How to Handle Your Pay Ratio Disclosures

This is an article that I wrote for Bloomberg BNA that was published last Friday, August 21. Note that you may not reproduce this article without express written permission from BNA.


Reproduced with permission from Pension & Benefits Daily, 162 PBD, 08/21/2015. Copyright 2015 by The Bureau of National Affairs, Inc. (800-372-1033)
 http://www.bna.com


Pay Ratio Rule: Practical Tips for Making the Best of a Bad Disclosure Day

 BY JOHN H. LOWELL

Introduction
I t’s been about five years since Congress passed and President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. In response to the financial crisis that escalated in 2008, legislators sought to put more controls on primarily the larger financial institutions that do business in the U.S. But, buried in this law was a little-debated provision sitting in Section 953(b). It has become known as the ‘‘pay ratio’’ rule.

On its surface, the pay ratio rule seems innocuous. Filers of proxies are to disclose the ratio of the compensation of the median-paid employee of the company to that of the CEO. However, as many have learned, this may be more difficult and more inflammatory than it seems.

In early August 2015, the Securities and Exchange Commission issued a final rule, effective for proxies for fiscal years beginning after 2016, explaining exactly who needs to disclose this ratio and how this is to be done. To its credit, the SEC tried its best to satisfy the needs of those who view this ratio as an important data point for a company and to satisfy companies that complained of potentially large expenditures to produce what they view as a seemingly meaningless number.

If what you need are the technical details specific to your company as to how these calculations are to be done, you can find summaries all over the Internet. Securities or executive compensation counsel will be more than happy to help you. What you may have more difficulty finding are explanations of how to prepare for that 2018 proxy season and what strategies your company may employ as permitted by the final rule.

Key Elements

Before we dive into that, it’s important to review some of the key elements of the final rule, particularly in places where either the SEC has made changes from the proposed rule or where it has afforded employers certain options.

• While the statute tells us that the number disclosed shall be the compensation of the median employee divided by that of the Principal Executive Officer (CEO for our purposes), both the proposed and final rules specify that it is in fact the reciprocal of that (a positive integer is intended). 
• Generally, all employees of the parent company and subsidiaries included in the consolidated financials must be included, but:  
• who is an employee may be determined as of any representative date within three months of the end of the fiscal year; 
• compensation for full-time employees may be annualized, but part-time, temporary and seasonal workers’ pay may not be annualized; 
• workers from countries with privacy rules that may preclude obtaining the necessary data may be excluded (if you exclude one worker from a country, you must exclude all of them); and 
• companies may exclude all workers from additional countries up to a total of 5 percent of the total company employee population. In doing so, first the employees excluded due to privacy laws are counted. If that gets the company to 5 percent or more, then there are no more exclusions. If not, then additional countries may be excluded so long as the total of privacy exclusions and selected exclusions does not exceed 5 percent of the total number of employees of the company. 
• Determination of the median-paid employee has been simplified: 
• solely for purposes of determining who is the median employee, the company may look to compensation amounts from payroll or tax records; and 
• once a median employee is chosen, the company may use the same employee as the median for two more years so long as there have not been changes to the company’s population or pay practices significant enough to make that determination unreasonable. 
• Companies may apply cost-of-living adjustments to equalize pay between countries. s Companies may add to their disclosures so long as the additions are no more prominent than the required disclosure. All that gives companies some useful options, but with options comes analysis to determine what to do and where the data will come from. 
• Determine which countries the company operates in. For those countries, determine: 
• whether privacy laws preclude obtaining necessary data, 
• what percentage of employees is excluded due to privacy laws, and  
• if less than 5 percent, are there other countries that it would be possible and beneficial to exclude? 
• What will it take to get payroll or tax records from all the countries? Alert people responsible for them in each foreign country now as to what you will need. 
• Consider whether the value in using cost-of-living adjustments outweighs the cost of doing so. For some countries, good cost-of-living data may be very difficult to obtain. For others, while the national cost-of-living index may be high or low, the cost in the areas in which your employees work may be very different.
• Consider the benefits of sampling employees rather than using the whole population. Based on the descriptions of sampling techniques described by the SEC in both the proposed and final rules, for most companies, this exercise will not be worth the trouble of understanding the sampling techniques. 

Perhaps the most important decision that a company will make regarding the pay ratio is what it chooses to disclose. Some companies won’t have to worry about it every year, but in some years these pay ratios are going to be very large. Even if the company’s board of directors feels certain that CEO compensation at their company is reasonable, the optics will be bad.

Good consultative thinking can be very helpful here. Let’s consider a few possible situations.

Examples

Company A – Many Seasonal Employees.

Company A (calendar-year filer) does significant business around the holidays. In fact, its workforce is typically about three times as large between September 15 and January 15 as it is the rest of the year. Because of that, the median-paid employee of Company A is likely to be a seasonal employee (recall that companies are not permitted to annualize the compensation of seasonal employees). Additionally, those seasonal employees likely never meet the requirements to participate in most of Company A’s benefit programs including its pension plan. This pay ratio is going to be high. Company A should consider making an additional disclosure showing a comparison of the compensation of its CEO to that of its median full-time employee. While this won’t change the required number, it will improve the optics significantly.

Company B – U.S. Pension Only.

Company B is a multinational organization with significant employees in countries around the globe. Most of the U.S. workforce is well-paid, making it unlikely that the median employee will be from the U.S. Company B has provided both a broad-based and a nonqualified pension plan in the U.S. for many years. In most of the countries in which it operates, providing pensions is not the norm and doing so would make Company B less competitive. Because the increase in the actuarial present value of accrued pensions is part of the calculation of ‘‘annual total compensation,’’ the pay ratio is going to be larger than Company B might like and its board thinks the required ratio is not representative. Company B should consider providing a ratio for the U.S. only and a ratio without regard to pensions as supplemental disclosures.

Company C – Excellent Performance Leads to Larger-Than-Usual Incentive Payouts.

Because of extraordinary performance over the period ending Dec. 31, 2016, Company C’s executives received much larger-than-normal cash incentive payouts (short-term incentive) and equity grants and awards (long-term incentive) in 2017. The pay ratio here is going to be very high, but the board’s rationale is that the CEO deserved it. There may be many readers of the pay ratio who don’t agree. Perhaps they won’t look at the reasons for the high pay ratio, but simply the number itself.

Company C might consider a number of options. First, there might be a narrative describing why certain elements of compensation were as high as they were. Second, Company C might disclose what the pay ratio would have been had the company (and CEO) merely met goals for the year rather than exceeding them. Third, Company C might disclose what the pay ratio would have been had its CEO received his average incentive payouts for the last three years or five years. Any or all of these will help to lend some perspective to the otherwise high pay ratio.

Company D – Varying Global Economies.

Company D has its operations primarily in the U.S. and in South America. It provides broad-based and nonqualified pensions in virtually every country in which it operates. During 2017, the economy in South America was vastly different from that in the U.S. As a result, while interest rates dipped in the U.S., they rose significantly in every country in South America in which Company D operates. This combination produced massive increases in pension values in the U.S. (for executives and for rank-and-file), but decreases (zero for annual total compensation purposes) in all of South America. Since pensions are a significant portion of actual compensation for Company D’s South American employees, their compensation will appear understated for 2017 while the CEO’s compensation will appear overstated.

Company D should consider several additional disclosure options:

• Disclose a ratio for its U.S. employees only,  
• Disclose a ratio assuming that pension discount rates had not changed in any country, or 
• Disclose a ratio without regard to pensions. 

Company E – Highly Diversified Global Business.

Company E is probably the most complex situation we will face. In the last few years leading up to and including 2017, it has generated a significant part of its revenue and most of its profits from its financial services division, which operates mostly in the U.S. Its CEO has to operate like the leader of a large bank and is therefore compensated commensurate with that. But, as a hedge against cyclical issues, Company E also operates in a variety of other industries and in multiple countries. The industries that are the most labor-intensive also employ the majority of their workers in low-paid third world countries. And, to the extent that Company E is involved in those industries in the U.S., its workers are largely unionized.

Company E has considered sampling to simplify the process. However, upon an examination of the rules, Company E realizes that it will have to do samples of each of its industry groupings in each country in which it operates. While it might reduce the number of employees that it has to evaluate, the expense of getting through the samplings outweighs the gains.

Company E realizes that its pay ratio is going to look very high. Philosophically, it is fine with that as its board feels certain that it is justified. But with multiple union contracts coming up for bargaining, Company E also knows that the unions will use the pay ratios to wage multiple media campaigns against Company E and its CEO.

In its disclosures that will go along with its required pay ratio disclosure, Company E needs to consider all of this. Here are some of the disclosures that Company E might make:

• U.S.-only pay ratio, 
• Disclosure of median pay for a typical employee in each of the U.S. unions with a breakout highlighting the company’s large expenditure on union pensions,  
• Salaried-employee-only pay ratio, or 
• Additional pay ratio compared to the union employee’s median pay encompassing elements not normally included in annual total compensation such as health care expenditure. 

Each of these additional disclosures has a cost associated with producing it. But, in Company E’s view, not producing ratios like this may be more costly than the hard costs to generate them.

Now What?

If you happen to be a part of one of the fortunate companies for whom this disclosure will neither be a calculational nor public relations problem, then your job should be easy. If, on the other hand, your company is closer to one of these more problematic situations, then you might have your work cut out for you.

Chances are that most in your company will not focus on this until after the end of fiscal year 2017. That may be okay, or it may not. Developing some of the ratios that we’ve discussed may be time-consuming and data-intensive. Trying to do that at the last minute may not be advisable.

Similarly, for a number of companies, this will be more than a calculation. It will be a strategy. Given the potential cost in investor relations and perhaps a battle over say-on-pay, it might be wise to have someone independently thinking about these issues. While using consultants haphazardly can create problems that were never there instead of solving them, here using a consultant who has thought through the issues and can help your company do the same would likely be money well spent.

You know that your company pays both rank-and-file and executives appropriately. Now you have to ensure that you manage the message so that all the interested observers know that as well.