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Looking Beyond the CEO to Median Employee Pay Ratio: Why Other Disclosures Matter More

Looking Beyond the CEO to Median Employee Pay Ratio: Why Other Disclosures Matter More

INTRODUCTION

The forthcoming disclosure of the CEO to median employe“ e pay ratio (“CEO Pay Ratio”) in 2018 proxy statements, as required under Dodd-Frank, has sparked much discussion among compensation committees, advisors and stakeholders as they prepare for the next proxy season. Those who are in favor of the CEO pay to median employee pay ratio believe that this disclosure will alert investors, the board and senior executives to excessive CEO pay, prompting action to reign in pay levels.

The CEO Pay Ratio concept had its roots in labor unions attempting to put a spotlight on CEO pay compared to the wages of the “rank and file” worker. Some academics have extolled the virtues of the CEO Pay Ratio as a better yardstick by which CEO pay can be measured, particularly compared to the current process of comparing pay against a selected peer group of companies. Some believe that the peer group comparison process has led to the ratcheting of CEO pay as companies play “leapfrog” to keep up with the higher compensation levels of competitors, resulting in an explosion of CEO pay and increasing income inequality between the top executive and average worker. Of course, the pay of the rank and file worker is not adjusted in the same way, resulting in an ever-widening gap of pay levels. So, somehow CEO pay will be tethered and therefore will not increase as dramatically.

There are a lot of problems with this theory including that CEO pay for larger companies has been substantially stunted since the 2009 financial crisis/ recession which resulted in the enactment of Dodd-Frank. Public outrage combined with investor outreach was heeded by large companies.

While the impending SEC rules on disclosure of the CEO Pay Ratio continues to generate headlines, the reality is that this ratio does not inform investors of anything useful. In part, this is due to the difficulty of comparing companies with different business models, geographies, use of contractors, labor forces, product line mixes, etc. For example, some companies outsource a large part of their work product, or have a large overseas employee base, or employ a large number of part-time workers, which will impact their CEO Pay Ratio.

Compensation committees should focus instead on other ratios and disclosures that are 1) more revealing of corporate governance issues and 2) more fundamental to human capital analysis—each more likely to improve profits and increase shareholder value. For example, investors may be very interested in the ratio of CEO to other top executive pay (“CEO-NEO Ratio”). One major benefit to investors of the CEO-NEO Ratio, as well as some other human capital ratios, is that they provide insight into the internal CEO succession planning process.

The reality is that the CEO Pay Ratio by itself fails to tell a compelling or useful story. In fact, a coalition that includes some of the largest U.S. institutional investors wants public companies to disclose a great number of details on how they manage, compensate and incentivize their employees. These would include details about worker demographics, skillsets, safety, productivity, human rights, compensation and incentives.

This article details alternative disclosures that compensation committees should consider in the upcoming proxy season.

CEO-NEO Pay Ratio

The concept put forth is that when CEO pay is substantially above the rest of the executive team, it leads to dysfunction and inefficiency at shareholder expense. A disproportionate pay ratio among corporate leaders may unfair and a likely symptom of poor corporate governance. Unfortunately, there is no bright line test for such ratios. While a CEO-NEO Ratio of 2.75 to 3.0 times has been mentioned by rating agencies such as Moody’s and shareholder advisory firms such as Institutional Shareholder Services, the proper ratio depends on a variety of factors. These include the industry, size, and ownership structure of the company and the tenure and responsibilities of the executives, particularly the NEOs.

When it comes to CEO-NEO Ratio, many compensation committee members have a general sense of these numbers, but few have integrated an explicit review of this data into their annual agendas. In fact, while this ratio is presently available in the proxy statement (meaning it can be calculated from information disclosed in the Summary Compensation Table), it is rarely specified directly. In our experience, some companies informally review this relationship as a way to get a reality check on pay levels that are determined based on the competitive marketplace and the relative strength of the incumbent executive to peers.

In order to provide a general overview of how companies today are structuring their internal pay equity among executives, we have examined the ratio of CEO pay to the average of other highest paid named executive officers (NEOs) for companies in the Russell 3000. To do this, Gallagher reviewed the annual proxy statements for all Russell 3000 companies that filed from January 1st through May 30th, 2017 (“Russell 3000 Study”).

Pay data for the CEO and NEOs of each company was reported in the Summary Compensation Table of these proxy statements. Total pay was calculated as the sum of the base salary, bonus, and long-term incentive awards as detailed in the summary table. Companies with CEOs making under $100,000 in annual total pay were removed from the CEONEO Ratio analysis on the basis of outlier data that is not representative of the typical CEO pay package. Companies with only one NEO listed in addition to the CEO in the Summary Compensation table were also removed.

Based on these parameters, the final dataset included 2,248 companies in the Russell 3000. The NEOs varied in title by company, and only 55% of companies had a traditional “Top-5” structure consisting of a CEO and four other NEOs. Of the remaining companies, approximately 25% had more than four NEOs listed in addition to the CEO, and approximately 20% had less than four NEOs listed in addition to the CEO. Gallagher calculated the average CEO-NEO Ratio for each company to come up with the 25th percentile, median, and 75th percentile ratios for all companies in the sample, as shown in Figure 1. In addition, Gallagher examined the ratio of CEO pay to selected individual NEO positions, including the Chief Operating Officer (“COO”), Chief Financial Officer (“CFO”), and General Counsel (“GC”).

The results of this analysis are as follows:

  • Median CEO pay is 2.71 times that of the other NEOs (based on the median NEO average). The 25th to 75th range is 2.03 to 3.67.
  • Median CEO pay is 2.12 times that of COOs at the same companies. The 25th to 75th range is 1.62 to 2.86.
  • Median CEO pay is 2.70 times that of CFOs at the same companies. The 25th to 75th range is 2.00 to 3.70.
  • Median CEO pay is 3.41 times that of General Counsels at the same companies. The 25th to 75th range is 2.56 to 4.37.

These findings are not surprising. The median CEONEO Ratio of 2.71 is in line with general expectations from ratings agencies, shareholders and proxy advisory firms. Over the years, CEO pay has become more and more dependent on incentive plans such as performance-based equity compensation programs that pay out large sums upon achievement of corporate goals.

Most compensation committees will benefit from a regular review of these ratios in order to identify and address concerns before complications occur. Companies can also make use of this type of ratio when assessing issues such as succession planning, retention, and talent development. Companies with lower CEONEO Ratios might have executives in positions seen as important as the CEO that should be awarded under a similar pay structure. Looking at the “by position” ratios in the graph above, the moderately lower CEO-COO Ratio of 2.09 demonstrates the importance of the COO role to most organizations. In many instances, the COO is groomed to become the next CEO when companies look internally in their succession planning.

In general, a high CEO-NEO Ratio can be indicative of many potential problems, as follows:

  • An unbalanced leadership model. A strong or imperial CEO who surrounds his or herself with weaker senior executives and effectively usurps responsibility.
  • A lower likelihood of an internal candidate succeeding the CEO. In general, it will be difficult for any other senior executive to function at the level of the highly controlling CEO, or to reassure external stakeholders that company stewardship will be transferred with minor disruption.
  • Higher cost of replacing the CEO. The board may give further deference to the incumbent CEO as they realize that the CEO is too valuable given the overall management team. This worsens the situation by maintaining or even increasing the unbalanced pay ratio

Along with the negative impact of a higher CEO-NEO Ratio on the readiness of internal candidates, promoting a “tournament” approach to executive succession may also hurt retention of top candidates because their career success is increasingly defined by the pursuit of the chief executive’s title. Not becoming a CEO may be seen as failure, or at least a critical juncture in their career progression. Worthy candidates are more likely to then pursue outside job opportunities.

Pay dissatisfaction is rarely the primary reason that senior executives leave a company, but it may be symptomatic of other issues. When executives believe their value is truly recognized (not just with compensation, but by increasing board interaction, new leadership responsibilities, etc.), they are less likely to view getting the CEO’s job as the only worthwhile step in their career.

Paying an exorbitant amount to a CEO runner-up will be quite costly and ultimately will not improve the likelihood of long-term retention under new leadership.

In fact, this action may just delay the executive’s departure. It can be more costly to the company in the interim and may create a difficult CEO transition. In addition, it could increase the costs of hiring the failed candidate as CEO for the next firm. They will have to make the executive whole on the forfeited longterm incentive awards that were used to keep the executive in place while the “tournament” was in progress.

Companies can increase the likelihood of holding key talent through a leadership transition by taking a thoughtful approach to executive pay, including the following actions. Ensure that senior executives are paid not only appropriately against the market, but consistent with internal equity considerations. In other words, the company should generously compensate long tenured executives who have proven they are truly exceptional in their roles, or are key “utility” players who ably fill varied roles as needed. During a period of stable CEO leadership and low executive turnover, boards may assume these executives really need not be paid so well. However, a policy of fair compensation can make a big difference in the response of an internal CEO candidate who ends up a runner-up.

The pay “gap” of the CEO and other executives also varies by industry and other related circumstances. For example, high performing CEOs may have justifiably higher pay ratios, particularly in larger companies or companies in certain industries. Higher CEONEO Ratios may occur because the CEO is paid well above market levels, or because the other executives are paid well below market levels, or a combination of both. When the other executives are paid below market, the board in fact encourages the CEO to run the company without strong support normally offered by other senior executives.

Gallagher’s Russell 3000 Study also looked at how company size and industry might affect the CEO-NEO Ratio. Non-financial companies were classified into five revenue categories, while financial companies were categorized by asset size. As another look, all companies were segregated into ten industry sectors.

The Financial companies CEO-NEO Ratio may be explained by the responsibilities of the NEOs, which typically are running the profit centers (e.g. the trading, IB, and other profit generating activities). Therefore, the CEO-NEO ratio may be smaller.

The findings from this more in depth analysis show a correlation between company size and the CEO-NEO Ratio. In general, the larger the company, the higher the ratio. This may be explained by the economy of scale of larger companies in that they are more complex and therefore more difficult to manage. Adversely, a smaller company is simpler to manage, resulting in a ratio that is lower.

For non-financial companies, the ratio started at 2.43 for companies with revenues under $400M, peaked at 3.32 for companies with revenues between $3B to $9.9B, and tapered back down to 3.16 for the largest companies with revenues over $10B.

For financial companies, the median ratio increased in lockstep with company size, starting at 2.09 for companies with assets under $2.5B and increasing to 2.62 for companies with assets over $10B.

When categorized by industry sector, the median CEONEO Ratio ranged from 2.37 (Financials) to 3.56 (Materials). The lower CEO-NEO Ratio of Financial industry companies may be explained by the responsibilities of the NEOs, which are largely related to running the profit centers (e.g. trading, investment banking, and other profit generating activities).

Other Human Capital Measures

The Human Capital Management Coalition (HCM Coalition), a global group of 26 institutional investors representing over $2.8 trillion in assets, recently submitted a rule making petition to the U.S. Securities and Exchange Commission (SEC) urging the adoption of standards that would require listed companies to disclose information on human capital management policies, practices, and performance.

The petition builds the investor case for enhanced disclosure while providing a foundation upon which the SEC can develop consistent and comprehensive standards that would allow investors to better understand and assess how well the companies they own are managing their talent. Current SEC workforce reporting rules only require companies to disclose employee headcount. The petition does not define specific metrics for reporting; instead, the petition offers nine broad categories of information deemed fundamental to human capital analysis as a starting point to dialogue: workforce demographics; workforce stability; workforce composition; workforce skills and capabilities; workforce culture and empowerment; workforce health and safety; workforce productivity; human rights; and workforce compensation and incentives.

The 29-page petition lays out an argument for why certain human capital management disclosures would be material to investors, though it does not prescribe how those disclosures should be presented and defers that decision to the SEC. The petition cites a series of studies about how workforce issues can impact companies’ bottom lines as evidence for why new disclosure rules are needed. The petition suggests that companies should include some disclosures from nine specific categories, whether quantitative or qualitative (or both).

These nine categories are as follows:

  1. Workforce demographics (number of full-time and part-time workers, number of contingent workers, policies on and use of subcontracting and outsourcing)
  2. Workforce stability (turnover (voluntary and involuntary), internal hire rate)
  3. Workforce composition (diversity, pay equity policies/audits/ratios)
  4. Workforce skills and capabilities (training, alignment with business strategy, skill gaps)
  5. Workforce culture and empowerment (employee engagement, union representation, work-life initiatives)
  6. Workforce healthy and safety (work-related injuries and fatalities, lost day rate)
  7. Workforce productivity (return on cost of workforce, profit/revenue per full-time employee)
  8. Human rights commitments and their implementation (principles used to evaluate risk, constituency consultation processes, supplier due diligence)
  9. Workforce compensation and incentives (bonus metrics used for employees below the named executive officer level, measures to counterbalance risks created by incentives).

CONCLUSION

Since companies are very different in their organizational and operational structures, we believe that there is limited utility in the CEO to median employee pay ratio disclosure that will be required by the SEC under Dodd-Frank. However, looking at the CEO-NEO Ratios of companies of the same size and/or industry sector can provide important information and insights. It is worthwhile for compensation committees to track this information internally and on a relative basis.

Such information can be used as part of the compensation benchmarking process and as a test of strong succession planning, as well as contributing to effective talent acquisition, management, and retention. In addition, companies should consider expanding disclosure to include a broader set of human capital measures, such as those recommended by the HCM Coalition.

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