Determining CEO Pay Ratio Isn't So Simple

Unions have long sought issuance of the Aug. 5 final rule from the U.S. Securities and Exchange Commission (SEC) requiring publicly traded companies based in the U.S. to disclose how median employee pay compares with CEO compensation. But while organized labor sees the information as an aid to its organizing efforts, many business advocates claim that the new disclosure gives a misleading and confusing view of CEO compensation, and some HR managers contend it will be burdensome to calculate.

The highly controversial disclosure, known as the CEO pay ratio, implements Section 953(b) of the Dodd-Frank financial reform legislation enacted in 2010. Public companies will be required to provide disclosure of their pay ratios for their first fiscal year beginning on or after Jan. 1, 2017. The SEC’s vote, taken on Aug. 5, 2015, split along party lines, with the two Republican commissioners opposing the measure, as SHRM Online reported.

An SEC fact sheet was posted online, along with the final rule.

A New Disclosure

Under the SEC plan, companies must disclose in their annual proxy statements the median of the annual total compensation for their employees and the ratio of that median to the annual pay of the CEO. This applies to companies with SEC filings that require executive compensation disclosure under Item 402 of Regulation S-K, but it exempts smaller reporting companies, emerging growth companies and foreign private issuers.

The pay ratio calculation includes part-time workers but excludes up to 5 percent of a company’s non-U.S employees, and non-U.S. employees in jurisdictions where data privacy laws prevent compliance.

The rule also provides transition periods for new companies, companies engaging in business combinations or acquisitions, and companies that cease to be smaller reporting companies or emerging growth companies.

Although the disclosure requirement had been delayed for years pending a final rule, Section 953(b) of the Dodd-Frank act states that all U.S. public companies (and companies that are not publicly traded but that have public debt), as well as other companies that are required to file reports with the SEC, must disclose the following compensation metrics:

• The annual total compensation of the chief executive officer. The annual total compensation for the CEO is currently available in the summary compensation table in SEC Form DEF 14A Filings (i.e., definitive proxy statements).

• The median annual total compensation for all employees (except the chief executive officer).

• A ratio of these two metrics: annual total compensation of the CEO divided by median annual total compensation for all employees (excluding the CEO)

The median annual total compensation metric for all other employees and the CEO-to-employee pay disparity ratio are new requirements.

“On the surface, these metrics might seem relatively simple and reasonable to calculate. However, digging into the data—and considering the complexity of factors that influence the numbers—reveals that the CEO-to-employee pay ratio defined by the Dodd-Frank Act can be difficult to calculate and interpret,” W. Leigh Culpepper, president and CEO of pay benchmarking firm Culpepper and Associates Inc., previously told SHRM Online.

“The pay disclosure requirements in the Dodd-Frank Act will require many companies to start calculating total compensation for every employee, so they will be able to calculate the CEO-to-employee pay ratio,” he noted.

What Constitutes ‘CEO Pay’

The SEC defines “total compensation” for the last completed fiscal year under Item 402 of Regulation S-K. Annual total compensation, in general, includes:

• The sum of salary, bonus, stock awards, option awards, nonequity incentive plan compensation, change in pension value and nonqualified deferred compensation earnings, and all other compensation (e.g., perks, personal benefits and property with an aggregate amount exceeding $10,000).

• Tax gross-ups.

• Company contributions to defined contribution retirement plans.

• Preferential stock purchase discounts.

• Preferential life insurance premiums.

• Dividends or other earnings not factored into the fair value of equity awards.

As the above list suggests, “the SEC's definition and calculation of total compensation includes the value of some but not all company-provided benefits,” Culpepper explained. For example, it includes retirement benefits, such as company contributions to 401(k) and other defined contribution plans, and changes in pension values. However, it does not include the value of other benefits available on a nondiscriminatory basis to all employees. “That would exclude company contributions to group insurance plans (e.g., health, life and disability insurance benefits),” for instance, Culpepper said.

The disclosure is required in any annual report, proxy or information statement, or registration statement that requires executive compensation disclosure. But the final rule allows a company to identify the median employee whose compensation will be used for the annual total compensation calculation once every three years “unless there has been a change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change in the pay ratio disclosure,” according to a comprehensive summary posted online by law firm Stinson Leonard Street LLP.

HR Challenges Ahead

“We are incredibly disappointed with the commission’s decision to implement the CEO pay ratio reporting regulations, rulemaking intended to name and shame American business executives,” Cara Woodson Welch, vice president for external affairs at WorldatWork, an association of total rewards professionals, told SHRM Online.

“Furthermore, we feel the final version has no benefits and requires companies to account for all employees, including overseas workers, with very limited exceptions. Now our members will be forced to comply with costly and time-consuming regulations to calculate the pay ratio for all company employees regardless if they are full-time, part-time or seasonal workers,” Welch said.

The U.S. Chamber of Commerce's Center for Capital Markets Competitiveness released a report last year that called the SEC's proposal “a fundamentally misleading and flawed statistic [that] could present a fundamentally misleading portrait of CEO pay, particularly compared across industries.” The reported further charged: “Businesses are already disclosing company and industry-specific metrics for performance and their relation to compensation. The pay ratio disclosure will not provide additional insight whether pay appropriately reflects the performance of executives or the condition and circumstances of the businesses they manage.”

Among unintended consequences, pay consultancy Performensation predicted that CEOs and boards will use low pay ratios as an argument for raising CEO pay. “No one wants to think their CEO is worth less than their competitors,” the firm said in an online post.

Another prediction: Compensation professionals will be tasked with explaining why the pay ratio at their company is not directly comparable to their peers, and that “Arguments will be made that divergent ratios are a result of different forms of pay, more variable pay (or higher risk) for the CEO, better work-life balance for employees, better employee satisfaction, high retention, etc.,” the post noted.

Along similar lines, disclosing CEO pay ratios could lead to employee misunderstanding with a negative impact on engagement, productivity and, potentially, turnover, advised Towers Watson. This concern should not be ignored, and can be addressed as part of a CEO pay ratio communications strategy.

Finally, law firm Winston & Strawn LLP provided a to-do list for implementing the final rule that included:

• Brief the board and/or compensation committee as to the final rules and the action steps.

• Select a methodology to identify your median employee based on the company's facts and circumstances.

• Assess your ability to calculate precisely all items of compensation or whether reasonable estimates may be appropriate for some elements.

• Begin to evaluate possible testing dates.

• Determine whether any of your non-U.S. employees are employed in a jurisdiction with data privacy laws that preclude you from including them in the median employee calculation.

Unions Praise Disclosures

“At a time when corporate profits are near an all-time high and income inequality is growing, employees and shareholders have a right to know whether companies are padding the wallets of executives at the cost of workers and the company's bottom line,” said Teamsters Secretary-Treasurer Ken Hall in a news statement.

According to an AFL-CIO study of CEO pay at S&P 500 companies, the average CEO earned 373 times more than the typical U.S. worker in 2014. In contrast, CEOs in 1980 made 42 times more than the average employee.

“Wall Street is much better at doling out lavish compensation packages than disclosing them,” said a statement from AFL-CIO President Richard Trumka. “The business community is claiming it would cost more than $185,000 and almost 1,000 hours of staff time per company to calculate the CEO-to-worker pay figure,” but, he contended, “Employers should already have this information on the books. Dodd-Frank asks companies to do some simple calculations, not put a man on Mars.”

Stephen Miller, CEBS, is an online editor/manager for SHRM. Follow me on Twitter.

Related SHRM Article:

SEC Pay-Ratio Rule Spotlights CEO Compensation, SHRM Online ​Legal Issues, August 2015

Related Resources:

Dispelling Some Common Misconceptions About Determing the CEO Pay Ratio, Willis Towers Watson, September 2016

SEC Adopts Final Pay Ratio Rule – A Comprehensive Summary, Stinson Leonard Street LLP, August 2015

To-Do List for Implementing Final Rules on the CEO Pay Ratio Disclosure, Winston & Strawn LLP, August 2015

Final CEO Pay Ratio Rules Provide More Flexibility for Compliance, Towers Watson, August 2015

SEC Pay Ratio Rules: A Recipe for Compliance and Model Disclosure, Orrick, August 2015

Understanding the SEC's CEO Pay Ratio Disclosure Rule and Its Implications, Mayer Brown, August 2015