Importance of CEO Pay Ratio Disclosure

Nicholas J Price
5 min read

Last year, in 2018, companies were required to provide CEO pay ratio disclosures for the first time. CEO pay ratio is the ratio of the CEO's total pay in relation to the pay of median employees at the same company. The new disclosure rule applies to the fiscal year that began on or after June 1, 2017. The disclosure rule doesn't apply to emerging growth companies, smaller reporting companies or foreign private issuers.

As the implementation of the rule ensues, board directors are just now weighing in on the impact of the disclosures. Board directors are assessing the impact on employee morale and impact on the stockholders. In addition, these changes give boards new opportunities to assess how the pay ratio disclosures compare with similar companies and whether there have been any drastic changes compared to previous years.

Data on CEO Pay Ratio Disclosure

The Compensation Advisory Partners released a report in 2017 on CEO pay ratio data and it was updated in September 2018. The report showed levels of CEO pay; median employee pay; and the pay ratio for companies on the Russell 3000 index, which includes 2,068 companies. There is a notable pay ratio difference for companies based on their size and type of industry.

The report states that the median CEO pay for the reporting companies was $4.7 million. The figure spans from $2.3 million at the 25th percentile to $8.5 million at the 75th percentile. By contrast, the median of the employees' pay for the reporting companies was only $63,000. The pay spans from $44,000 at the 25th percentile to $100,000 at the 75th percentile.

What do the numbers look like when we put them into ratio form?

The median CEO pay ratio for reporting companies was 70:1. The ratios spanned from 33:1 at the 25th percentile to 144:1 at the 75th percentile. The differences become acutely distinct when we look at company size. For small companies with revenues less than $0.5 billion, CEO pay ratios were 27:1. For large companies with revenues greater than $15 billion, the pay ratio rose to 230:1. In making comparisons by industry type, the median CEO pay ratio was 40:1 for financial corporations and 186:1 for companies in the consumer discretionary sector.

Calculating CEO Pay Ratios

There are essentially five steps in determining the CEO pay ratio, which include:
  1. Determine the CEO pay for the fiscal year. The total pay consists of salary, annual bonus, incentive award, perquisites and benefits.
  2. Determine the group of covered employees, which includes full-time, part-time, seasonal employees and temporary employees. The group should not include independent contractors.
  3. Determine the median employee pay for the group covered employee, which can be retrieved from W-2 forms.
  4. Determine the median employee pay for the corresponding fiscal year.
  5. Calculate the CEO pay ratio by dividing the CEO pay by the median employee pay.

How Do CEO Pay Ratios Impact Employees and Shareholders?

Disclosure on CEO pay and pay ratios has a substantial impact on board directors, shareholders and employees. Let's begin with the impact on shareholders.

CEO Pay Ratio Impact on Shareholders

The general consensus from shareholders is that they are in favor of CEO executive compensation programs. According to the 2018 Say on Pay and Proxy Results'Russell 3000, 97.4% of the companies who reported holding a Say on Pay vote in 2018 had a favorable vote from shareholders on their executive compensation programs. The report noted that 1,611 of the 1,909 companies reported they disclosed the CEO pay ratio to their shareholders. The CEO pay ratio didn't significantly impact the Say on Pay vote in 2018. It is too early in the game to determine whether the pay ratio disclosures will have any impact on stock prices.
While the initial figures are interesting, the next few years of seeing disclosures of the CEO pay ratio and the median employee pay will give us a better idea of how the CEO pay ratios could change.

CEO Pay Ratio Impact on Board Directors

When deciding executive remuneration, most compensation committees have been focused solely on the CEO's compensation package. The new disclosure rules require compensation committees to consider who their median employees are and how much they get paid. For boards that assign compensation matters to a committee, compensation committees will need to consider several new factors.

First, compensation committees will need to take stock of how their CEO pay ratios and median employee pay rates compare with rates at comparable companies. Secondly, committee members will need to consider the potential response from employees when they discover the figures for CEO pay ration and median employee pay. The results could have a negative impact on employee morale, and board directors will need to be able to explain the pay ratio and be prepared to confront resulting morale issues. Third, board directors should be discussing the potential impact on CEO pay ratio disclosures on the company's stock price. Perhaps they need a response plan if stock prices suddenly drop. Finally, boards will need to be cognizant of CEO pay ratios that deviate substantially from prior years. It's important to look at why ratios may have been larger or smaller and how those changes impacted the median employee pay. In addition, they'll need to look at how their own changes over time compare with changes at other companies over time.

CEO Impact on Employees

The disclosure of CEO pay ratios and median employee pay may shock employees. No one is happy to learn that their pay level is well below median employee pay or that they're being paid far less than if they worked at a competing company. Public discussions about pay levels can create a negative impact on the company's culture and can reduce the overall morale among employees. Today's boards need secure board management software such as Diligent Boards to work on these issues confidentially.

Overall, the disclosures may prompt employees to place pressure on companies to increase standard employee pay rates. The more information employees have, the more they're apt to lobby for higher pay. Boards may feel that they need to steadily increase employee pay to keep workers content and prevent turnover.