Pay ratios: Fact or fiction?

In July of 2010, the Dodd-Frank Reform Act was passed, requiring the US Securities and Exchange Commission (“SEC”) to promulgate a rule obligating companies to disclose the ratio of the CEO’s pay to the median salary of the company’s workers. Almost five years after Dodd-Frank’s enactment, we are still waiting for that rule.

Fierce debate has ensued since the enactment of Dodd-Frank. Proponents argue that pay ratio disclosure will force companies to rein in executive pay because shareholders will demand a smaller pay gap. Critics argue that it will be extremely costly for companies to calculate the pay ratio, especially those with worldwide operations and unintegrated pay systems.

It seems inevitable that pay ratio disclosure will soon be routine. Over the years, politicians and shareholders have pushed for more and better disclosure of executive pay schemes, and every year companies provide even greater detail than the year before. The European Union is considering requiring companies to both publish a pay ratio and put that ratio to a mandatory shareholder vote.

Instead of resisting the SEC’s rule, we should focus on shaping the rule’s substance to ensure that it results in the disclosure of meaningful, rather than misleading, information. The SEC has an opportunity to draft a rule that is clear and effective, and that can serve as a model for other countries.

In drafting the rule, some lessons can be learned from companies that voluntarily disclose pay ratios. Perhaps the best example is Whole Foods, which has a corporate policy that limits the cash compensation paid to any employee to 19 times the average annual wage and bonus of all full-time employees. As a result of this rule, Walter Robb (the co-CEO of Whole Foods) saw his salary and bonus capped at $757,200 in 2014, 19 times the $39,953 average annual wage of full-time employees. However, Whole Foods’ compensation story does not end with a 19:1 ratio. In fact, this ratio does not include the most lucrative portion of Walter Robb’s 2014 remuneration: a grant of options and share incentives that brought his total income up to $2,742,520, or almost 69 times the average salary and bonus of workers.

This example demonstrates how the omission of one portion of an executive’s remuneration package from the ratio’s calculation can obscure the actual levels of income inequality within a company. This result comes from a company that has a laudable goal of limiting executive remuneration levels. What fictional ratios will be seen from companies with no such intention, or with the intention of minimizing the ratio?

If pay ratios are to provide meaningful information to the market, the SEC must give clear direction on how to calculate them. The SEC should require companies to account for all elements of remuneration, including the fair value of any share incentives granted during the year. Share incentives can frequently amount to many multiples of an executive’s cash income. Consider the South African company, Naspers, which does not award its CEO any cash income. Instead, the CEO receives a periodic grant of share incentives, sometimes worth billions of rand. It would be completely nonsensical to ignore the value of those share incentives and instead compare the CEO’s non-existent cash income to the average worker’s pay.

Not only must the SEC be clear on what constitutes remuneration, it must also provide direction on which employees should be used in calculating a company’s average salary. Should the calculation include the pay of worldwide employees? Domestic employees? Contractors? A sample of employees? If a sample, how exactly must the sample be selected? What about part-time employees, who tend to be the lowest paid and often form the lion’s share of the workforce?

Given the myriad of employee categories, if companies are able to choose which categories to include in calculating an average wage, they will essentially be able to decide in advance what ratio is desirable and then pick and choose those employees with salaries leading to that ratio. For example, the Financial Times reports that British American Tobacco discloses a pay ratio of 8:1 when comparing the salary of the CEO to a comparator group of 80 senior managers. While there is nothing wrong with comparing the salary of the CEO to the salary of senior managers, this statistic does not actually address the true level of income inequality between the CEO and the company’s 50,000 odd employees. Similarly, it does not allow shareholders to compare the level of income inequality within British American Tobacco to any other company that uses a different comparator group to calculate its pay ratio. Standardization will ensure that companies cannot manipulate the numbers to produce a favourable ratio, and will also allow for a meaningful comparison across companies.

Given that the SEC has had five years to draft the pay ratio disclosure rule, one can hope that all of these concerns have been addressed. Unfortunately, it is more likely that the SEC is deliberately stalling, and will eventually release a watered-down rule giving companies significant flexibility in calculating an average wage. If this occurs, not only will the resulting statistics fail to accurately portray income inequality within an organization, they could actually lead investors to believe that pay ratios are reasonable even if they are completely out of control.

Misinformation is worse than no information. The SEC should either do it right or not at all.

What do you think? Should companies be required to publish pay ratios? If so, what must be included in the calculation?

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