Will it be a snore to which no one pays attention or a bombshell that shakes the foundations of corporate America? Either way, the CEO pay ratio seems certain to cause at least some discomfort in the board rooms of many publicly traded companies in the U.S.
Required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the ratio of the chief executive’s pay to that of the “median” employee must be disclosed in company proxy statements beginning in 2018, based on 2017 compensation, under Securities and Exchange Commission (SEC) rules. Even though the first pay ratio disclosure is more than a year away, some companies are beginning to take a first look at what goes into producing this number.
Managing the calculation process
The reason companies are beginning to look at the pay ratio is that its calculation can be an involved process, especially if the company has a large workforce and compensation information is not stored in a single or integrated payroll system. This may be the case where the company has a geographically dispersed workforce, including meaningful populations of employees in foreign locations. Also, disparate compensation data may exist where companies have made significant acquisitions but have not integrated the payroll systems.
If a company expects to encounter any issues in collecting and organizing the needed compensation data, the sooner the company is aware of the challenges and how to resolve them, the better.
The CEO pay ratio is to be disclosed in the company’s proxy statement, and it would be problematic to have the proxy statement delayed because of problems collecting the data needed for the ratio’s calculation.
There are also strategic reasons companies have begun to study the CEO pay ratio. For example, the disclosure of the ratio will be the first time all employees will have a look at median pay in the company. This number may be far more interesting to some company stakeholders than the CEO pay ratio since the CEO’s pay must already be disclosed and is, in many companies, old news by now. For a company that has a union workforce, the relationship of the median pay and the pay of the union workforce may be of particular interest.
Similarly, a company with a large foreign workforce — possibly because of outsourcing, or where there’s a large number of minimum wage employees (e.g., retail) — may want to consider the broader social and political questions the ratio’s publication may generate. An early start to calculating the pay ratio will give the company time to develop a communication strategy regarding the issues that go beyond the mechanics of the calculation.
Managing the risk
Every company should consider how to conduct a ratio calculation process that will satisfy its auditor’s or general counsel’s expectations. Developing a sound process and documentation may also prove invaluable in the event the plaintiff’s bar should turn its attention to ratio disclosures, finding the pay ratio a convenient means to challenge the accuracy and completeness of the proxy and threatening the delay of the annual meeting to extract a monetary settlement.
Even where a company has a globally integrated payroll system, there may be important decisions to make about data collection:
- What “pay” definition is best suited to identifying the median-paid individual (the SEC rules afford considerable flexibility)
- How to manage the data so that the ratio remains reasonably constant year over year (e.g., select a U.S.-based employee to avoid currency fluctuations)
- Should certain foreign employees be excluded because they represent a small percentage of the entire workforce, as the SEC rules allow? Would their exclusion help or hurt the ratio strategy?
We also suggest that companies consider the use of sampling, the practice permitted under the SEC rules that allows companies to test for the median-paid employee by calculating or applying the pay of certain groups of employees through a sampling method (rather than the group’s entirety). Trying the sampling approach before the disclosed number is required seems prudent to most managers expecting to use it.
Finally, consider the need for professional review of the ratio calculation. Many companies will want their outside auditors, legal counsel and compensation consultants to agree or even certify to the appropriateness of the ratio calculation before it is published. We suggest that companies do some socializing of their chosen calculation method at this early stage so their advisors can review and provide input ahead of when the actual calculation is needed.
No matter your expectations about the impact of the CEO pay ratio, the responsibility to disclose information is fast approaching. And companies would do well to avoid a mad rush and begin their preparations now.
For more information on the CEO pay ratio, see “Final CEO Pay Ratio Rules Provide More Flexibility for Compliance,” Executive Pay Matters, August 6, 2015, and “Flexibility at a Price: A Look at the Additional Disclosures Required to Take Advantage of Optional Provisions in the CEO Pay Ratio Rule,” Executive Compensation Bulletin, October 20, 2015.
Guest Blogger Marshall Scott is a director in the executive compensation consulting practice in Willis Towers Watson’s Chicago office.