[Ed. Note: The Securities and Exchange Commission issued on Aug. 5 its final rules on CEO pay ratio disclosure, mandated in the Dodd-Frank legislation. In anticipation of the SEC's action, the authors wrote an article a year ago for Directors & Boards that advised boards on how they should be thinking strategically about changing their compensation programs and disclosures. The following is an excerpt from that article. To receive a copy of the full article, which is titled, “The Pay Ratio Rule: Get Ready, Get Going,” email James Kristie.]
Today, most boards justify their decision-making process for setting executive pay by referencing the pay of other “peer” company executives. In compensation disclosures most companies will use this “peer group” to explain that their particular executive is paid commensurately with others and that therefore the board has acted reasonably in setting compensation figures.
However, now that they must publish the corresponding figure for median worker pay, companies will be forced to explain executive compensation decisions in a very different context. Rather than looking externally, to other executives, they will have to address the relation of pay to internal compensation dynamics.
Fodder for Discontent
Besides investors, a company's own employees are the most important consumer of proxy statements and annual reports. The information that is conveyed and the impression that is imparted have the potential to greatly affect how employees — whether middle management or assembly-line workers — view the company's mission, purpose and integrity.
An employee's perception of these reports will affect their confidence in the enterprise long term. Done well, an annual report can help solidify employee commitment and facilitate a highly functioning organization. Done poorly, however, the reporting and the substance can become fodder for discontent and disillusion, creating broad-based dissension.
Employees will pay particular attention to this antagonistic pay-disparity ratio. Moreover, pay comparisons to other executives will not provide an adequate justification of board decision making as far as this important constituency is concerned. Such explanations will only inflame the pre-existing broad-based concerns about preferential treatment and meritless reward for executives. Peer group references to other executives will only serve to reinforce the common notion of a clubby and back-scratching boardroom culture.
Rather, boards and compensation committees will have to work closely with their human resources professionals to design and explain executive pay around internal company compensation system protocol.
No, It's Not ‘Political'
All employees understand that as one is successful and promoted within the enterprise, pay goes up concurrently. It must be communicated that executive pay, and the CEO-to-median-worker ratio, are ultimately the result of this dynamic internal incentive structure and not of “political” or unfair treatment. This, instead of simple reference to other executives, will make executive pay disclosures relatable and palpable to more employees.
Additionally, if done correctly, by communicating the character of the incentive structure of the organization, and valorizing the potential rewards to long-serving and successful employees, this disclosure may in fact provide positive benefits.
A company's response to this rule needs to involve more than just a change of approach with regards to proxy disclosures.
The aforementioned peer groups are not just utilized to explain pay but are also heavily relied upon in setting it too. In a mechanistic fashion companies will target the total value of a CEO's compensation to a specified percentile, or benchmark, almost always at the 50th percentile or above. This process has become a substitute for a careful board consideration of the company's internal compensation dynamics and, in effect, drives the decision-making process.
Major Disconnect
The result has been executive pay practices that are increasingly disconnected from the internal contextual factors that should otherwise shape and influence their development.
However, in order to respond effectively to this new disclosure in a manner that will be acceptable to employees and avoid dissension, companies will need to incorporate these factors and concerns. Companies will have to move away from the rote application of peer benchmarking and percentile targeting and engage in a more holistic approach to setting pay.
As such, the ratio disclosure could be the impetus for a sea change in compensation practice, one which we have advocated before — see “What Is a CEO Worth? Don't Look to Peers,” Directors And Boards, Third Quarter 2011. This change will ultimately benefit the compensation area and, through that, corporate America greatly.
Charles M. Elson (at left) is the Edgar S. Woolard Jr. Chair in Corporate Governance and director of the John L. Weinberg Center for Corporate Governance, University of Delaware. He can be contacted at elson@udel.edu.
Craig K. Ferrere served as the Edgar S. Woolard Jr. Fellow in Corporate Governance at the Weinberg Center from 2010-2014. He is now studying at Harvard Law School.