CEO-Employee Pay Ratios: Navigating the Minefield of the New Pay Disclosure Requirement

CEO-Employee Pay Ratios:
Navigating the Minefield of the New Pay Disclosure Requirement
October 2010

The U.S. financial reform legislation enacted in July includes a new pay disclosure rule that will require many companies to report the ratio of CEO pay to median employee pay in annual proxy statements. The new CEO-Employee Pay Ratio requirement has sparked lively debates and questions concerning the utility of this ratio, how it is calculated, and the potential for it to be misleading and misused.

Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act¹ will require all U.S. public companies, companies that are not publicly traded but have public debt, and other companies required to file reports with the U.S. Securities and Exchange Commission to disclose the following three compensation metrics:

The annual total compensation of the chief executive officer.
The annual total compensation for the chief executive officer is currently available in the Summary Compensation Table in SEC Form DEF 14A Filings (i.e., definitive proxy statements).
The median annual total compensation for all employees
(except the chief executive officer).
And, a ratio of these two metrics.

Annual Total Compensation of the CEO

Median Annual Total Compensation for All Employees (excluding CEO)

The median annual total compensation metric for all other employees (#2 above) and the CEO-employee pay disparity ratio (#3) are both new requirements.

On the surface, these metrics may seem relatively simple and reasonable to calculate. However, as you dig into the data and consider the complexity of factors that influence the numbers, you realize that the new CEO-Employee Pay Ratio defined by the Dodd-Frank Act is difficult to calculate and interpret.

We thought it would be instructive to take a closer look at this new pay disclosure requirement and calculate CEO-employee pay ratios from the Culpepper Compensation Survey database. Our analysis includes data collected from public and private technology and life science organizations reporting prior-year compensation data for full-time employees in the United States. We excluded data for part-time employees and employees located outside of the United States.

Defining Total Compensation
Before diving into the numbers, it is essential to first define Total Compensation and understand the elements of compensation included in the calculations.

The SEC defines Total Compensation in Item 402 of Regulation S-K ^{2, 3}. Annual total compensation includes the sum of salary, bonus, stock awards, option awards, non-equity incentive plan compensation, change in pension value and non-qualified deferred compensation earnings, and all other compensation (e.g., perquisites, personal benefits, and property with an aggregate amount exceeding $10,000; tax gross-ups; company contributions to defined contribution retirement plans; preferential stock purchase discounts; preferential life insurance premiums; and dividends or other earnings not factored into the fair value of equity awards).

As currently written, the SEC's definition and calculation of Total Compensation includes the value of some, but not all company provided benefits. For example, it includes retirement benefits, such as company contributions to defined contribution plans (e.g., 401k) and change in pension values. However, it does not include the value of other benefits available on a non-discriminatory basis to all employees. That would exclude company contributions to group insurance plans (e.g., health, life, and disability insurance benefits) and medical savings accounts.

The new pay disclosure requirements in the Dodd-Frank Act will require many companies to start calculating Total Compensation for every individual employee so they will be able to calculate the new CEO-Employee Pay Ratio.

Due to the administrative burden of reporting the value of perquisites and benefits provided to individual employees, we do not require our survey participants to provide this level of data for each employee.

For purposes of our analysis, we did not calculate CEO-employee pay ratios using the SEC's definition of Total Compensation. Instead, we calculated CEO-employee pay ratios for three commonly used compensation metrics:

Annual Base Salary
Annual base salary consists of guaranteed, short-term, non-variable cash compensation.

Annual Total Cash Compensation
Annual total cash compensation is calculated as the sum of base salary + cash allowances + bonuses + commissions + cash profit-sharing + other forms of variable cash payments.

Annual Total Direct Compensation
Annual total direct compensation is calculated as the sum of total cash compensation + total fair value of all annual long-term incentives (e.g., stock option awards, restricted stock shares/units, performance stock shares/units, phantom stock shares, stock appreciation rights, and long-term cash awards).

U.S. CEO-Employee Pay Ratios
The median value of the ratio of CEO total direct compensation to the median total direct compensation of all other employees is 5.4 (Table 1). In other words, the typical CEO's total direct compensation is approximately five to six times larger than the median total direct compensation of all other employees in their organization.

However, to put this ratio into context, it is important to consider a variety of factors, particularly company size (e.g., annual revenue, number of employees, market capitalization). As companies increase in size, the multiple of CEO compensation to employee compensation increases. This is consistent with the principle that company size is typically the predominate factor influencing executive compensation.

Table 1: U.S. CEO-Employee Pay Ratios by Annual Revenue
	Median Value of Ratio of CEO Pay to Median Pay of All Other Employees
	Annual Base Salary	Annual Total Cash Compensation	Annual Total Direct Compensation
All Companies	4.0	5.6	5.4
Annual Revenue (USD Millions)
Up to $5	2.3	2.3	2.3
Over $5 to $10	2.4	2.7	2.7
Over $10 to $50	3.0	3.5	3.5
Over $50 to $100	4.0	5.2	5.2
Over $100 to $250	4.6	6.9	7.3
Over $250 to $1,000	6.7	10.4	12.5
Over $1,000 to $2,500	10.7	21.8	33.2
Over $2,500	16.0	36.5	91.6
Source: Culpepper Compensation Surveys U.S. Database, October 2010.

Figure 1 illustrates how the difference in pay between CEOs and other employees exponentially increases for companies over $100 million in revenue. The opportunity for CEOs to earn large cash incentives and equity awards magnifies significantly in larger companies, particularly for large public companies with complex global operations.

The median CEO-employee pay ratio for companies over $2.5 billion in revenue was 16.0 for base salary, 36.5 for total cash compensation, and 91.6 for total direct compensation. Companies in the 90th percentile had multiples of 19.4 for base salary, 63.8 for total cash compensation, and 187.1 for total direct compensation.

The highest multiple exceeded 200 for total direct compensation. In other words, the total direct compensation for the CEO was 200 times larger than the median total direct compensation of all other employees in the organization.

Source: Culpepper Compensation Surveys U.S. Database, October 2010.

Other Factors to Consider that Impact CEO-Employee Pay Ratios
In addition to company size, there are numerous other factors to consider that influence CEO-employee ratios, including industry sector, job mix, and geographic location.

Geographic Location
While company size is the predominate factor influencing compensation for executive jobs, geographic location is the predominate factor influencing compensation for most non-executive jobs. Our analysis revealed that companies with a majority of employees in geographic locations with higher labor costs (e.g., San Francisco, New York) had lower CEO-employee pay ratios than companies in geographic locations with lower labor costs (e.g., Salt Lake CIty, Indianapolis).

Industry Sector / Job Mix
Our analysis did not reveal significant differences between technology and life science industries. However, we did find that many companies in other industries had higher CEO-employee pay ratios. This is primarily due to the fact that technology and life science companies employ a higher percentage of skilled professional workers with a higher average level of compensation.

For example, companies with a higher percentage of low-paying jobs (e.g., call centers, manufacturing, retail) typically have higher CEO-employee pay ratios than companies with a higher percentage of high-paying jobs (e.g., biotechnology, software).

When using a statistic like the CEO-Employee Pay Ratio, it is important to control for company size, geographic location, industry sector, and mix of jobs. If you do not carefully consider the impact of each of these factors, it is difficult to draw accurate conclusions about this ratio and how it compares to other companies.

More Questions and Concerns
As you dig deeper, more questions and concerns surface about other complex issues that impact the calculation, interpretation, and use of the CEO-Employee Pay Ratio required by the Dodd-Frank Act.

What about the value of medical benefits?
As currently written, the SEC's definition of Total Compensation excludes company contributions to group health insurance premiums and medical savings accounts. Medical benefits are a significant portion of most employees' total rewards package (compensation and benefits). Excluding the value of medical benefits inflates the CEO-Employee Pay Ratio and distorts the true relationship between CEO and employee pay.

Are employees outside of the U.S. included in the "all-employees calculations"?
If so, how do you fairly and accurately compare companies that only have employees in the U.S. to multi-national corporations that have employees across different countries? A variety of complex factors need to be considered to address differences between countries, such as cost-of-labor, cost-of-living, currency fluctuations, tax rates, and government-provided benefits. Each of these factors could potentially distort the calculation of a meaningful CEO-Employee Pay Ratio.

What about part-time employees?
Are part-time employees included in the "all-employees calculations"? If so, how do you fairly and accurately compare companies that have a lot of part-time workers to companies primarily employing full-time employees? Do you calculate full-time equivalent pay rates for each part-time employee? Companies that do not calculate a full-time equivalent pay rate for part-time employees will have higher a CEO-Employee Pay Ratio.

What about independent contractors?
Are independent contractors exempt from this calculation? How do you fairly and accurately compare companies with a low percentage of contract workers to companies that outsource a high percentage of low-cost labor to independent contractors and other companies?

Each of these issues needs to be addressed and carefully considered. Based on the SEC's tentative schedule, the rules for clarifying and implementing the new CEO-Employee Pay Ratio required by the Dodd-Frank Act will be proposed in mid-2011 ⁴.

Critics cry that this is a "political" ratio, not an "economic" ratio, with an objective to cap executive compensation and punish companies with excessive CEO compensation. A bill has already been introduced to Congress that would provide preferential income tax rates and government contracts to companies who pay their CEO or management-level employees less than 100 times what they pay their lowest paid employee⁵.

In its current form, the rules defining how the CEO-Employee Pay Ratio is calculated have the potential to favor companies with factors that create lower ratios. For example, the ratio will favor companies in geographic locations with higher labor costs. It will favor companies in industries with higher-paying jobs. And it will favor companies that outsource low-paying jobs.

A Loaded Statistic
Regardless of the intent of the new pay disclosure rules, from a pure market-based compensation pricing approach, the CEO-Employee Pay Ratio is not an ideal metric for external benchmarking. It is a loaded statistic with too many factors to consider to infer meaningful insights or valid comparisons between companies.

A more accurate way to understand differences in compensation between jobs is to use job specific data, carefully considering the impact of company size, geographic location, and industry sector.

- W. Leigh Culpepper, CCP, GRP, CBP
- Eric Hurst, Ph.D.

Footnotes:
¹ Dodd-Frank Wall Street Reform and Consumer Protection Act

² Item 402 of Regulation S-K: Executive Compensation

³ SEC Devision of Corporation Finance: Manual of Publicly Avauialble Telephone Interpretatons of Item 402 of Regulation S-K

⁴ Implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act

⁵ H.R. 1874: Patriot Corporations of America Act of 2009

Copying. If you copy portions of this article into your own publication, please cite Culpepper as the source by including the following statement: "Source: CEO-Employee Pay Ratios: Navigating the Minefield of the New Pay Disclosure Requirement, Culpepper eBulletin, October 2010, www.culpepper.com"

CEO-Employee Pay Ratios:Navigating the Minefield of the New Pay Disclosure Requirement October 2010

CEO-Employee Pay Ratios:
Navigating the Minefield of the New Pay Disclosure Requirement
October 2010