Paul Hodgson: As the SEC looks at pay ratios, how much more is the CEO paid than me?

How useful are CEO-worker pay ratios for investors?

The Securities and Exchange Commission is looking at the ratio between CEO and worker pay today (September 18).
Specifically, the SEC will discuss whether to propose rules to require companies to disclose the “median annual total compensation of all employees and the ratio of that median to the annual total compensation of the company’s chief executive officer”.
This ratio was mandated – some time ago – by Section 953(b) of the Dodd-Frank Act.
Those of us interested in finding out how much more the CEO of Apple earns than the median of all his employees should not get too excited, however.
Even if the SEC proposes the rules, there will be yet another lengthy comment period, and then some more messing about, so it seems unlikely that the rules could be proposed and finalised before late 2014, making them effective for the 2015 proxy season for most companies. With the kind of delaying tactics from corporations that we have come to expect, it could even be more realistic to expect the first disclosures only by the 2016 proxy season.
Bu where did the idea for this CEO-worker pay ratio come from? Its usefulness for shareholders is not immediately obvious; its incendiary headline grabbing nature is more evident.

The ratio was proposed by Democratic New Jersey Senator Robert Menendez, and was originally part of separate legislation. Apparently Senator Chris Dodd (Democrat-Connecticut), and one of the co-sponsors of the bill, agreed to the rule as a favour to Menendez. At the time, apparently, Dodd said: “Let’s give it to the SEC and let them figure out how to do it.”
And that’s exactly what’s been happening since July 2010, when Dodd-Frank was signed into law. Part of the problem has been the broad discretion allowed to the SEC in developing and applying the ratio. For example, the SEC can determine the frequency of disclosure and the method used to calculate median pay for employees.It already has discretion on how to define CEO remuneration, so that’s another variable to put into the rulemaking process. The other part of the problem is the corporations themselves, who have opposed the implementation of what, on the face of it, would seem to be a fairly simple piece of legislation.
Annual disclosure of the ratio would seem to be sufficient, and it is expected that that is what will be proposed. As to the calculation of employee pay, this will include – where relevant – all the pieces that are typically used to calculate CEO remuneration: salary; cash bonus, perks; benefits; pensions; stock awards; and stock options. Senator Menendez has also been very clear about which employees should be included in the calculation. In an explanatory letter to the SEC in January 2011 during the first round of comments, he said: “Specifically, I want to clarify that when I wrote ‘all’ employees of the issuer, I really did mean all employees of the issuer. I intended that to mean both full-time and part-time employees, not just full-time employees. I also intended that to mean all foreign employees of the company, not just U.S. employees.”

Clearly the inclusion of part-time workers and foreign workers in low wage countries is likely to lower the median pay figure for employees and therefore increase the ratio. While demanding their inclusion might seem churlish and irrelevant, companies with a policy of only employing part-time employees and/or outsourcing manufacturing or services to low-wage countries will be exposed by such a disclosure and shareholders, and indeed stakeholders, can take the action that they think is necessary.
And the definition of CEO remuneration – relatively fixed at the moment – may also be subject to change in the near future in the US, as the SEC could be moving towards a “realised pay” model rather than an ”estimated pay” model. Realised pay includes the actual present value of vested stock and real profits on stock options.

Estimated pay includes the expected value of these stock awards. If the SEC does make this shift, this will also increase the size of the ratio at most firms because realised pay is higher than estimated pay in more than 90% of examples, leading to yet more embarrassing disclosures.
I have only seen one company actually disclose the ratio, insurance company MBIA… and it only did it once, in its 2011 proxy statement. There it was disclosed that the average and median salary for all employees other than the NEOs (385 employees) were $151,700 and $130,000, respectively. The average and median salary and bonus for all employees were $223,000 and $165,000, respectively. These compare to Mr. Brown’s salary of $500,000 (3.3 times average and 3.9 times median) and salary and bonus of $2,300,000 (10.3 times average and 14.0 times median) for 2010.
In this instance, the CEO did not exercise, nor was he awarded, any stock options or any other kind of stock award, so the ratio was relatively small. But since equity is one of the main drivers of the growing disparity between CEO pay and the rest of the economy, MBIA is not the most illuminating example.
So, apart from embarrassing CEOs, what is the point of the pay ratio?
Internal pay differentials are a key metric in assessing standards of governance at companies, but these are generally taken to mean the differential between the CEO’s pay and those of their direct reports. That differential helps shareholders understand the power balance in both the boardroom and the executive suite. The importance of this ratio in the future value of firms received additional support recently in a paper on pay disparity and the cost of capital. This ratio – if too high – is generally considered to be more indicative of governance problems than the proposed Dodd-Frank ratio.
And, frankly, most shareholders appear to be more interested in the relationship between the CEO’s pay and the company’s performance than in the relationship between worker pay and CEO pay. Fix that, they feel, and many other problems will simply go away.
It’s almost as if the Dodd-Frank ratio is a social policy issue. Not that it is unimportant because of that, it’s just that its place in a financial reform act seems a little odd. There is no doubt that the ratio between worker pay and CEO pay has increased exponentially. It has even increased exponentially in the UK, land of relative moderation, so you can imagine what’s happened to it in the US. According to a report by the High Pay Commission in 2010, median pay for FTSE 100 CEOs had risen from 69 times median wage levels in 1998 to 145 times in 2009.While there have been claims that CEO pay in the US is over 350 times that of average worker pay, this differential has shrunk since the financial crisis, but, as in the UK, it is climbing again. According to a Bloomberg report from April this year, across the S&P 500, the average multiple of CEO remuneration to that of rank-and-file workers is 204, up 20% since 2009.
In addition, the ratio is also going to be a figure that is wildly disparate from one company to the next. The differential at Wal-Mart is going to be very different from what it is at Goldman Sachs, for example, because Goldman has a lot of very highly paid employees (some of whom might earn more than the CEO in any given year), while Wal-Mart has a lot of poorly paid and part-time staff. In other words, a comparison between the ratios at Wal-Mart and Goldman Sachs is not going to tell anyone much of any value.
On the other hand, the ratio is a good indicator of the reasonableness of remuneration both within a company and within an industry, allowing for a context for remuneration assessments between companies of similar size and industry. In addition, J. Robert Brown, writing in the Harvard Business Law Review says that: “Because a bad ratio may be embarrassing, the board has an incentive to alter compensation in order to avoid adverse disclosure. Disclosure of the ratio may, therefore, impact the amount of compensation paid to employees and the CEO.”
In other words, a bad ratio could be a tool in the hands of an otherwise dispirited remuneration committee which it could use to force a CEO to accept lower pay.
While I am not completely convinced that the Dodd-Frank ratio is the best way to force companies to disclose, the thing that interests me is the storm of protest from corporations and their minions. I understand it’s going to be difficult to calculate, but compared to running a huge multinational business, my guess is that it will be comparatively simple. Furthermore, compared to the lawsuit the US Business Roundtable and the US Chamber of Commerce used to block proxy access (the right of shareholders to nominate non-executive directors), the level of protest against the CEO/worker pay ratio seems to be out of all proportion to its importance. Let’s hope that the SEC does a proper cost benefit analysis of this rule, because the lack of one allowed the Chamber and the Roundtable to succeed in blocking proxy access.
The Center for Executive Compensation, a corporate sponsored pay think tank, has been a vocal opponent of the pay ratio, writing letter after letter to the SEC. Some of its most prominent sponsors may have the most to hide. Apparently, some 17 companies on the Center’s board of directors have CEO pay ratios in the top 20% of S&P 500 corporations.

These include General Electric (ratio: 491); McDonald’s (351); and AT&T (339).
And it is not only corporations that have been attempting to block the introduction of this piece of legislation. Even Congress has moved to reverse it with the introduction of yet more legislation. The Burdensome Data Collection Relief Act called for the repeal of the Dodd-Frank’s clause where the ratio is defined.

The Act is not progressing well, but its existence, and all the other protests make me very, very suspicious.It suggests some companies already know what the ratio is and they really do not want it in the public domain. As Congress and the House Financial Services Committee consider the repeal of this clause, however, its members should remember that most voters are workers, not CEOs.

Paul Hodgson is an independent governance consultant