The executive pay ratio rule, which the SEC adopted rules for in 2015 as part of the 2010 Dodd‑Frank Wall Street Reform and Consumer Act, is forcing companies to consider how best to disclose unfavorable ratios related to CEO compensation.
Comparisons of pay ratio results within industry and peer groups are already starting to appear in popular media. Bloomberg has tracked the CEO pay ratio of S&P 500 and Russell 1,000 companies according to each company’s economic sector. In future years all companies, and especially those that compare poorly to industry competitors, must decide how to disclose and explain their pay ratios.
While the pay ratio rule is intended to increase transparency into executive compensation, executive compensation disclosure overall has grown increasingly complex in recent years and stand‑alone ratios may not always tell a company’s entire story. The SEC has acknowledged these concerns. In September 2017, the SEC and the SEC staff issued helpful guidance emphasizing that the pay ratio rule provides for flexibility.
Importantly, companies are allowed to craft a narrative around their ratio in order to shed light into contributing factors. What follows is a brief synopsis of flexibility within the executive pay ratio rule and methods of contextualizing the ratio that have been observed in the first year of implementation.
Calculation and Flexibility
The pay ratio rule requires companies to disclose the ratio between the median of the annual total compensation of all employees compared to the annual total compensation of the CEO. However, companies are permitted to use several different methods to find their median employee. This includes using the total employee population, statistical sampling, or other reasonable methods, which must be disclosed if implemented. The rules also allow for specific circumstances that employees may be excluded from the employee calculation:
- Directors, independent contractors, “leased employees” and workers employed by, and whose compensation is determined by, third parties are excluded.
- If a company’s non‑U.S. employees account for 5% or less of its total employees, the company may exclude these non‑U.S. employees, but if some non‑U.S. employees are excluded, then all non‑U.S. employees must be excluded. If a company’s non‑U.S. employees exceed 5% of its total employees, it may exclude up to 5% of its total employees who are non‑U.S. employees.
- Any employees obtained in a business combination or acquisition for the fiscal year that the transaction becomes effective may be excluded; however, the company must identify the acquired business and disclose the approximate number of employees it is excluding.
- In certain circumstances non‑U.S. employees from countries with data privacy laws or regulations that make companies unable to comply with the rule may be excluded.
Although the SEC requires disclosure of the mandated pay ratio, companies are given flexibility in how they present the information and are allowed to provide context. This leaves companies with critical decisions as they navigate these unchartered waters. Early results from fiscal year 2017 filings suggest pay ratio disclosure will evolve, especially as an adaptation to a sub‑par ratio. Companies with disappointing ratios should consider implementing the following strategies.
Strategy 1 – Include a Supplemental Ratio
The SEC allows companies to provide supplemental ratios to provide context for investors. For example:
- Sears Holding Corporation, with a ratio of 264:1, provided on a supplemental basis that when considering only salaried employees it had a pay ratio of 66:1;
- Six Flags Inc., with a ratio of 1,920:1, disclosed that due to the extreme seasonality of its business some of its employees only work one or two months a year and therefore provided an estimated supplemental pay ratio of 247:1 (which only included full‑time employees);
- Williams‑Sonoma, Inc. disclosed an SEC required pay ratio of 1,477:1, along with a supplemental ratio of 372:1, which excluded permanent part‑ time, temporary and seasonal employees.
In addition, companies may also consider whether to add the following ratios to provide additional context to their required pay ratio:
- A pay ratio excluding bonuses, incentive compensation, or one‑off equity awards.
- A ratio excluding all oversees employees.
- A ratio excluding all part time employees.
Strategy 2 – Include Supplemental Textual Information
Companies are also permitted to provide supplemental textual explanations. This can include information about how the employment policies or corporate structure of the enterprise effects the pay ratio, information about opportunities for advancement and career development programs for lower wage employees, or simply more personal information about the median employee. For example, McDonald’s Corporation disclosed that its median employee in 2017 was “a part‑time restaurant crew employee located in Poland.” Likewise, Mondelez International, Inc., noted that out of the nearly 100,000 employees in more than 80 countries around the world, most are hourly, many are part time or seasonal and 82% are located outside of the U.S. Companies may also consider the following information to provide a narrative around how they reached their ratio:
- Provide a more detailed description of the median employee.
- Provide a more detailed description of the location of the median employee.
- Provide a disclaimer instructing shareholders that pay ratio comparisons may not be an accurate comparison among “peer companies.”
Strategy 3 – Location Augments Context
Finally, the SEC has no requirements for where the pay ratio must be disclosed in the required disclosures of the proxy statement and/or 10‑K. Companies should strategically consider where the pay ratio would best be positioned. Many companies have included the pay ratio at the end of the Compensation and Discussion Analysis (CD&A) section of the proxy statement. This placement allows the reader to be introduced to major themes or drivers affecting CEO pay before consideration of the pay ratio. We anticipate over time companies will present pay ratio information earlier within the CD&A presentation as Compensation Committees begin to consider the pay ratio of competitor/peer companies and discuss the value (if any) of executive pay ratio in each Committee’s compensation philosophy.
Companies should strategically consider how they can provide a positive narrative around their disclosure, regardless of the pay ratio number. Contextualizing the executive pay ratio may be achieved by adding supplemental ratios, providing additional textual information and strategically locating the ratio within the required disclosure.