CEO Pay Ratio Development Considerations
Included in the 2010 Dodd-Frank Act is Section 953(b), the so-called CEO pay ratio rule, which requires publicly traded companies to disclose the ratio of their CEO’s pay to that of their median employee. Companies will be required to report the pay ratio disclosure based on compensation paid in their first full fiscal year beginning on or after January 1, 2017.
There have been recent proposals to defer or repeal portions of the Dodd-Frank Act, including the CEO pay ratio rule. In fact, a Treasury Department report released on October 6, 2017 recommended that “section 953(b) of Dodd-Frank be repealed and any rules issued pursuant to such provisions be withdrawn.” However, any potential changes to the requirement are not likely to occur before the filing deadline, so companies should prepare to include the disclosure in the next proxy filing.
We predict that there will be significant discussion in the media regarding the CEO pay ratio once 2018 proxies are filed, so the messaging contained in the proxy will be important. While there is likely to be some attention focused on the methods of disclosure for the pay ratio in each company’s proxy, it’s hard to argue that anything will prove to be more important than the ratio itself. To that point, companies must consider that the media is likely to provide significantly more coverage to disclosures where the ratio of CEO pay to median employee pay is deemed very high.
Since there is little flexibility in calculating CEO pay, if the goal is to minimize the magnitude of the ratio, then the method of determining the median employee becomes the key. Certainly, having the highest possible median employee compensation would minimize the ratio, but consideration needs to be given to employees’ reaction to the median compensation figure. Employees already understand that the CEO makes a lot more than most employees, but they may be more interested to see how their own pay compares to the median worker. Accordingly, using a method of identifying the median employee that results in a higher pay level may not be the most desirable in all circumstances.
Determine the effective date that will be used to determine the employee population, and thus the median employee. This date can be any date within the last three months of the fiscal year that the proxy is being prepared for.
Compile a payroll report for all employees who were employed on the effective date, including basic information such as name, position, and hire/termination dates. The report will also need to include compensation data such as salary, overtime, and bonuses. Another measure of compensation that would be useful to include is the amount in Box 3 of the employee’s W-2 (Medicare taxable wages).
Once the employee compensation data is compiled, it will be useful to identify the median employee in a couple of different ways. We suggest using total cash compensation, as well as W-2 Box 3 wages, in order to see how the results differ using each method.
After the median employee is identified, compile information on equity grants, company paid benefits, company contributions to retirement plans, and the actuarial change in pension plan value (if applicable) for that median employee.
Prepare the total compensation figure for the median employee the same way that the CEO’s total compensation figure in the Summary Compensation Table (SCT) was prepared.
Determine the ratio of the CEO’s SCT total compensation to the total for the median employee.
Prepare the disclosure, including the median employee’s annual total compensation, the annual total compensation of the CEO, and the ratio of these two amounts.
Consider whether additional ratios and supplemental disclosures are appropriate. Additional information is permitted, so long as the information is accurate and is not given greater prominence than the required disclosure. One possible additional ratio would be total realized pay of the CEO versus the median employee. This would be particularly useful in a year where the CEO had a large equity grant, but realized pay was much less.
The rules allow for (but do not require) compensation to be annualized for permanent employees who did not work a full year. Consider whether annualizing pay for these employees helps achieve the company’s goals related to the CEO pay ratio disclosure. Note that pay for temporary or seasonal employees cannot be annualized, and pay for part-time employees cannot be converted to full-time equivalent rates.
When looking to identify the median employee, do not include independent contractors or anyone who is not considered an employee of the company as of the specified date. The SEC notes that companies should “apply a widely recognized test under another area of law that the registrant otherwise uses to determine whether its workers are employees.”
If the employee determined to be the median employee has “anomalous characteristics” in their compensation, then an employee with substantially similar compensation can be substituted. For instance, if the median employee did not receive any 401(k) match or did not participate in the company’s health insurance plan, but the typical employee did receive these benefits, then a substitution could be made.
There is not much flexibility in the calculation of the CEO’s pay in the SCT; however, items under non-discriminatory benefit plans that total less than $10,000 can either be included or excluded. If included for the CEO, the same items would need to be included for the median employee. Depending on the end goal, including or excluding something like the portion of health insurance paid by the company could significantly impact the ratio.
The final rule published by the SEC does allow for a de minimis exception, which provides that non-U.S. employees can generally be excluded from the calculation if they make up 5% or less of the company’s total employee population. This exemption could prove particularly useful for companies with just a handful of employees outside the U.S.
Once the ratio of CEO pay to that of the median employee is calculated, it will be important to provide an explanation of the calculation methodology, as well as facts and circumstances behind the compensation of the CEO and median worker at the company. As the date for disclosing the CEO pay ratio grows closer, it will be important for companies to consider how employees, shareholders, and the media will react to the disclosure. Carefully crafted disclosures will assist in minimizing the risk of negative reactions while maintaining compliance with the existing law.
-Joe Kager, Managing Consultant