Bracing for Impact on Comp Ratios
HR leaders at public companies in the U.S. should be preparing for some difficult compensation conversations as the 2018 proxy season begins, experts say.
In 2015, the Securities and Exchange Commission finalized its ruling that U.S. companies must report the ratio of the compensation of its CEO to the compensation of its average employee. Under the final rule, a public company must begin including pay-ratio disclosure in its annual proxy statements for the 2018 season, or in its Form 10-K if it does not file a proxy statement.
According to the SEC, this mandate, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, was implemented for the sake of investors, but experts question how these reports will affect investor and shareholder decisions, as well as morale at companies where the disparity may be especially high.
You simply can’t get two more extreme examples for comparison, says David A. Hofrichter, senior partner and leader of executive compensation and governance at Aon Hewitt.
“The average employee is a function with so many variables, and the CEO is one person,” he says.
Experts seem to agree that this mandate will likely cause more trouble than it’s worth—starting with determining the median employee.
Collecting all the necessary data to comply with the mandate is time-consuming and expensive, particularly for large, global businesses or those that underwent numerous acquisitions, says Hofrichter. These companies may have different systems that aren’t harmonized, or different currencies that need to be converted to U.S. dollars.
Gregg Passin, senior partner and North America executive rewards practice leader at Mercer, says the pay ratios will likely be subject to “vast and wild misinterpretation” and lead to a muddy situation for employers.
“Hopefully organizations have communicated their compensation and broader employee value proposition, about how they’re compensated and rewarded, all along,” Passin says. “For those that haven’t, leadership needs to figure out how to properly contextualize this information.”
Experts agree that if a company has fair-compensation practices in place, the pay ratios shouldn’t be too worrisome to disclose. But that doesn’t mean there won’t be any blowback, whether in the form of innocuous questions or employees’ expressions of serious dissatisfaction.
According to Ethan Rouen, assistant professor of business administration at Harvard University, public interest in these numbers will be high because it’s the first time that employees will see where they fall on the pay spectrum.
“This reporting measure may open a can of worms for employers because of this median-employee business,” he says. “Who is the median employee? If it’s a software engineer, you’re going to have every other software engineer knocking on your door asking, ‘Why am I paid less?’ ”
Rouen, who recently published an extensive working paper titled Rethinking Measurement of Pay Disparity and its Relation to Firm Performance, says that his research is timely. As an accounting researcher, he has a deep interest in income inequality and began his paper when the SEC proposal was approved. His goal was to bring data to an empirical question that was being debated.
Previous research has been rather contradictory regarding the impact of compensation gaps between the average employee and CEO and a firm’s “accounting” performance, Rouen notes. Some findings point to dissatisfied employees, low engagement and satisfaction and high turnover, while others suggest better performance for firms with large compensation gaps.
Rouen analyzed data from the U.S. Bureau of Labor Statistics for 931 firms in the S&P 1500 between 2006 and 2013. He then used empirical models to determine how the ratio between CEO pay and median employee pay impact firm performance.
He found that companies with high unexplained pay ratios saw firm performance drop by nearly half, compared to industry competitors with low levels of unexplained pay ratios.
Approximately one-fifth of all companies he studied overpaid their CEOs and underpaid their employees. “When both of these occur, that’s when you really see the firm performance suffer.”
The CEO and C-suite need to explain the compensation ratio, Rouen says, adding that if a business simply releases the pay ratio and doesn’t explain the methodology behind it, that’s how it becomes a poor-performing firm.
For example, if you compare Apple to Microsoft, there’s going to be a large average employee-pay disparity between the companies, both employee-to-employee and employee-to-CEO comparison. The average Apple employee is likely working in retail, whereas the average Microsoft employee is more likely a software engineer. Not only will the pay difference between a retail employee and a software engineer be huge, but so will the former’s pay compared to the CEO’s pay. If this isn’t explained properly, HR may have a big satisfaction problem on its hands, says Rouen.
He adds that HR executives can get ahead of the potential blowback by coming up with a concrete, clear way of explaining the compensation practices of their organization.
Hofrichter builds on this explanation, suggesting that leaders “tell the story of the company.”
“HR and other leadership have an opportunity to discuss facts about the marketplace, labor economics and the company’s pay system. Stress to employees that they’re paid at, say, the median level or at the 60th percentile for their job. Leaders need to embrace transparency around their pay-scale philosophy—show them the numbers,” he says.
Rouen suggests that companies could benefit from putting the CEO in front of employees to generate discussion about the company’s pay policies, how they’re determined and why they’re fair. He also says it may be important to point out that the only true way to determine income inequality is to compare salaries across peer demographics, i.e., male versus female compensation for the same job.
“The only positive that may come from this [SEC mandate] is an open dialogue about income inequality,” says Rouen. “I hope that companies become more transparent in compensation practices and are open to discussing compensation to determine if it’s fair.”