New CEO pay ratio rule offers narrow view into executive compensation

The new CEO pay-ratio rule has provided a new view into executive compensation — but more a peephole, limited and slightly distorted.

Public companies have long had to disclose the compensation of their five highest-paid executives, including the CEO. Under the new regulation, public companies need to report the ratio of the CEO's pay to the pay of the median employee at the company.

"First off, no doubt CEO pay needs to be looked at and debated," said David Larcker, a professor at Stanford University's Graduate School of Business who studies executive compensation and corporate governance.

But he has concerns about the new rule: "I think it's dangerous to collapse the debate down to a simple ratio like this without thinking about the situation of the company."

The rule, part of the 2010 Dodd-Frank Act, was intended to highlight the income gap between CEOs and workers. When the Securities and Exchange Commission adopted the final rule, though, it gave companies flexibility on how they reported the numbers.

Because of the various allowable formulas, comparisons of the pay ratio between CEO and median compensation is more apples to oranges, Larcker and other experts said. Comparisons among companies in different industries can be misleading. Even comparing competitors can be problematic.

Yet the median-compensation number is something new that can generate more conversations among industry groups and within companies themselves.

Because not all companies' fiscal years follow the calendar year, in the first year of reporting, 25 of Minnesota's 50 largest public companies disclosed the ratio, according to the Star Tribune's annual review of executive compensation at public companies. The ratios range from 12-1 to 699-1, with the median at 101-1.

Equilar, a provider of board intelligence solutions, has tracked CEO pay nationally including CEO pay ratios. Through July 16, the firm has looked at 2,216 pay ratios, with the median pay ratio in that group at 65-1.

Generally speaking, high CEO pay ratios are directly correlated with the size of the company, both in revenue and number of employees. Companies that have a lot of part-time and seasonal workers and companies that have a lot of workers in low-wage foreign countries have tended to report the highest ratios.

"The numbers have come in way lower — on average — than what people thought they would be," Larcker said. "I don't think it has generated lots of controversy that wasn't there to begin with."

Total compensation of the CEO was already disclosed in the company's summary compensation table of the annual proxy statement. It includes salary, bonuses, the value of long-term equities when granted and other compensation.

But there are a number of ways to tally compensation.

The Star Tribune has long used a methodology that includes the value of long-term equity awards, stock options and restricted stock awards, when they are realized. That is when previously issued options are exercised or when stock awards vest during the year.

The CEO pay ratio and median compensation the Star Tribune references in the review, though, are those disclosed in the company's proxy statement.

Amy Seidel, a partner with the Minneapolis law firm Faegre Baker Daniels, advises public companies on SEC reporting requirements. She said the legislation was proposed as a "simple benchmark" to help investors monitor CEO pay and how companies treat employees.

"Many suspect the goal was to shame companies into paying CEOs less, but most agree that the rule as proposed and adopted doesn't achieve that objective," Seidel said.

The SEC itself wrestled with putting the rule in place, and that is part of the reason it took so long to go into effect. "The SEC said in its rule-making that it struggled with the purpose of the rule and how to implement it, as well as how to balance the cost-benefit of the rule, which is a required part of any SEC rule-making," Seidel said.

Some factors that make the rule difficult to use for comparison: Companies can exclude some foreign workers; exclude employees added through acquisitions in the past year; and cannot annualize the pay of part-time and seasonal employees.

Retail companies in particular object to the last provision that pay cannot be annualized, saying it penalizes operations that have large part-time, seasonal or entry-level employees.

"The majority of retail companies had a median employee who was a part-timer or a seasonal worker," said David French, senior vice president of government affairs at the National Retail Federation. "The rule by definition forces you to choose the category of worker who are least likely to be paid on a full-time basis."

For companies, there also are costs associated with accurate measurement of the ratio, said Brian Blackwood, an executive compensation consultant with the Minneapolis office of the national consulting firm Willis Towers Watson.

"On the one hand, this is really simple math," Blackwood said. "What's new and what is taking hard and soft costs is the denominator [median employee pay]. The costs associated with that, both hard and soft, revolve around really getting their arms around an awful lot of data."

Big corporations might have to use multiple systems in multiple countries to get that data. Blackwood said many large companies did dry-run calculations in the summer months of 2017.

"Finding all of the records and all the data in multiple systems across the globe is no simple task," Blackwood said.

The SEC has estimated that it will cost U.S. companies a collective $1.3 billion to calculate the pay ratio and about half that cost in subsequent years.

Ryan Colucci, an associate with the Compensation Advisory Partners, an independent executive compensation advisory firm based in New York, studied the first 300 disclosures closely and the rest of the Russell 3000 companies that have made their disclosures since then.

Some companies have anticipated that their numbers might look a lot different next year and to explain that have calculated one or more supplementary CEO pay ratios. Colucci estimates 15 to 20 percent of the companies have reported one or more supplementary ratios.

"The supplemental ratios can help explain a one-time event," Colucci said.

Target Corp. did something like that this year when they disclosed a pay ratio of 408-1. That was based on Brian Cornell's compensation as disclosed in the summary compensation table of $8.4 million. But due to a shift forward in the timing of a large equity grant, a supplementary view of Cornell's total compensation was $13.5 million and a supplementary pay ratio off that number was 657-1.

The median compensation number has actually raised more people's interest in being a useful tool for companies and trade groups.

When employees see the median compensation number at their company they are going to compare it to their own compensation. Blackwell of Willis Towers Watson said the number allows an opportunity for companies to talk about many human resources issues, including how it pays people.

It also "facilitates a nice opportunity to discuss career development and talent and professional development," he said. "That I would say is healthy dialogue."

Patrick Kennedy • 612-673-7926