How does your company’s pay measure up?

Under the Dodd-Frank Act, public companies must calculate and disclose a ratio comparing CEO compensation to the median compensation for other employees. Although this requirement was finalized in 2015, companies will be first required to include the ratio in proxy statements, annual reports and registration statements in 2018 (using 2017 compensation data). While it’s too early to draw any detailed conclusions, the ratios appear to vary widely within and across sectors.

Pros and cons

Pay-ratio disclosure is a controversial topic. For a public company, higher median employee compensation would make the overall ratio appear less severe and possibly blunt criticisms over the pay gap between the CEO and rank-and-file workers. Conversely, a low pay ratio could signal to investors that the company is spending too much on rank-and-file employee compensation and isn’t effectively controlling its costs.

Proponents of the rule say pay-ratio disclosures will help inform shareholders in say-on-pay votes. Investors and labor unions support the measure; they see it as a step toward reducing outsized CEO pay packages. They believe that high pay disparities can hurt employee morale and productivity, as well as have a negative effect on a company’s financial performance.

On the other side of the debate are public company executives who see pay-ratio disclosure as costly for companies to implement, while providing no real benefit to investors. They argue that details about public companies’ executive compensation are already disclosed in their proxy statements. So, the pay ratio provides no new insight into what executives are making.

In addition, business groups complained that including foreign workers in pay ratio computations would be costly and misleading. Most companies don’t have payroll systems that track information globally. And differences in the cost of living, compensation practices and foreign exchange rates from country to country could unfairly skew the pay ratio. Some companies also wanted to exclude part-time employees from the ratio, because the comparison between their compensation and that of a CEO who works full time would inevitably be misleading.

Pay-ratio calculations

To comply with the pay-ratio disclosure requirement, companies will have to calculate the median compensation of their workforce and present the number in a ratio comparing it to the CEO’s total compensation. The final rule allows companies to exclude up to 5% of their non-U.S. workers. Companies are also permitted to adjust the ratio to account for differences in the cost of living between regions, although they must present that data along with the nonadjusted version.

The new rule doesn’t prescribe a specific method for calculating median employee compensation. Instead, public companies can choose a process that fits their structure and compensation programs, as long as they disclose the methodology used to determine the median employee pay and the estimates used in calculating the pay ratio.

For example, a large company could use a statistically representative sample of its workforce rather than the entire population. Companies also won’t be required to calculate the exact compensation when identifying the median. Rather, a company can apply any “consistently used compensation measure,” such as the amounts reported in payroll or tax records. Companies will still have to calculate annual total compensation, but the SEC will let them use “reasonable estimates” for the calculation.

A rough start

In early 2018, companies started filing the first round of proxy statements after the new pay ratio rule took effect. The results varied significantly, according to a recent study of 35 filings by law firm Davis Polk & Wardwell LLP.

The following table summarizes the range of ratios of CEO compensation to median employee compensation from several industry groups:

Industry group Range of pay ratios
Energy 0.9:1 to 25:1
Financial 1:1 to 429:1
Health care 6.4:1 to 338:1
Industrials 50:1 to 428:1
Real estate 14.81:1 to 111:1

One reason for divergent pay ratios is that companies used different methods to compute compensation and included different types of employees in their calculations. For example, some companies in the sample used only U.S. employees. One company annualized its CEO’s compensation after a midyear promotion. Another company used realized pay only.

In addition, while some companies used base salary or W-2 wages to identify their median employee wage, most chose a “base pay plus” approach and added further compensation components to base salary. Such additional compensation includes commissions, annual bonus, overtime pay, equity compensation and other incentive payments.

More oversight needed?

Advocacy group Public Citizen is concerned that the SEC is treating the new corporate disclosures of CEO pay ratios “without adequate care.” In a recent letter to the SEC’s Division of Corporation Finance, Public Citizen urged the SEC to step up oversight of “this important new disclosure.”