The Securities and Exchange Commission (SEC) recently adopted a new executive compensation disclosure requirement which will require comparison of the compensation of a company’s CEO to that of a “median employee” of the company.
The pay ratio rule is seemingly simple—compare the CEO’s compensation to that of a median employee, expressed as a ratio. But “getting to the ratio may require some effort,” in the words of one of the SEC’s Commissioners. Fortunately, the new pay ratio disclosure will not be required until the 2018 proxy season (covering compensation for 2017), so there is time to prepare.
The compensation of the CEO is straightforward, as it will be taken (with some possible adjustments, as discussed below) from the “Summary Compensation Table” in the company’s proxy statement. This information has been contained in proxy statements for many years.
Determining the compensation of the “median employee” will not be so easy, and was a source of much political wrangling in the course of finalizing the new rule. Interestingly, the “median employee,” once determined, will be an actual (but anonymous) person, as opposed to just a statistical median of all company employees.
The pool for determining the “median employee” is broad—all worldwide full-time, part-time, seasonal, and temporary employees. The new rule will be a particular headache for companies with a substantial number of international employees. Among other obstacles, employees working in least developed countries may earn significantly less than similar employees in the U.S., but such foreign employees may have a lower cost of living, making direct comparison misleading (the rule allows for cost-of-living adjustments). Additionally, gathering the compensation information required by the rule may violate the data privacy laws of foreign jurisdictions.
The SEC has attempted to ease some of the burden in identifying the median employee, allowing considerable flexibility in how the calculations may be made. Depending on the size and complexity of its workforce, a company could rely on a single measure such as W-2 wages (no overseas employees and a single payroll system) or utilize statistical sampling (large and complex workforce). Generally the company can chose any methodology that it believes is appropriate, but the methodology, as well as any material assumptions, adjustments or estimates, must be disclosed and consistently applied. It’s likely that most (if not all) SEC reporting companies will initially rely on outside compensation consultants or other specialists to determine the median employee.
A company only needs to identify the median employee once every three years, unless there has been a change in the company’s employee population or compensation arrangements that it believes would result in a significant change in the pay ratio disclosure. Even though the identified median employee may be used for three years, the company must still calculate that employee’s annual compensation each year, and use that amount to update the pay ratio annually. If the identified employee’s circumstances change during the period, such as a promotion or departure, the company may select a substantially similar alternative employee.
The new pay ratio rule has engendered considerable controversy and criticism, including from two of the five SEC Commissioners, who dissented to the adoption of the rule. Differences in business industries, corporate structures, and the ability of companies to choose from a variety of calculation methodologies may make comparison of the pay ratio among companies difficult or impossible. The SEC’s adoption of the rule was required by statute (the Dodd-Frank Act) and it has been suggested that the SEC acted reluctantly. Neither the Dodd-Frank Act nor the SEC’s rule expressly state the specific objectives or intended benefits of the rule, and one of the dissenting SEC Commissioners contended that the real purpose of the rule was to “name and shame” companies into lowering CEO pay.