United States: Consultant Pay Governance Analyzes Pay Ratio

Last Updated: June 11 2018
Article by Cydney Posner

In this analysis, compensation consultant Pay Governance looks at the factors affecting pay-ratio results and, in light of the feverish media coverage that insists on comparing ratios among companies, offers advice on dealing with that onslaught of comparisons. In their analysis, the authors conclude that pay-ratio results are more affected by median employee pay than by CEO pay. And, because median employee pay can be highly variable depending on the company's industry, geographic location, international operations and business model, pay-ratio comparisons among companies are "fraught with technical and structural issues," and "potentially problematic," especially between the companies with the highest and lowest pay ratios. Of course, it was never the SEC's intent that pay-ratio be used for comparative purposes across companies; as the SEC made plain in the adopting release, "the final pay ratio rule should be designed to allow shareholders to better understand and assess a particular registrant's compensation practices and pay ratio disclosures rather than to facilitate a comparison of this information from one registrant to another." That caution notwithstanding, the issue continues to confront boards and comp committees, and the authors suggest ways that boards can navigate these shoals.

Pay Governance studied pay-ratio data for 389 companies in the S&P 500. Interestingly, among those companies, the median CEO pay level was relatively consistent with that shown in many other studies at $12.1 million; however, the median of the "median employee pay" level—$70,129—was almost $20,000 more the average U.S. private sector salary of $50,620, as determined by the U.S. Bureau of Labor Statistics. (Counterintuitively, the pay-ratio median includes part-time employees and (presumably lower-paid) foreign employees.) The study focused on two questions:

  1. "How much of the pay ratio variation is associated with CEO and/or median employee's pay?
  2. What variables affect the pay ratio, and which drive a ratio to the extremes of the public company distribution?"

Although the pay-ratio disclosure requirement appears to have been rooted in the desire to clamp down on perceived runaway executive pay, the authors conclude that, ironically, "pay ratios are more strongly correlated with median employee pay than with CEO pay due to greater variability in median employee pay across S&P 500 companies." (The correlation coefficients were 57% for CEO pay and -72% for median employee pay (showing an inverse correlation)). The authors attribute the difference in variability to the number of drivers: CEO pay is driven primarily by industry and size, while median employee pay depends on industry, business model (e.g., whether certain functions are outsourced to low-paid non-employees or performed internally in geographically diverse labor markets), geographic employee distribution and skill level. As a result, the differential between the highest- and lowest-paying industries for median CEO pay was 92% but, for median employee pay, the differential was 305%. Note, however, that the situation was reversed for company revenue, with the differential between above- and below-median revenues at 55% for CEO pay and only 18% for median employee pay.

The authors then looked at the attributes of companies with pay ratios in the top 10% (747:1) and bottom 10% (55:1). With regard to revenues and number of employees, high-ratio companies tended to have higher revenues ($13 billion) and more employees (69,000) than low-ratio companies (revenues of $5 billion and 7,700 employees). High revenues are associated with higher CEO pay (median CEO pay of $15.3 million), and high employee headcount is associated with lower employee pay (median employee pay of $19,000), hence the higher pay ratios. By comparison, companies with low pay ratios had median CEO pay of $5.7M and median employee pay of $108,000. Interestingly, the study also found that companies with higher profit per employee also tended to pay their employees more and have lower pay ratios. For example, high pay-ratio companies showed median profit per employee of $13,522 compared to $78,840 for the lowest pay-ratio companies.

The authors conclude, however, that, relative to industry pay data from the Bureau of Labor Statistics, it was not the case that high pay-ratio companies consistently underpaid their employees. Rather, the study found that high-ratio companies were in industries with lower market pay levels according to BLS labor market data ($40,739 compared to the annual mean national wage of $50,620 in 2017). Note also that, in contrast to the BLS data, the pay-ratio data included non-US employees and part-time employees, which, to some extent, may help explain the difference between the median employee pay of $19,170 for highest-ratio companies and the BLS labor market data. In contrast, the lowest-ratio companies were in industries that had higher BLS market pay levels (median of $102,242, compared to the pay-ratio median of $107,771, suggesting that off-shore employees did not have as significant an impact for these companies.)

While low-ratio companies tend to have lower CEO pay (which, the authors suggest, may reflect founders or CEOs with prior large equity holdings or grants), large high-ratio companies may have typical CEO pay but lower median employee pay (potentially reflecting offshore or part-time employees). As a result, the authors conclude that "[t]aken together, these facts illustrate why pay ratio comparisons, particularly between the highest- and lowest-decile pay ratio companies, are potentially problematic."

In an effort to further understand the impact on pay ratios of CEO versus employee pay, the authors conducted additional analyses: their "findings, after adjusting for company size and labor market, supported [the] study's overall findings. While both CEO and median employee pay had major impacts on the ratio, employee pay had a larger impact." For example, "at the median ratio, a 10% increase in CEO pay increased the ratio by 25.6 points (from 171:1 to 197:1), while a 10% decrease in employee pay increased the ratio by 40.6 points (from 171:1 to 212:1)."

Despite the cautions that comparisons are inapt, if raised by the media, by investors or otherwise, companies and boards may still be compelled to address them. In that event, the authors suggest that companies assemble data for a group of five to ten comparative companies that focuses on the competitive labor market (because, as noted above, employee pay has a greater effect on the ratio.) These comparative companies would have "similar broad-based employee demographics: that means similar headcounts, geographic distribution of employees, employee skill level, and staffing models (e.g., part-time versus full-time)." The group is very likely to be different from the peer group used for executive pay benchmarking. The authors caution that "some of the largest S&P 500 companies may have few appropriate companies for comparison, if any, and pay ratio comparisons or benchmarking should not be forced in such cases."

Instead of comparisons, however, the authors advocate that companies take the view that the ratio is only one of many components, adopting a principles-based approach to pay equity that focuses on the appropriate markets, governance and competitiveness of CEO pay and employee pay. To that end, the authors suggest consideration of responses to the following questions:

  1. "Are the compensation practices and levels for both executives and employees consistent with the company's business strategy and philosophy? While some stakeholders may second-guess a company's compensation program (ie, a high level of CEO pay and low level of employee pay), an economically successful company will create productive jobs with competitive pay over the long term.
  2. Are executive compensation setting processes and disclosures exhaustive and consistent with good governance standards? Is say-on-pay support high?
  3. Are broad-based pay levels fair and competitive for the level of skill, experience, and hours of employment? Have these levels been confirmed with market data?
  4. Do broad-based pay structures represent a competitive wage for full-time employees in the local economy?
  5. Have recent company-wide surveys identified pay as a concern? Where did pay stand in relation to other concerns?"

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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