Navigating the Pay-Ratio Quagmire

Thanks to the Dodd-Frank pay-ratio disclosure, companies need to formulate cogent explanations for CEO pay to avoid potential problem areas.
By: | April 10, 2018 • 8 min read

At a time of growing concern about income inequality, CEO pay ratios will be appearing in the proxies of companies whose fiscal year ended in December. The Dodd-Frank financial law applies to all corporations with market capitalizations in excess of $75 million—with the only exceptions being emerging-growth companies, smaller reporting companies and foreign private companies—and requires that they disclose in the proxy statements the ratio of the CEO pay to that of their median employee.

It is not hard to access a CEO’s pay, as it is shown in the summary-compensation table in the proxy. It is not, however, so easy—as well as being costly and burdensome—to ascertain the total pay of the median employee based on the same elements of pay that must be included in the summary-comparison table for the CEO. In fact, the U.S. Securities and Exchange Commission estimated first-year implementation costs of $1.3 billion.

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There are guidelines on how to do this, and companies will be permitted to report the same number for three years if they wish to do so, unless there has been a change either in the employee population or compensation arrangements that would result in a significant change to their CEO pay-ratio disclosure. It will also probably be the case that the company’s outside auditor will have to certify both the process used and the appropriateness of the number used for the pay of the company’s median employee, given that the pay ratio is subject to Sarbanes-Oxley certification requirements. But if the company discloses that its number is an estimate, this takes the pressure off the certificate requirement.

In a 2013 editorial, the New York Times argued that the disclosure of the ratio of pay between the CEO and the median worker is “information investors and consumers need to fight effectively against pay packages that are unjustified and disadvantageous.” It went on to note that this approach can enable investors to “judge the effect of the company’s pay structure on productivity, efficiency, innovation and other aspects of workforce performance but also will help consumers determine whether companies are solid corporate citizens” and would also help “economists and policymakers detect emerging asset bubbles and impending crashes.”

However, I argue that these predicted benefits are illusionary and the costs are not justified.

While pay-ratio information is supposed to be useful to investors, attention needs to be paid to the anticipated reactions to these disclosures by the media, current and potential employees and unions. Anyone who is a shareholder will have access to this information, including employees, who may own stock either directly or through a 401(k) plan. Religious and other groups who own just a single share will also have access to it. And for larger companies, it would be surprising if the media did not focus on “outliers.”

Predicting Problem Areas

Consider the issues that will undoubtedly be raised by employees, investors and the media once pay ratios are published. Employees will likely draw comparisons between pay ratios at different companies—for instance, at one, the CEO makes 1,500 times the median employee and, at another, he or she makes 600 times the median employee—which could lead to employee discomfort and distrust.

Differences in median employee pay could also cause strain for the business. For instance, employees may question the average pay at their company in comparison to similarly situated organizations, especially competitors. Those whose salaries fall below the median pay at their company will also likely press for a reason, particularly if they consider their work above-average. If the median number for unionized companies is higher than the median for non-unionized companies, that difference may prompt some employees to consider forming a union.

Current employees won’t be the only ones affected. Potential employees may be reluctant to consider joining the company because its median pay is low for the industry. On the other hand, if the median pay is higher than a competitor’s, a shareholder may question if the company has a bloated cost structure, with its selling, general and administrative expenses out of line.

Unique Considerations

Not only do cogent answers to these questions need to be developed quickly, but managers need to be trained to provide the answers in ways that relevant audiences will find convincing. While in most cases there will be answers that make sense, there no doubt will be situations that require further analysis and explanation.

Differences in ratios among companies, even in the same industry, will not provide useful insights to investors, as they will reflect different business strategies (especially in-house work versus outsourcing) and differences in market rates of pay in locations around the world. If Company X has a ratio of 100 and Company Y has a ratio of 135, what do stockholders, consumers and employees learn? If they investigate, they may discover that Company X outsources most of its manufacturing to Asia while Company Y hires its own employees in Asia.

Ownership structure may also be an issue, such as if a company franchised and its primary competitor has its own company units. For instance, the numbers for McDonald’s (largely franchised) and Starbucks (largely company-owned) will be very different.

Median-employee pay may not always give the full picture about the type of employee. For large retailers, the median employee could, in fact, be either a part-time seasonal worker or a call-center employee in India. When it comes to CEO pay, certain situations may require a company paying a very large up-front bonus to attain a new CEO, which could skew ratios. Additionally, a CEO’s pay could be considered relatively modest if he or she is a company founder and receives most of his or her compenation through stock ownership.

Messaging is Key

As a body, shareholders have not sought pay-ratio disclosures as prescribed by Dodd-Frank. There have been very few shareholder proposals seeking a pay-ratio disclosure and, of the dozen that were voted on between 2010 and 2012, more than 93 percent of shareholders, on average, voted against the resolution.

Furthermore, the detailed explanations in company proxies of CEO and top-level executive pay have increased corporate disclosure. The wisdom of adding a disclosure that most investors will and should ignore is not a cost shareholders should have to bear.

Yet, what has happened has happened, and, at least for this year, managers and HR leaders will be busy researching and developing credible responses to the questions that will inevitably be raised. Directors, too, need to be briefed, and they should ask about the communication process the company has put in place with respect to relevant audiences.

It should also be noted that a handful of companies have been disclosing the difference between CEO pay and their average employees for many years. Three such companies are Whole Foods (now part of Amazon), utility company NorthWestern Corp. and Noble Energy. The Dodd-Frank pay-ratio disclosure requires that corporations compare the total pay of the CEO to the pay of the median employee, including part-time, full-time, seasonal and temporary employees, located domestically or outside of the U.S. Based on a much narrower comparison, Whole Foods had a policy that no executive’s salary—not total pay—could exceed 19 times (up from eight times several years earlier) the average U.S. full-time employee’s pay. The ratio was 24 for NorthWestern, based on a comparison of CEO pay to the median pay of full-time employees only.

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At the end of the day, while the pay-ratio calculation is burdensome and costly to employers—and thereby to shareholders—there is little information that can be gained from the ratio, particularly as it relates to providing insights to investors to help guide their investment decisions. Is a company with a high pay ratio a less-attractive investment? Should investors expect a company with a low pay ratio to provide greater returns over time? Are employees in a company with a high pay ratio paid above or below the market rates for their jobs?

One thing that can be stated with certainty is that there is little reason to believe the benefit to shareholders from the pay-ratio disclosure will represent a worthwhile use of company resources.

When asked about the CEO pay ratio, the CHRO of a major consumer-products company made two points. First, the calculation takes an inordinate amount of work—so much so that most companies, including his, are spending shareholder dollars to hire consultants to help them do it. Second, the outcome is meaningless to a shareholder because there is no rhyme or reason with respect to company comparisons.

For example, he notes that a competitor company in his compensation peer group has most of its operations, including manufacturing, in the U.S., so its median employee is going to be a U.S.-based person making a good wage and the CEO pay ratio will be low.

However, across its global operations, the median employee is going to be in a place like Brazil, Malaysia, Mexico or South Africa.

“Our CEO pay ratio will be a very high number,” he says. But, he asks, how is this information helpful to anyone?

He’s not alone in asking that question—and for very good reason.

Fred K. Foulkes is a professor at Boston University’s Questrom School of Business and is director of the Human Resources Policy Institute. Send questions or comments to [email protected]