Compensation Focus

The CEO Pay Ratio Rule: Navigating the Process and Answering the Questions

By Deb Lifshey and Sharon Podstupka, Pearl Meyer   |  April 2017
I Heard the (Business) News Today, Oh Boy

Even if you don’t believe that the CEO pay ratio will ultimately be a required disclosure or that if disclosed, it’s not going to make significant waves, companies must still be prepared to react. The likelihood for questions is high and the range of stakeholders is diverse. While the best case scenario would be very little noise around the subject, that’s not a realistic expectation for 2 key reasons:

  1. Pay Equity Issues Are Not Going Away. Given today’s political and business environments, the subject of pay disparity will draw media attention like moths to a flame. CEO pay levels will continue to make for easy headlines and news channel panel commentators will have a field day. This means that your internal troops (i.e., corporate communications, public and investor relations, the C-suite and board) must be well prepared for any possible incoming media fire about why your company’s CEO, and potentially the other named executives, earn exponentially more than the median employee. Remember, anything you say could make front-page news.
  2. New Access to Published Pay Data Will Cause Challenges. While investors may not care much about the CEO pay ratio, you can bet that the public will. The media will continue to push the pay inequality controversy and proxy statements will have a new, greater level of visibility — drawing a fresh audience to the Compensation Discussion & Analysis (CD&A). This, coupled with pay information websites, is bound to raise interest from your employees about the fairness of their own pay. To this end, human resources and people managers will need to know how to clearly defend your company’s pay practices, policies, and processes.

So, what can you do now?  First, develop an inventory of anticipated questions and answers by your stakeholder group. Then, decide who within your organization is best suited (and can be trained) to address them. The bottom line is that regardless of whether the CEO pay ratio falls on deaf ears or even goes away entirely, it is incumbent on companies to have a response strategy or risk being unprepared for the fallout. Weak responses to pay questions can easily lead to negative press, misinformed employees and frustrated investors.

Perhaps one of the most controversial provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the requirement to track and disclose the ratio between a company’s median paid employee and its CEO (often called the CEO pay ratio). The U.S. Treasury secretary and top financial regulators will convene and deliver a report by June outlining what they believe is, and what isn’t, working under this rule. In addition, the acting chairman of the Securities and Exchange Commission (SEC) sought additional public comments specific to the CEO pay ratio, which were submitted at the end of March.

While it is possible the CEO ratio rule will either be amended or delayed, companies should still be spending some time preparing for the rule because any significant changes will require Congressional action, which typically takes time. At the time of this writing, companies should be operating under the assumption that the requirement will go into effect for proxies filed in 2018. Whether your company has hundreds of thousands of employees spread throughout the world or is a smaller domestic business, we recommend a structured approach to ensure organized collection of data and clear presentation of the ratio.

The Basics

When adopted, Dodd-Frank simply required that companies disclose the median annual total compensation of all employees, the CEO’s annual compensation (which was already a required disclosure), and the ratio between the two. More than five years later, the SEC provided a host of supplemental guidance to help interpret this requirement. Some of the most critical points are:

  • Which employees must be considered? All employees means all employees with no exceptions for part-time, seasonal or temporary workers, and only limited exemptions for independent contractors and overseas workers.
  • When and how often is the calculation made? The median employee must generally be determined once every three years, and can be determined any day within the last three months of the fiscal year.
  • Which method can be used to find the median paid employee? Companies have flexibility to choose methodology to identify the median employee, which can actually complicate the process. The SEC allows companies to use statistical sampling, reasonable estimates or just choose to use certain pieces of compensation that are easily identifiable (e.g., payroll or W-2 compensation). However, any methodology used must be explained in the proxy, and must be reasonable.
  • How is the median employee’s pay reported? Once the median employee is identified, the job is still not complete. That employee’s pay must be recalculated as if the employee were to be in the summary compensation table (SCT) of a proxy statement.
  • How is the CEO’s pay determined and reported? Fortunately, this is the easy part. It is simply the total number reported in the SCT. If there are multiple CEOs, their compensation may be combined or the compensation of the CEO in the position on the date the median employee is determined may be annualized.
  • What other disclosure is required? Other than the pay of the median employee and CEO, a ratio must be reported, along with a brief explanation of how the ratio was calculated. While the rules don’t require much, we suspect companies will spend considerable effort in the message the ratio creates, and in future years, how this ratio compares to those of similar companies.

Where to Start?

Undoubtedly by this point, most companies have given at least some thought about how to gather and statistically analyze the potentially massive amount of data needed to find the median employee. Here is a summary to help streamline and simplify the process:

  • Identify the team and work plan. As a first step, a working group should be formed that may include — in addition to the HR team, particularly the workforce analytics and compensation professionals — individuals from the company’s legal, IT, accounting, finance, investor relations and/or corporate communications departments. A special project manager coordinating the work and deadlines is also helpful. Outside advisers (e.g., legal, compensation consultants, public relations, statisticians, etc.) should also be retained and consulted as needed. The project manager should develop timelines and goals with specific dates for drafts, iterative and final versions of the proxy disclosure.
  • Identify the pay data sources. Next, identify where the compensation data is housed for employees throughout the company and develop a plan to centralize the data. Existing systems may need to be modified or developed to capture the necessary data. Non-U.S. jurisdictions may complicate this task.
  • Determine the median employee. This is probably the most complex step and will require a judgment call in some circumstances. Factors to consider include:

    • What is the company’s goal? Interestingly, we have observed that many of our clients have different goals in computing this compensation for the median employee. The initial reaction has been to use data, carve-outs and statistical sampling in an effort to find the highest paid median employee (and thus reduce the difference between the CEO and median employee to show better alignment between the top and middle of the company). As time passed, we worked with more and more clients who preferred to have the median number be as low as possible. While at first blush it seemed counterintuitive, the rationale was well founded. These companies cared more about the employee perception of being paid more or less than the median employee. The lower the median employee’s pay, the better the employee population may feel about their own compensation. While everyone knows the CEO will make a lot more than most of the company, most employees are more concerned about how their pay compares with other employees.
    • Which employees are included? The list is very inclusive, covering all full-time, part-time, seasonal and temporary workers employed by the company or any of its consolidated subsidiaries both in the United States and overseas. Even furloughed employees may be counted in some circumstances. It excludes independent contractors and leased employees whose pay is not determined by the company. Up to 5% of employees may be excluded in some overseas jurisdictions or due to data privacy laws. However, taking advantage of these carve-outs is not that simple, and counsel should be consulted as to additional requirements if these exemptions are utilized.  
    • What date will be used? Companies may choose any date within the last three months of their last completed fiscal year to determine the employee population to use to identify the median employee. Individuals who are employees on this date are included and everyone else is excluded, which may significantly affect companies, such as retailers, that hire seasonal or temporary employees. In addition, companies must choose an appropriate time period for collecting the compensation data that will determine the median employee. They do not need to use a time period that includes the date on which the employee population is determined nor is it required to use a full annual period. For example, they may use annual total compensation from a company’s prior fiscal year so long as there has not been a change in the employee population or employee compensation arrangements that would result in a significant change of pay distribution to its workforce.
    • What measure of compensation will be used to rank employees? The SEC provided companies with some degree of flexibility to determine the median employee but requires what it calls a “consistently applied compensation measure” (CACM) that reasonably reflects the annual compensation of employees that can be used to identify the median employee. For example, companies may use base, bonus or equity grants, or any combination of the three. Alternatively, they may use W-2 box three Medicare wages. There are also other discretionary considerations: the pay of those who were employed less than the full year may be annualized; cost of living adjustments are available for non-U.S. jurisdictions; and exclusions for mergers and acquisitions are possible. Companies may also use various statistical sampling methodologies to limit the population included. But bear in mind, any approach used would need to be described in the proxy, which might add further complexity to the disclosure. Similarly, whatever CACM is ultimately used must be described in the proxy and must be reasonable. It must try to include all significantly widely used elements (e.g., equity grants cannot be excluded if they are widely used). If time permits, model out different measures of pay before choosing. Once a measure is finalized, the data must be consolidated and sterilized, stripping out all identification of the actual employee as the disclosure only requires pay data, not the name or position of the median individual.
  • Determine the median employee’s compensation. Once identified, the median employee’s compensation is recalculated using the same rules used to report named executive officer (NEO) compensation in the SCT.
  • Determine the CEO’s annual compensation. This amount will be taken straight from the SCT, but may be adjusted in the event that there were more than 2 CEOs during the year.
  • Calculate the pay ratio. This is presented as a ratio in which the annual total compensation of the median employee is equal to 1 (i.e., 200:1 or 1:200) or narratively in terms of the multiple that the CEO’s annual compensation bears to the median employee amount (i.e., 200 times larger than the median employee’s annual total compensation).
  • Draft the proxy narrative and develop a communication strategy. The last step is likely the most important. Decide where in the proxy statement the CEO pay ratio will appear and how much discussion will be provided about the methodology and meaning. While the most interested parties are likely the press and shareholders, companies must also keep in mind the impact on employees. Contemporaneous with the regulatory disclosure, companies must also consider the in-house corporate communications aspect of now providing data on the pay of the median employee.

About the Authors

Deb Lifshey is managing director and technical services practice leader of Pearl Meyer, based in New York.

Sharon Podstupka is a principal with Pearl Meyer, based in New York.

Read the April edition of Compensation Focus.

Contents © 2017 WorldatWork. No part of this article may be reproduced, excerpted or redistributed in any form without express written permission from WorldatWork.

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