcompensated Employees

This is not a common or even prevalent problem – having employees who are overcompensated. However, in small, privately held businesses, this can and does occur. Overcompensation leads to several problems that small business owners should be aware of:

  • You discourage the right type of turnover. If mediocre employees are overpaid, why would they leave? Yes, you can fire them, but that comes with its’ own set of problems.
  • Your employees may begin to feel entitled. If you have a great year and give everyone a fabulous bonus, chances are they will be upset the following year when the bonuses are smaller, or more “normal”. Overpaid employees believe that they deserve “it” and that you owe it to them. They won’t know why, exactly, but they will often develop a sense of entitlement.
  • They will not work as hard as they normally would. People who are already rewarded don’t work as hard as those who will get rewarded if they do work hard. Overcompensation often leads to mediocre work quality.
  • Similarly situation employee. If you pay one employee X for doing a job, you’ll need to pay the other employee X for doing similar work. If the first employee is overcompensated, then the second employee will need to be overcompensated.
  • Overcompensated employees have less dignity. One of the best ways you can help your employees gain dignity is by giving them a stretch goal, resourcing them properly and then letting them achieve that goal. When people try harder and achieve more, their personal esteem and dignity shoots through the roof. When they are already getting a reward for “normal” work output and quality, they are robbed of the opportunity to grow professionally and build their personal esteem and dignity.

If you try to lower the salary of your employees when they are overcompensated, you’ll likely destroy your business because your employees will work even less hard and many will self-select out to another employer (if they can find comparable compensation). The worst situation is to lower an employee’s salary and then have a disgruntled worker who stays on, working less, delivering less quality, poisoning the environment and generally harming your business.

So what should you do?

First, connect more of their compensation to individual, team and/or company performance. Take their large salaries, reduce the base, but then give them more than they would have otherwise made for achieving a bit more than they were. Some will be able to do reach their goals. Those who don’t or can’t or won’t will be eligible for coaching and eventual firing if they can’t step up their performance. For example, if each sales needs to sell $5M/year in gross revenue and they are currently paid at $200,000, then consider lowering their base to $140,000 with increased commissions that give them the opportunity to make $300,000 if they sell $5.25 or $5.5 or even $6M. This type of program will require you to understand your break-even point and how sale margins affects your cash flow. But the point is to introduce the opportunity to make more money by performing at a higher level.

Secondly, explain why they have been over-compensated and then do a three or five year gradual reduction in their pay. Yes, some will leave – but if they are key employees, then you’ll likely not be able to lower their compensation. You can only do a gradual reduction over time and only if you can clearly explain why you’re reducing their salary.

Thirdly, during the reduction process, give them a chance to improve their skills and contribution to the company, thereby allowing them to either retain or increase their compensation.

Lastly, if there is a crisis, such as a recession or a significant drop in sales, use that crisis as the opportunity to get all the compensation changes you want. Never let a crisis go to waste. I know this sounds harsh and selfish, but given the inherent problems created through overcompensation, the results for your business and employees will be better than avoiding this problem.

Overcompensation often happens in smaller, privately held companies because they owners mistakenly believe that by paying more than market, their employees will like the owners more, work harder and deliver more than if they are paid at market rates. Nothing could be further from the truth. In addition, “investing” in your employees at salaries above market does not help the business owner fulfill whatever values they have because of the natural way that overcompensated employees respond to higher-than-normal salaries (see above). You don’t do yourself, Mr. and Mrs. Business Owner, any favors by overcompensating your employees. So, do not use salaries to get your employees to like you or to feel good about yourself. Instead, pay your employees at market rates, give them stretch goals to achieve, resource them properly and then watch them do more than you or even they ever thought possible.

Bill English