By Nora McCord & Ram Kumar – Associate Partners, Consulting, Radford
Up until the surprising results of the recent presidential election, the CEO pay ratio was one of the biggest news stories in US executive compensation and related corporate governance circles.
The CEO pay ratio, slated for required disclosure in the 2018 proxy season, is just one of several compensation and governance related elements in the Dodd-Frank Wall Street Reform and Consumer Protection Act.
It requires that companies identify the median-compensated employee within the company and then publicly disclose in the US Securities and Exchange Commission (SEC) filings the ratio of pay to that employee compared to pay to the company’s CEO. Inserted at the last minute into the omnibus regulations, the CEO pay ratio has always been a relatively unpopular element of the Dodd-Frank regulations and the one most lacking in strong support from the mainstream institutional investor community.
While the governance community has focussed for years on the ratio of pay between the CEO and other named executive officers as a way to identity potential concerns regarding succession planning or an imperial CEO, the community historically has not been focussed on how pay to executives compared to that of rank-and-file workers. Unlike the other compensation and governance-related elements of Dodd-Frank, which were largely grounded within mainstream governance trends at the time, the CEO pay ratio was more of an outlier, viewed as important by those in the labour community, but without broad support outside of that community.
While response from the institutional shareholder community may have been tepid, companies have strongly resisted the ratio, arguing that the number would say much more about how businesses were structured than about whether the company was compensating workers fairly. For example, two companies with identical businesses might have dramatically different CEO pay ratios, depending on whether they have decided to outsource manufacturing or keep it in-house or whether they have chosen to maintain significant operations overseas. Companies have also been concerned that this ratio, taken out of the business context to which it is inextricably linked, will be used simply to shame them publicly for their pay practices by those wishing to promote a more populist agenda.
Even the SEC, in proposing and subsequently adopting the CEO pay ratio rules in August of 2015, commented that it did not believe comparisons of ratios across companies to be meaningful, while acknowledging that investors might glean value from monitoring year-over-year changes of the ratio within a company.
Significant legislative and budgetary efforts to repeal this provision in 2016 were curtailed by the election season, but the surprise election of Donald Trump, coupled with Republican majorities in both houses of Congress, could revive these efforts. While Republicans have an ambitious policy agenda, including, notably, the overturn of the Affordable Care Act and a host of other, much more sweeping policy changes, the CEO pay ratio is sufficiently unpopular that it may very well be overturned. While many US companies have embraced this possibility whole heartedly, if there is one thing that recent events have taught us, it is that one should not put too much stock in ‘certain’ outcomes and companies would be well-advised to continue preparing for the implementation of the CEO pay ratio, even if it looks increasingly likely that it might be repealed at the eleventh hour.
Calculating the CEO pay ratio
In simple terms, the CEO pay ratio requires companies to disclose:
■ The median of the annual compensation of all employees, except the CEO
■ Annual compensation to the CEO
■ The ratio between these two values
For the purpose of the calculation, annual compensation is calculated in accordance with the total compensation calculation already disclosed for named executive officers in the summary compensation table of the proxy.
Companies must briefly describe the methodology used to select the median employee, as well as any assumptions or estimates made to select the median employee or calculate their pay. Companies are also permitted, but not required, to supplement the required disclosure with a contextual narrative or supplemental ratios that they believe may be of value to shareholders in assessing the company’s CEO pay ratio.
However, in part because of concerns about the limited utility of the CEO pay ratio, the SEC regulations permit companies a significant degree of latitude in how to calculate the ratio, most importantly in how companies select the median employee. For example, while the regulations explicitly include all employees, whether part-time or full-time, domestic or international, companies are only required to select the median employee every three years. Additionally, companies can select any date in the last quarter of the fiscal year for purposes of defining the employee population, permitting companies with significant seasonal workforces to scope these employees out of the calculation.
The regulations also provide companies with some ability to exclude foreign employees, in instances where foreign data privacy laws preclude lawful collection of the appropriate data, or in instances where they represent less than five per cent of the employee population and as long as all employees in a particular jurisdiction are either included or excluded in the population. While cost of living adjustments are permitted under the regulations, companies must also disclose the ratio calculated on an unadjusted basis.
And finally, companies have significant latitude in how to identify the median employee. For example, median employees can be identified using annual total compensation as required for the calculation of the ratio itself, or some other consistently applied compensation measure, such as payroll data if equity is not widely distributed. Companies are also permitted to use statistical sampling to identify the median employee.
While it is true that for many companies the act of aggregating the requisite data and calculating the CEO ratio has been a significant undertaking, despite the latitude permitted under the regulations, it has been a largely administrative exercise. Furthermore, for many companies, changing these ratios is not possible, as this would require either pay increases to the general employee base significant enough to increase the annual compensation of the median employee, or conversely, meaningful decreases to CEO pay.
“Significant legislative and budgetary efforts to repeal [the CEO pay ratio] were curtailed by the election season, but the surprise election of Donald Trump, coupled with Republic majorities in both houses of Congress, could revive these efforts”
Given the impracticality of changing the ratio itself, companies are much better served by devoting time to considering how to provide additional information, which will provide shareholders with the context necessary to evaluate the pay ratio, not only within the context of the company over time, but also when comparing the ratios across companies.
For many companies, this includes a discussion of business strategy and how that strategy impacts the pay ratio. For example, a company may choose to keep manufacturing operations in-house to control quality, resulting in a significantly higher ratio than a company in a similar industry that may have chosen to outsource manufacturing.
Understanding how your own pay ratio compares to peers is an important prerequisite to drafting this narrative. Where possible, companies should seek out survey or other data that might assist in the estimation of pay ratios for likely comparators. While other companies in similar industries are clear comparators, companies should also consider the importance of geographical comparators, particularly given the likelihood that local press will write an article comparing CEO pay ratios among local businesses. In this instance, relatively large companies are particularly vulnerable, as size appears to be one of the most important drivers of the CEO pay ratio; on the one hand, larger companies are more likely to have larger workforces, with more significant overseas populations, while on the other hand size is one of the biggest drivers of CEO pay.
Develop a disclosure and engagement strategy
Once companies understand the context in which their own CEO pay ratio will be oriented, a disclosure and engagement strategy should be developed. This may vary, depending upon the company and the context. In instances where the CEO pay ratio is viewed as well within the limits of various appropriate comparator groups, disclosure may well be brief and to the point. However, in instances where the CEO pay ratio is likely to be out of step from comparators, a more robust disclosure and outreach strategy is likely warranted. Companies should discuss the primary drivers for the ratio and tie these drivers explicitly to the creation of shareholder value. In addition to proxy disclosure, talking points should also be drafted, empowering both board members and company representatives to provide concise and persuasive responses to questions from shareholders and the media.
For most companies already engaging with shareholders on a regular basis on topics of executive compensation and related corporate governance matters, consider adding the CEO pay ratio as a regular discussion item, both to ensure that they have the necessary context to evaluate the ratio as well as to solicit feedback on their views. Influential proxy advisor ISS has already indicated that it will review the CEO pay ratio, but that its review will be focussed more on how the ratio changes within a particular company over a multi-year period. Although not relevant in the first year, this suggests that companies should focus on how other strategic changes in the organisation, for example, a new CEO with a significant sign-on equity award or large changes in bonus payouts, might drive significant changes in the CEO pay ratio for a particular year.
Finally, companies should be mindful of how CEO pay ratios might be viewed by internal constituencies. While companies with significant professional services populations may benefit from relatively low CEO pay ratios, it is also more likely that the median employee will fall in a group of high- potential or high-performing employees. Consideration should be given to which employees might be adversely impacted by the new realisation that they are paid below median and how that might impact their levels of engagement and satisfaction. Additional outreach by managers or others in the organisation may be needed to ensure that these employees continue to feel valued by the company.
Although companies may live in renewed hope that the CEO pay ratio will be repealed, they should continue preparing for its disclosure in 2018 proxies. While the ability to change the pay ratio may be limited, how that ratio is viewed by internal and external constituencies can be influenced. Companies would be wise to devote time to crafting their message to ensure that their CEO pay ratio is considered within the appropriate context.
About the Authors:
Ram Kumar is an associate partner in Radford’s compensation consulting practice focused on executive compensation, equity design and corporate governance. Ram has more than 15 years of experience in the governance and compensation industries. Ram works with public and private companies that range in size, complexity and stage of development across the life sciences and technology industries. Prior to joining Radford, Ram was an assistant vice president in the executive compensation practice of Aon Consulting. Prior to Aon, Ram worked in the corporate governance industry for more than six years, including four years at the prominent proxy advisory firm, Institutional Shareholder Services (ISS). While at ISS, he led the US research group charged with analyzing all public US companies and making proxy recommendations to institutional investors.
Ram earned a bachelor of arts from Johns Hopkins University. He is a frequent speaker on various compensation topics and published in industry journals, and is based in Boston.
Nora McCord has over 15 years of experience advising clients on the design and implementation of executive compensation and board remuneration programs. She also assists clients in the development of comprehensive shareholder outreach programs, including CD&A drafting and creation of shareholder talking points and presentation materials. Nora is a frequent speaker and author on compensation and corporate governance topics for organizations such as WorldatWork, The Conference Board, National Association of Corporate Directors, National Association of Stock Planning Professionals, Global Equity Organization and Directorship. She is also the author of a chapter on board compensation in the sixth edition of The Compensation Handbook and co-author of a chapter on compensation committee best practices in The Handbook of Board Governance.
Prior to joining Radford, Nora was a Managing Director at Steven Hall & Partners, a boutique executive compensation consulting firm headquartered in New York City and a Senior Manager in charge of research operations at Equilar, Inc. Nora holds a master’s degree from Georgetown University’s McCourt School of Public Policy and a B.S. from Georgetown University’s Edmund A. Walsh School of Foreign Service.