Preparing for Pay Ratio

Could the politically charged pay ratio calculation and disclosure of Dodd-Frank Section 953(b) go away with this year under this Republican Congress? Of course it could. Since companies generally will not be doing this disclosure until early 2018, does that mean they should hope that it goes away and not plan for it? No. The process will be long and data collection will be arduous for many companies. You don't want to get caught unprepared.

For those of you not familiar, I have written on this extensively. And, despite the fact that I think it will be a huge expenditure of effort by issuers of proxies and that I think it will provide little value to shareholders and the public generally, it's still the law and it becomes a requirement in the upcoming proxy season.

In a nutshell, determination of the pay ratio will follow this process:

• Identify the CEO (that should be easy)
• Identify the employee in the controlled group globally whose annual total compensation (a term of art including almost all forms of current and deferred compensation) when ranked sequentially among all employees falls right in the middle of that ranking
• Determine the annual total compensation for the CEO (you're doing this for the proxy already)
• Determine the annual total compensation for the median compensated employee
• Determine the ratio of the two

You may be wondering at this point where the complexities may lie; that is, in what situations are you more likely to want to consider outsourcing this determination than doing it yourself. Consider these as complicating factors:

• You operate in multiple countries
• You sponsor multiple pension plans perhaps in multiple countries
• You provide equity compensation broadly
• You provide other unusual forms of compensation
• You are afraid for whatever reason that your pay ratio will be high enough to garner unwanted negative publicity and you'd like guidance on managing the message

If you do have any of those situations, I'd suggest you consider seeking outside help. After all, this sort of data manipulation and these sorts of calculations are likely not in your core competencies. And, if they're not, I'd love to find a way to make your determination of the pay ratio less painful for you.

Interpretive Guidance Issued, But Pay Ratio Determination Still Difficult

Staff at the SEC recently issued interpretive guidance on the pay ratio rules under Section 953(b) of Dodd-Frank. Regular readers will know that I have written on the pay ratio many times. What many regular readers (those who are used to dealing with benefits issues, for example) may be less familiar with is that the interpretive guidance of staff carries full weight. That is, it's not just a suggestion.

Before digging into the guidance, let's recall what the pay ratio disclosure is. Generally, companies that issue definitive proxies in the US must, beginning with fiscal years starting in 2017, disclose the ratio of CEO compensation to that of the median-compensated employee in the company. And, for those purposes, compensation is that used in the Summary Compensation Table of the proxy. So, it includes (oversimplifying a bit), for example, the value of equity, deferred compensation, and qualified retirement plans provided by the employer.

The employee population for this purpose is not limited to full-time workers or to US workers. So, companies with lots of international employees who are compensated in a variety of different ways may have difficulty with this determination.

If you need a refresher on what the final rule said and how you might handle it, there is useful material here.

Back to the interpretive guidance.

As you may recall, you may determine who your median employee is by using simplified definitions of annual total compensation so long as your facts and circumstances support it. For example, if it's clear that compensation for the median employee will resemble W2 pay, then you can use information from tax or payroll records to determine who the median-compensated employee is. But, if you provide pensions or equity compensation broadly, this may be inappropriate to your situation. In fact, for many companies, determination of who their median-compensated employee is will be the most difficult part of the process.

What staff made clear is that rate of pay (hourly rates or salary) is not reasonable to use as a consistently applied compensation measure (CACM). Staff gave examples where those rates could be part of the process, but in order to make the measure reasonable, companies would need to know how many hours each hourly-paid worker actually worked and for what portion of the year salaried workers were employed.

The interpretive guidance makes clear that in determining the median employee, the population may be evaluated using any date within 3 months of the end of its fiscal year. Once the population as of that date is selected, the employer can go through this process:

• Identify the median employee using either annual total compensation or a CACM ... by
• Selecting a period over which to determine that CACM (the period need not include the selected date so long as based on the facts and circumstances indicate that there will be no significant changes (undefined term, of course) between compensation used and actual compensation for the fiscal year)

It is up to employers to determine, again based on all the facts and circumstances whether furloughed employees should be considered in the population. Employees who were hired during the year or who worked less than the full year due to a leave of absence may have their pay annualized. But, part-time and seasonal employees may not have their pay annualized.

And, finally, the staff weighed in on how to determine who might be or not be an employee for purposes of the pay ratio. Essentially, the determination of whether a worker who is not a common-law employee of the employer should be considered an employee for these purposes is based on, you guessed it, all the underlying facts and circumstances. Primarily, the employer should look to whether it sets the compensation of, for example, contract workers, or if that pay is set by someone else.

So, for example, if the company advertises that it will pay contract telephone callers $15 per hour, then they would be employees for these purposes even if they are not employees for tax purposes. On the other hand, a worker who is brought on board through a temporary staffing agency or for a specific contract is likely not a worker.

Well, this clears it up for you, doesn't it? Okay, I thought not. Continue to follow me here for more updates as they come rolling in. Or, let me know if you have questions.

Benefits and Compensation After the Elections

Suppose there was a presidential election this year. Just suppose. And, further, suppose that election had a winner. Just suppose.

It is extremely likely that the winner will be someone nominated by either the Democratic Party or by the Republican Party. And, it is not at all unlikely that the party of the winner will keep or gain control of both houses of Congress.

From the standpoint of tax policy, and by extension, benefits and compensation policy, what will this mean for you, the employer or employee? Should you care?

I don't think we're far enough along to do a candidate-by-candidate analysis, but I do think that we are aided by the fact (at least I think it's a fact) that the remaining viable candidates fall generally into a few small buckets from these standpoints (yes, Carly Fiorina will give us a 3-page tax code (no idea what it might say) and Gary Johnson who has declared for the nomination of the Libertarian Party is a Fair Tax proponent). In fact, I think there are at most four such buckets remaining.

Let's identify them from left to right (that is how we usually read):

• The Democratic Socialist (DS) Bucket whose main component, Senator Bernie Sanders (I-VT, but caucuses with the Democrats and running for the Democratic nomination) has recently told us, "Yes, your taxes will go up."
• The Mainstream Democratic (MD) Bucket whose main component, former Secretary of State Hillary Clinton will, according to her website today (it did say something somewhat different on this topic at the end of last year), lower taxes for the middle class (and by extension the lower class) and raise taxes on the wealthy including big business.
• The Traditional Republican (TD) Bucket that includes the likes of [alphabetically] Chris Christie, governor of New Jersey; John Kasich, governor of Ohio; Marco Rubio, junior Senator from Florida; and Donald Trump (yes he is mainstream for this purpose), businessman from New York, which generally would lower tax brackets and flatten, or make less progressive, the tax code.
• The Conservative Republican (CR) Bucket that includes Ben Carson, retired physician from Maryland, and Ted Cruz, junior Senator from Texas which would replace the current income tax structure with a flat tax.

I'm going to make things a little tougher on you here Rather than reiterating these buckets, I'll comment on how different philosophies might affect things.

We all know the health care debate. Sanders wants to move to a single-payer system. Clinton likes the status quo under the Affordable Care Act (ACA). The Republicans with the exception of Kasich want to repeal the ACA and start over again. Kasich, on the other hand, thinks that this is an impractical solution and would keep some portions of the ACA and change others.

On the pension side, Republicans as a group are in favor of self-reliance. This would tend toward a world of nothing but 401(k) (and similar) plans. Their philosophy is that prudent Americans should be able to save enough for their own retirements, especially with the benefits of an employer match. Of course, many of them will be dismayed WHEN they read my blog to know that I disagree with that.

Clinton is much tougher to figure out on this. But, we can look to her stated tax policy and work our way back. When taxes on high earners and large corporations increase, so does the value of tax deductions. So, under a Clinton presidency, we might expect to see more high earners and profitable corporations accelerate contributions to benefit plans in order to accelerate tax deductions. Could this result in somewhat of a rebirth of defined benefit (DB) plans? Theoretically, it should, but in practice, I would expect that even if that rebirth occurs, it will be very limited.

Sanders would prefer to see a single government-run retirement system for everyone; that is, we would have expanded Social Security and Medicare with smaller benefits and less availability for those who have been the highest earners. In this scenario, although I personally don't see Congress going along with it, the prevalence of employer-provided retirement plans could decline significantly. On the other hand, it would not be antithetical to his philosophy to see a DB requirement in much the same way that the ACA leaves employers with a health care requirement. Could we see pay or play here?

With regard to executive compensation (nobody is saying much about broad-based compensation other than to say that under their Presidency, there will be more and better jobs and pay will increase rapidly), we have another large rift between the candidates. Here, one of the biggest elements is the view of what has probably been President Obama's second signature bill, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). (Why couldn't they have given the law a short name like Fred so that I don't have to test my typing skills every time I cite the law?) 

Sanders is a huge fan of Dodd-Frank. That said, he doesn't think the law has gone far enough. He has said many times that the reinstatement of Glass-Steagall should have been part of Dodd-Frank. Sanders, much like Senator Warren (D-MA) as well as former Senator Dodd (D-CT) and former Representative Frank (D-MA) believes that one of the most important parts of Dodd-Frank is Title IX, the section on executive compensation. Sanders is a huge proponent of tieing levels of executive compensation to that of the rank and file and of their companies as well as generally limiting executive compensation. Under a Sanders presidency, do not be surprised to see a presidential proposal that would limit CEO compensation for example to a pay ratio as defined in Section 953(b) of Dodd-Frank to something like 10.

Clinton is also a Dodd-Frank fan. But, there is a big difference here. Secretary Clinton has long had both ties and obligations to the large Wall Street banks. She periodically invokes Glass-Steagall, but knows that its repeal allowed Goldman Sachs, for example, to grow into the financial giant that it has. At the same time, though, Clinton, who I believe is still far more likely than not to be the Democratic nominee, knows that the Democratic platform will be influenced by the likes of Sanders and Warren. Expect that the compromise will be in the form of promises to scale back executive compensation. As broad-based plans in which executives participate tend to be exempt from similar scrutiny, those higher-paid individuals may look to solutions that have been proposed over time in this blog.

On executive compensation, Republicans are fairly united. All, that I am aware, would push for the repeal of Dodd-Frank and for no more (or fewer) restrictions on executive compensation. As free market proponents, they would tell us to let the fair markets determine how top executives should be paid. All that said, proposals like that will be anathema to most (perhaps all) Democrats and unless the GOP were to gain a filibuster-proof majority in the Senate, such proposals are not likely to become law. However, as Republicans without exception are looking to lower the top marginal tax rates as well as corporate tax rates, look for more emphasis on current compensation and perhaps less emphasis on deferral opportunities.

As the 2016 election process matures and there are fewer candidates, we'll be able to dig deeper. In the meantime, you have my opinion. What's yours?

And, if you think my opinions have any merit, let me help you address what will be coming with the 2016 elections.

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.

SEC Finalizes Pay Ratio Rule -- Read the Plain English Description Here

Wednesday, after much controversy over the last five years, the Securities and Exchange Commission (SEC) released its final rule under Dodd-Frank Section 953(b) sometimes known as the Pay Ratio Rule. I have friends who are executive compensation attorneys and if you need legal advice on this rule, I can recommend any number of them to you, but I am going to write about it from a practical standpoint in plain English. What happened?

First, I'd like to commend the SEC. The statute on this rule has been very controversial. The SEC, in my opinion, has taken an approach that remains largely faithful to the exact wording of the statute and fully faithful to the intent of the statute (I'm not here to argue if the statute is worthwhile) while at the same time being sensitive to the concerns of employers with regard to the potential cost of compliance. It's rare that a government agency handles such a quandary this well.

Back in 2013, the SEC released a proposed rule on this topic. Since that time, the SEC received 287,400 comments on the proposed rule. More than 285,000 of them were form letters, but that still means that roughly 2,000 people took the time to write customized comments. To the credit of the Commissioners, they appear to have considered every last one of them. What they have crafted is practical, assuming that you find the result of the work practical.

What does the rule say? Here we go.

In its definitive proxy, each registrant shall disclose three items (at least since the rule says that the disclosure may be augmented):

• The pay (as defined for proxy purposes) of the PEO (generally known as the CEO or Chief Executive Officer),
• The pay (same definition) of the median-compensated employee of the employer, and
• The ratio of the first item to the second expressed as some number (integer will work) to 1.

Identifying the median compensated employee can be a very costly process. Consider a company with 1001 employees. The median compensated will be the one whose compensation is more than that of 500 others and less than that of 500 others. In order to determine this (by the letter of the law), one would need to determine the annual total compensation (that's the proxy compensation) or ATC for each of the 1001. They would need to be ranked and then we would find the 501st person. That is a lot of work.

The final rule allows for two significant simplifications for purposes of determining the median employee:

• Companies may choose to use sampling techniques in order to reasonably determine who the median paid employee is, and
• Companies may use and consistently applied measure of compensation from payroll or tax records.

While the first of those may be more trouble than it is worth, the second should be a big help to lots of companies.

Further, once a company establishes a median employee, it may use that same employee for three years provided that there have not been significant changes (undefined term) in the compensation practices or the makeup of employees. If that employee terminates, then the company may reasonably select a similarly situated employee as a replacement.

Many commenters were concerned about the disclosures for multi-national companies especially those with significant numbers of employees in lower cost-of-living countries. Certainly, for example, $50,000 per year goes further in Kyrgyzstan than it does in the US. The final rule allows companies to adjust (on a nation-by-nation basis) compensation for cost-of-living differences.

Calculating proxy compensation can be cumbersome. It includes other than just cash compensation. So, for companies with defined benefit plans and broad-based equity compensation arrangements, it is entirely possible that multiple outside experts would need to be engaged. While that remains the case, the final rule allows companies to make reasonable estimates of components of compensation.

The statute makes clear that an employee is every employee worldwide, whether full-time, part-time, temporary, or seasonal of the controlled group. The final rule allows for all of these simplifications or adjustments:

• A determination date applied consistently within 3 months of the end of the fiscal year
• Only subsidiaries included in the consolidated financial statements need be considered
• Employees where data may be unattainable due to national (or EU) privacy rules may be excluded
• De minimis numbers of employees (up to 5% in total) may be excluded on a country by country basis

Let's look in more detail at those last two. Suppose the number of employees excluded under the privacy rule exception exceeds 5%. Then you are done with your exclusions. On the other hand, if your privacy exclusions are exactly 2% of your total population, then you may exclude other countries whose total employee population is less than an additional 3% of your total population. If, for example, you can't find another country with fewer than 3% of your total employees, then you are done with your exclusions.

In preparing these disclosures, companies will make lots of assumptions, simplifications, and estimates. All must be disclosed.

In somewhat of a gift to employers, additional disclosures and ratios are permitted, but not required so long as the additional disclosures and ratios are no more prominent than the required ones. I think this could be useful.

Consider a company with its management team and sales force in the US, but the bulk of its production facilities in third world countries (I'm not weighing in on whether this is a good or responsible practice or not). Because manual labor is particularly inexpensive in Burkina Faso, for example, Everybody's Favorite Company (EFC) has an extremely high pay ratio, say 10000 to 1. Its CEO had total compensation of $10 million and most employees in Burkina Faso earned only $1000. And further, EFC can't find cost-of-living data for Burkina Faso, so it is not able to do that adjustment. EFC is perhaps rightfully concerned about its pay ratio disclosure, so it elects to do a second pay ratio disclosure limited specifically to US employees. In this case, the ratio declines to 100 to 1.

A second company with a December 31 fiscal year end, everest.com, does a massive holiday business. As a result, Everest has a high pay ratio reflective of its hiring each year of seasonal employees. In fact, in a typical year, Everest has more than twice as many employees from September 1 through December 31 than it does the rest of the year. As a result, Everest reports a pay ratio of 750 to 1. Everest doesn't like this, so it chooses to determine an additional ratio of all but seasonal employees. The company is much more pleased to find that this ratio is only 175 to 1.

Generally, companies are required to report the pay ratio for any fiscal year beginning on or after January 1, 2017 (there are exceptions for certain new filers and emerging companies). This means that the first required disclosures (companies are encouraged to disclose before then) will generally be in the early months of 2018.

The final rule is long and complex. There are many legal issues around it and for those you should contact an attorney. 

There are also issues that are far more consultative in nature. They will generally require quantitative acumen, actuarial knowledge, and comfort with executive compensation, as well as a focus on business issues. For those, you should just click here.

Proxy Hysteria Coming For Companies With DB Plans

You read it here first. During the upcoming proxy season, there is going to be hysteria over the executive compensation disclosures in proxies for companies with defined benefit (DB) plans, especially those with nonqualified plans for their named executive officers (NEOs).

What's going on? As part of an NEO's compensation, filers are required to include the increase in the actuarial present value of DB plans. The actuarial present value is a discounted value of the anticipated payment stream just as it was a year earlier. While there are many assumptions that actuaries select in determining an actuarial liability, two, in particular, have changed for many companies from 12/31/2013 to 12/31/2014. One is the discount rate which will have decreased by somewhere in the neighborhood of 100 basis points and the other is the mortality assumption. Late last year, the Society of Actuaries (SOA) released its newest mortality study and many companies elected to adopt the new tables.

The effect of the change in discount rate will vary, largely on the age of the NEO in question, but it's not unreasonable to think that for most NEOs that just that discount rate change will have increased the actuarial liability attributed to them by 8%-12%. Yes, Americans are living longer. Mortality assumptions should be updated from time to time. But, for proxy purposes, the year of the update causes an additional spike in the liability attributed to the individual NEO, perhaps an additional 5% depending upon age and gender.

So consider an NEO whose 2013 compensation included $1,000,000 due to the increase in the actuarial present value of accrued pension benefits. If that person is still an NEO at the end of 2014, he or she will have had an increase in liability due to surviving one more year (interest and mortality totaling perhaps 6%), an increase due to increases in included compensation (a large bonus could have increased even 3-to-5 year average compensation by 25% (recall that in the case of a 5-year average that 2014 which was a good year for many businesses replaces 2009 which was a dismal year for many businesses)), and increases due to changes in discount rates and mortality assumptions.

So, with no changes in compensation practices, our NEO who had $1,000,000 of compensation attributable to him or her in 2013 might see that turned into an increase of $1,500,000 in 2014.

There will be outrage. Proponents of the pay ratio rule of Dodd-Frank Section 953(b) will point to these increases and say that the rank-and-file got 2%-4% increases. The media will not understand what happened. Congress, and this might be the year that it matters as the new Republican control has suggested that it will try to repeal some parts of Dodd-Frank, will not understand.

But those people who chose to read my ramblings will get it. Companies that foresee the issue can address it. It can't be solved in its entirety, but it can be managed.

I know how.

Do you?

Possible Delay of Pay Ratio Regulations -- Practical or Political?

Right before Thanksgiving, the House Committee on Financial Services sent a letter to the Chair of the SEC asking that guidance on the so-called Dodd-Frank Pay Ratio rule (Section 953(b)), and therefore implementation as well be delayed. The letter called this implementation a low priority. No similar correspondence has come from the Senate or any of its committees.

Gee, what a surprise that is. House committees are controlled by Republicans currently while Senate committees are in the hands of Democrats for few more weeks. Dodd-Frank was another bill and then law praised by Democrats and loathed by Republicans. The letter points out that the law does not specify a time by which the SEC must promulgate a rule on this issue. Additionally, the letter tells the SEC that the pay ratio disclosure has little value and that knowing the pay ratio for publicly traded companies back in the 2006-2008 timeframe would have done nothing to avert the financial crisis.

Let's regroup for a moment. For those who don't know, Section 953(b) of the Dodd-Frank law requires that registrants disclose a single number -- the ratio of the pay of the median-paid employee in the company to that of the CEO. Pay for this purpose is pay as defined in the executive compensation section of the proxy. I have argued that while such relative information may be useful to some that this calculation is the wrong one and needlessly burdensome. Last year, the SEC issued a proposed rule on the pay ratio calculation. While it provides a means of simplification for many companies, companies that do take advantage of the sampling techniques proposed will not find them simple by any means.

So, is the single number valuable? I don't think so. If one insists that such a comparison is valuable, then to me, it would be far more instructive to show CEO compensation and a chart of commonly held jobs within the company showing a compensation range for actual or hypothetical full-time employees(if no full-time actual employees exist for such job classifications) for each of those jobs alongside the CEO compensation.

Advocates of the pay ratio point out companies in the fast food industry. They note that CEOs make many millions of dollars while most fast food workers earn minimum wage or only slightly more. In this case, is the pay ratio valuable? To me, it's not. Running a multi-billion dollar business and defining its strategy to compete and grow has no similarities to monitoring a drive-thru window. Comparing the compensation of two such individuals makes no sense to me.

Currently, the SEC has three Democrats and two Republicans. The Chair is a Democrat. The commissioners still have meaningful Dodd-Frank work to do whether they make 953(b) a priority or not.

I don't know what they will do, but thus far, they have not shown a predisposition to act quickly on ensuring that the pay ratio is disclosed for registrants.

Pay Ratio Rule Explained ... In Plain Pithy English

Yesterday, the Securities and Exchange Commission (SEC) approved by a 3-2 vote along party lines a proposed rule implementing the pay ratio rule of Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Only here are you likely to see an explanation of the rule in words that you can understand and use. And, be forewarned, there is nothing in the rule that either serves to reform Wall Street or to protect consumers. In case you missed that, let me repeat in different words: the rule serves no useful purpose.

That said, I commend the commissioners and their staff for their efforts in crafting a rule that seems to well follow the statute while removing significant burden on companies in complying. I do not believe that the two dissenting votes object so much to the way the rule was crafted as they do that the rule was crafted at all.

Some of you will need some background on the rule. For those who don't, to refresh, 953(b) requires an issuer [of proxies] to disclose the ratio of the compensation as defined in Item 402(c)(2)(x) of Regulation S-K for the median-compensated employee in the company to that same definition of compensation for the CEO.

So, what does the proposal say? And, why, John, do you of all people, since you have clearly been anti-953(b) commend the commissioners and their staff?

The rule allows for significant simplification in the process. That said, multinational companies with decentralized payrolls may still spend millions of dollars complying with 953(b), but that still pales when compared with what they might have spent.

Disclosure Items

The rule requires the disclosure of three specific items:

1. Compensation for the median-compensated employee in the company
2. Compensation for the CEO (or PEO if you like the SEC vernacular better)
3. The ratio of 1 to 2, expressed as 1 to some integer, e.g., 1 to 377

Where a company uses sampling techniques, simplifying processes, or other estimation techniques (to be discussed later), the company is to describe these techniques, processes, assumptions, and methods in enough detail to be understandable to an investor, but not necessarily to satisfy an economist or statistician.

The issuer, at its discretion, may include other disclosures with it to assist an investor or potential investor in understanding the ratio. Such disclosures should be provided on a reasonably consistent basis. In other words, if in year 1, the issuer uses wiggle words to explain why the pay ratio is 1 to 999, then in year 2, the issuer should use similar verbiage to explain why the pay ratio is now 1 to 17.

Calculation of Compensation

As for other purposes in the proxy such as the Summary Compensation Table, compensation is to be calculated using the methods in 402(c)(2)(x). Without confusing the reader, this includes cash as well as the value of certain equity compensation and the increase in the present value of accumulated pension benefits, among other things. While the issuer (company) will already have calculated this for the CEO, the calculation for the median employee, hereafter referred to as Jane Doe, will also use the same methodology. So, to the extent that Jane is granted stock options and participates in one or more employer-sponsored pension plans (government-mandated plans are generally excludible), that must be included as part of compensation. 

Additionally, all disclosures are to be done in US dollars. Therefore, to the extent that (and I pity the poor company) Jane is paid in foreign currency, the value of such currency must be converted to US dollars. No adjustments may be made for cost-of-living differences in foreign geographies.

Who Gets Counted and How

All employees of the employer on the last day of the fiscal year are to be counted (leased employees and temporary employees of contractors may be excluded). Permanent full-time employees who worked less than the full fiscal year may have their compensation annualized. Part-time, seasonal, and temporary employees may not have their compensation annualized. And, as should now be clear unless you have slept through my first few paragraphs, foreign employees must be counted.

Simplifying the Process

This is where the SEC made us proud (hey, I was proud of them for this, but I guess I shouldn't put words in your mouth). Frequent readers will recall that I described 953(b) as a legislated disaster. (Actually, I need to thank Mary Hughes, my editor at Bloomberg/BNA for coming up with that description.) I am going to get a bit technical for a moment as I explain why to those people who have been hiding behind the rock in my blog.

Section 953(b) requires that companies disclose compensation for their median-compensated employee. Suppose a company has 999 employees. Then, the median-compensated employee (you remember her, Jane Doe) is the 500th highest-compensated. In order to determine who that is, the company would have to determine the compensation (402(c)(2)(x)) for each employee in the company. Currently, that is a by-hand process for the five employees usually disclosed in the Summary Compensation Table of the proxy. Doing it for another 1,000 or so would not be a worthwhile operation. Remember, for many companies, many employees will have many elements of compensation that take many hours to determine and that is way to many manys to be justified in the spirit of reforming Wall Street or protecting consumers.

The proposed rule allows companies to use sampling methods and and alternative forms of compensation in determining the median employee. For example, a company with only US employees, but having 250,000 of them might sample by selecting only those employees whose Social Security Numbers end in 22, 55, or 88. This seems unbiased and would still tend to produce a group of 7,500 people or so. I could go through the math for you (but, you're very welcome, I will refrain) to show you that the compensation of the median-compensated employee of the 7,500 will not vary significantly from that of Jane Doe. Further, in then determining the median of the 7,500, the company may (if it is appropriate for that company) use a convenient measure such as W-2 compensation specifically to determine which employee is the median-compensated one. Then, the company must determine 402(c)(2)(x) compensation for the CEO and that one other person.

Effective Date

I am used to reading IRS regulations. They usually tell you when you must comply with a regulation and they tell you using words (it may the only place they use such words) that you and I can understand. The SEC has chosen to do otherwise. In fact, after reading through their description three or four times, I am still not convinced that the actual rule says what their description of their own rule says. In other words, it is really confusing.

That said, I will use the SEC's own example. If the final rule were to become effective in 2014 and the issuing company had a fiscal year ending on December 31, then such issuer would need to comply for the 2015 fiscal year meaning that the pay ratio disclosure would need to be provide by 120 days after the end of 2015.

Request for Comments

Again, I praise the SEC. They actually want to get this right. They asked 69 questions requesting comments. While I don't entirely agree with their choice of questions, their willingness to ask them and to seek good answers is laudable. 

I will be commenting. I would encourage other interested parties to comment as well.

How Should Issuers Prepare?

The good news is that issuers have lots of time to prepare. It sounds to me as if you won't have to be disclosing pay ratios for another 30 months or so. That's a lot of time. It gives you time to get your ObamaCare ducks in a row before you think about this.

But, pay ratio disclosure will come. Here is a non-exhaustive list of things I think you should do.

• Figure out all the payrolls that you have company-wide
• Determine a measure of compensation that is (or something comparable is) reasonably and readily available such as W-2 or the foreign equivalent(s)
• Understand all the places and to whom equity compensation is issued
• Understand all the defined benefit (including cash balance) plans out there as well as nonqualified deferred compensation
• Prepare your foreign payroll administrators for the eventual need
• Develop a sampling method that is appropriate for your company (need help?)

You Have Questions?

The regulation and explanation combined are 162 pages. It's not exciting reading and in fact, does not have a good plot. I tried to present a readable and understandable summary here, but there's obviously much more. 

If you do have questions, you can ask me.

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Pay Ratio Here, I Fear

The did it. By an overwhelming 3-2 vote, strictly along party lines (tsk, tsk), the Securities and Exchange Commission approved a proposed rule under Dodd-Frank Section 953(b). The two dissenters, Commissioners Gallagher and Piwowar, both issued scathing condemnations of both the statute and the proposed rule while the other commissioners praised it for the assistance that it will provide to investors and potential investors.

The rule has not been published yet, or at least, I can't find a copy, but I did take some good notes, so my readers get an early summary with surprisingly enough, some cynicism from your faithful blogger.

Issuers will need to provide three numbers:

1. Compensation (Rule 402(c)(2)(10)) for the median-paid employee
2. Compensation of the CEO
3. The ratio of 1 to 2

Despite this being what the law calls for, #3 is stupid. For those who are not sure what I just said, #3 is stupid. Suppose I told you that the ratio of compensation of the median employee to the CEO is .0073. What would that number mean to you unless you are mathematically facile? Is that a good number or a bad number? Should you be happy?

I repeat, #3 is stupid. The ratio should have CEO pay in the numerator and be an integer.

Haters of the statute did get a few breaks:

• Companies may determine the median employee via statistical sampling. After doing this, they must determine the 402(c)(2)(10) compensation of that median employee rigorously. Despite commentary from Commisioner Piwowar to the contrary, this is a huge concession to issuers.
• Compensation of permanent full-time employees may be annualized.

On the other side, there are these provision:

• Part-time, temporary, and seasonal employees pay may not be annualized.
• Compensation of global employees must be currency converted.

And, on the I'm not sure until I see the actual regulation side,

• There is no rule to say how statistical sampling must be done, but it must be reasonable and consistent.
• The dispersion of pay should be a significant contributing factor in determining the sample size for statistical sampling.

I understand that the novel which shall be heretofore known as the Dodd-Frank pay ratio rule is quite voluminous. Stay tuned here to get the most easily readable and entertaining reports on what it says.

The Need For Honest Debate

It's that time again, it's time for a rant. But, I hope that it will be instructional as well. I'm going to talk about our need for honest debate in our legislative process. And, because this is a blog that, at least in theory, deals with benefits and compensation, I'll use benefits and compensation issues to illustrate my point.

For those who are wondering, the antagonists here are the large part of the 535 (that's the usual number) elected officials who in combination are the voting members of Congress. The protagonists, if there are any are the other 315 million or so of us who get to live by what the 535 come up with.

Let's start with nearly everyone's favorite whipping boy, the Affordable Care Act (PPACA, ACA, or ObamaCare). We all know what happened. President Obama really wanted to reform the US health care system. At various times, he indicated that he wanted to move toward a single payer system. Many of his fellow Democrats among the 535 also wanted a single payer system, but knowing that was unlikely to get enough support to become law, they settled for a bill that eventually became PPACA. The Republicans banded together to vote against it, unanimously. My distinct impression is that most didn't care what was in it. It was to be a landmark piece of Democrat-sponsored legislation and Republicans were voting against it. My distinct impression was also that most Democrats didn't care what was in it either. It was going to be a win against Republicans, so Democrats voted for it. As Nancy Pelosi (D-CA) famously said (and I am going to include the whole quote so that it is not taken out of context):

You've heard about the controversies within the bill, the process about the bill, one or the other. But I don't know if you have heard that it is legislation for the future, not just about health care for America, but about a healthier America, where preventive care is not something you have to pay a deductible for or out of pocket. Prevention, prevention, prevention -- it's about diet, not diabetes. It's going to be very, very exciting. But we have to pass the bill so that you can find out what is in it, away from the fog of the controversy.

Did Ms. Pelosi know what was in the bill when she voted for it? She probably had a general idea, but didn't know the specifics. How about the other 534? I'd wager that most of them had neither read more than a page or two, at most, of the legislation and had not been briefed on it by anyone who had read it.

Where was the debate? Where was the opportunity for individual members of Congress to discuss the good parts and the bad? Even among the most ardent Republicans who voted against the bill, I suspect it would be difficult to find many who think that mandatory preventive coverage and coverage of kids up to age 26 are bad things. On the other hand, the medical device tax that was inserted deep in the bill's bowels as a revenue raiser would probably not get support today from more than a few Democrats who voted for the bill.

Suppose the bill had truly been debated. Suppose the good parts had been picked out as the foundation for a bill that might have gotten some bipartisan support. Suppose the parts that virtually all of us can agree don't make sense had been left out. What would debate have taught us? It would have confirmed that our health care system needed some reform. It would have confirmed that providing health care coverage to millions of uninsured costs money. It's not budget neutral. It's certainly not helpful to the budget. But, we didn't have good, honest debate and we eventually have learned what was in the bill.

Dodd-Frank was another bill that was passed without a whole lot of what I might refer to as crossover voting. That is, a few Republicans voted in favor and a few Democrats voted against. But, to call it bipartisan is a bit of a stretch. The bill was massive. Many who voted for or against had a pet little provision in there that triggered their votes.

The bill was supposed to clean up Wall Street and protect consumers. I know this to be true because of the full name: The Dodd-Frank Wall Street Reform and Consumer Protection Act. Names of laws don't lie, do they? Say it ain't so.

Somehow, it became important to get Title IX in there -- the part on executive compensation. And, Senator Robert Melendez (D-NJ) managed to sneak in what regular readers know to be my personal favorite, the pay ratio provisions in Section 953(b).

I've communicated with a few people who follow Capitol Hill closely, Congressional reporters. None of them are sure how this provision actually got into the bill. They all agree that it was not debated. What happened?

Implementation of Section 953(b) will require some simple mathematics, or arithmetic if you prefer. Senator Menendez, the purported author of the section was a political science major before attending law school He was also a member of a Latin fraternity. He first entered politics at the ripe old age of 20.

I looked hard. I cannot find any evidence of Senator Menendez' mathematical prowess or of his knowledge of executive compensation. Perhaps that is why Section 953(b) is so incredibly messed up -- bad enough that I have written about it enough times to finally learn how to type the word ratio without placing an n at the end of it even though my fingers seem to prefer to type ration.

To the credit of the 535, Dodd-Frank was debated ... as a bill. But, it's tough when you have a bill that, at least in one printing, contains about 3200 pages to debate every provision. Section 953(b) escaped debate. It became part of the law.

It is bad law. Despite what the AFL-CIO says, Section 953(b) is bad law. There, I said it. Perhaps it should have been debated. Perhaps Ms. Pelosi should have said that [we] have to debate the bill so that we can put useful provisions in it. Perhaps I am dreaming.

Pay Ratio Rules are Coming

I've written about it many times. It lives in Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It's the pay ratio requirement. If this is new to you, you can get the background on it here. The New York Times wrote about it recently and finds no evidence as to how or why Senator Menendez (D-NJ) added that section into the Act. Perhaps this site maintained by AFL-CIO was a motivating factor.

I write about this again because of the rumor mill surrounding the SEC (I know, you can't find it in the supermarket tabloids).This rumor mill tells me that the SEC will provide its first guidance on this and other [Dodd-Frank] Title IX issues next month (September 2013).

Suppose you are an employer subject to Title IX (generally an SEC registrant), what should you do and what should you look out for?

If you are in the simplest of all situations-- that is, no employees outside of the US, no part-timers, no seasonal employees, no equity compensation, no defined benefit plans and no perquisites, your job is easy. CEO compensation and that of other employees is going to look a lot like W-2. You might even have a centralized payroll system on which you can run a report and easily determine who the median-paid employee in the company is. This could be a 30-minute exercise.

Oh, you're not in that simplest of all situations? It's going to be more complicated then. You will be faced with the exciting prospect of currency conversions, actuarial present value calculations, Black-Scholes calculations, gathering of data from multiple payroll feeds, and determination of the value of other benefits on which you usually don't place a price tag.

We think that one of the reasons that the SEC has taken three years to provide rules on much of Title IX is that they have not been able to figure out what makes sense. After having received thousands of comment letters, many suggesting simplifying procedures, apparently they are close. We will see soon what the rules look like.

In the meantime, if you fall into the group of companies that has one or more of the "problem areas", you will want to see what the rules say and see how they will affect your company. When the rules are published, you can read my analysis here. It may not cover every legal detail as the ones from law firms do, but I hope that it will give you practical advice.

And, now or then, if you'd like to get a head start on how to deal with this, e-mail me and we can discuss how to handle your situation.

It's not going to be pretty, I'm afraid.

More on the Dodd-Frank Pay Ratio

I've written many times on the Dodd-Frank pay ratio rule found in Section 953(b) of that voluminous law. You can read about it here if you haven't before. Recently, and I can't tell from the online version what the date was, the Washington Post wrote on the topic. The 1104 online comments to the Washington Post article tell me that there are certainly a lot of opinions on this.

Interestingly, nobody seems to have consulted an actuary or any type of retirement consultant. Why does this matter? The most variable calculations of the lot that can go into the 953(b) pay ratio calculation are defined benefit. They can be qualified plan or nonqualified in the US and they can be executive or broad-based in other countries. Each will be different and each will use different actuarial assumptions.

Last week, the Economic Policy Institute (EPI) declared that the average chief executive officer last year made 273 times what the average employee made. Is average a mean, a median or something else? Does EPI know how the 273 was calculated? Do the values for the average employee include the same components that the CEO calculations do? I would be willing to wager a lot that the answer to the last question is no. The reason for that is that such calculations do not exist for the average worker. However, most reporters, unless of course they read my blog will never work this out.

I understand what Section 953(b) was supposed to do. Like so many other provisions of ultra-long laws, however, their intent and their drafting are often very different.

Unfortunately, we will probably have guidance soon.

Do the Eyes Have It?

Leave it to an opthalmologist turned US Representative. Nan A. S. Hayworth (R-NY) introduced to the House Financial Services Committee HR 1062, the Burdensome Data Collection Relief Act (BDCRA).

I know, what in the world is that?

If you are a regular, or even occasional, reader of this blog, you know what I think of Section 953(b) (the pay ratio rule) of the Dodd-Frank Act. You have read that I think that it has some conceptual merits, but that it is poorly conceived and will not produce useful information.

Well, I have to give Dr. Hayworth a lot of credit. She has written a bill which is remarkable both for its good effect and for its brevity. I reproduce the bill in its entirety below:

A BILL

To amend the Dodd-Frank Wall Street Reform and Consumer Protection Act to repeal certain additional disclosure requirements, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Burdensome Data Collection Relief Act'.

SEC. 2. REPEAL OF ADDITIONAL DISCLOSURE REQUIREMENTS.

Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) is hereby repealed and any regulations issued pursuant to such subsection shall have no force or effect.

That's it. That's all there is to it. The good news is that it has been moved from Committee to the full House for consideration. If gambling were legal here, the betting line would be significantly in favor of the bill passing the full House. But, as you know, it then must make it through the Senate (still Democrat controlled) and be signed by the President. If, as I am, you are for repeal of 953(b). then while you hold out great hope for enactment of BDCRA, you don't expect it to happen before January, 2013, at the earliest.

We'll keep you informed here. In the meantime, unfortunately, prepare for the worst with regard to this one.

Pay Ratio Disclosure Still Alive

I've written about it before, and not in the kindest terms. In fact, I called it the stupidest rule. It's the pay ratio disclosure rule under Section 953(b) of the Dodd-Frank law.

Scores of intelligent people have written to the SEC asking them to provide an easy means for companies to comply with this section of the law. Many of the same people have asked Congress to repeal it. So, what's all the hubbub?

For those who have not been following the issue, Dodd-Frank had as it primary goal cleaning up Wall Street. Largely, it was a reaction to TARP, "too big to fail", and the Wall Street "fat cats" getting fatter. Section 953(b) was pushed for and trumpeted upon passage by large labor. What does that mean? It means that the large labor unions like it.

Section 953(b) will require issuers of voting proxies who are SEC registrants (generally, companies with US public shares or public debt) to disclose the ratio of compensation of the median employee of a company to that of the CEO. I know, that doesn't sound so bad on the surface. But, here is what is really bad about it:

• The ratio is backwards. If it has any value at all, then CEO compensation should be in the numerator and median employee compensation in the denominator so that the disclosed ratio is (or looks a lot like, just in case the SEC would require more significant digits) an integer. A ratio of 0.0083 is not going to be a number that shareholders can latch on to. A ratio of 120 (its reciprocal), on the other hand would have some meaning.
• The definition of compensation is not what Joe Six-Pack thinks it is. It's not just cash compensation. It includes values of equity awards and grants, and changes in the value of certain nonqualified deferred compensation arrangements, among other things. That latter element is particularly troubling because CEOs of certain companies will be deemed to have earned more money simply because interest rates have fallen.
• The law doesn't just apply to US employees. Suppose, for example, a company is in the rubber business. Well, there just aren't a whole lot of rubber plantations in the world's thriving economies. So, rubber plantation workers don't earn a whole lot of money; it's the nature of their local economies. Yet, this could make the pay ratio look really bad for that company.
• Again, the law doesn't just apply to US employees. Foreign employees usually get paid in their local currency. So, this not very useful pay ratio may fluctuate do to foreign currency exchange rates. And, how will that happen? Well, we don't know. Suppose I worked in a country that uses the Euro (I'm not going to make this overly complicated and use an obscure currency). Further, assume that I get paid twice per month. Does my employer need to take each of my 24 paychecks and convert its value to dollars using the then current exchange rate, or do they get to use one exchange rate for the year? Either way, this process is unnecessarily cumbersome.
• Determining the median employee is not easy. For the mathematically challenged, finding the median of a population entails ranking the entire population and picking the person in the middle. In this case, that means that the company will have to determine the compensation of every single employee worldwide. And, one other thing that we don't know is which employees this includes. Does it include temporary workers, seasonal workers, part-time workers, workers who were hired during the year, workers who terminated employment during the year? Would it be easier if it included those people or not? Would the answer be more useful if it included those people or not?

Finally, we will get a number for each company. And then what? Richard Trumka, President of the AFL-CIO thinks that a reasonable ratio (when the fraction is flipped) is 4. I don't know of a large company in the United States that would have a ratio of 4, unless there was a CEO who voluntarily chose to not be paid in that year. That's just not the nature of CEO compensation. And, with regard to CEOs that I am familiar with, frankly a ratio of 4 would be highly discriminatory against the CEO when compared with unions. In my experience, it's not unusual for a CEO to work 80 hours in a week. If that CEO were in a union, he would get time-and-a-half for overtime, plus shift differentials, double time (or more) on some weekends and holidays, and other bumps. If part-time workers, temporary workers, and workers who were employed for less than the full year were included, the CEO might have a lower effective hourly rate than the median employee.

So, here is where things stand now. On the negative side, the SEC says that the law is clear and that the SEC does not have the power or the flexibility to interpret the law in a way that would appease the commentators. Unless it gets repealed, SEC registrants will have to deal with it.

On the positive side, registrants will not be required to comply with this section until the SEC has regulated it. Looking at the SEC's regulatory calendar, this writer thinks that may not be in time for the 2012 proxy season. Maybe saner heads will prevail by then.

Are CEOs Paid Too Much?

That's a simple question that I ask: "Are CEOs paid too much?" Or is it? I would bet that most people who read this have a fairly immediate answer, but unlike everyone having an immediate and hopefully unanimous answer to the question "Is the Earth flat?", in this case, I would not expect unanimity.

Last Thursday, CNN had an online article on the topic. Their headline stated that CEOs earn 343 times as much as typical workers. Later on, we learn that they are citing statistics from an AFL-CIO website.. Does the fact that these are AFL-CIO compiled statistics make this comparison incorrect? No! To the contrary, does that fact make the comparison correct? No!

The article tells us that the typical US worker for all occupations earned $33,190 for all occupations in 2009. This, they say, is according to data compiled by the Bureau of Labor Statistics (BLS). The comparison was made to the 2010 pay of Fortune 500 CEOs. The CEO compensation is proxy compensation which means that it includes the increase in value in pensions and deferred compensation. The BLS data does not.

Richard Trumka is President of AFL-CIO. His salary is roughly four times that of the 'typical' worker. He says that he will be happy when average CEO pay is at four times that of the typical worker.

I think that Fortune 500 CEOs make a lot of money. Some of them make more than they deserve, in my opinion. Most that I know of work more than twice as many hours every week as the 'typical' worker. In fact, I don't even know if the typical worker, according to this data, is a full-time employee anywhere.

In any event, this is another example of the media (and they all do it) taking a story that has an air of sensationalism to it and making headlines. This is just wrong. At least the AFL-CIO paywatch website breaks down the compensation of the executives. Here is an excerpt from the AFL-CIO site.

2010 Average CEO Pay at S&P 500 Companies
Salary	$1,093,989
Bonus	$251,413
Stock Awards	$3,833,052
Option Awards	$2,384,871
Nonequity Incentive Plan Compensation	$2,397,152
Pension and Deferred Compensation Earnings	$1,182,057
All Other Compensation	$215,911
TOTAL	$11,358,445

I expect that data for the typical worker does not include all of these elements. For example, my observations lead me to conclude that most AFL-CIO workers have pensions, but they are probably not included in the compensation for a 'typical' worker. At some companies, at times, they have received equity awards. These are not included in their compensation.

Maybe you think that $11.4 million is too much compensation for the average Fortune 500 CEO (by the way, we don't know if average is mean or median here). Maybe I do as well. But, if someone is actually trying to inform, they will, at the very least, make an apples to apples comparison.

Here is the problem. What this really all goes back to are two things that I have written about in the past: Say-on-Pay and the Dodd-Frank Pay Ratio disclosure. Mr. Trumka has been an outspoken proponent of both, and he is certainly entitled to both his opinions and to his right to voice them. At this point, four companies have received a no vote from their shareholders with regard to Say-on-Pay. Given that only four have gotten that thumbs down, I think those companies deserve to be called out here:

• Beazer Homes USA
• Hewlett Packard
• Jacobs Engineering Group
• Shuffle Master

Perhaps, ultimately, the message to companies here is to communicate and to explain. Yes, there are things that are required in a proxy disclosure, but there is plenty of room for narrative. If there is a really good reason that executive compensation has increased dramatically, disclose it. If a particular component is going to look bad in print, but there is a perfectly good reason, disclose it.

And, if you can't figure out how to disclose things to make them understandable to your shareholders, you know how to find me.

IMHO: The Stupidest Rule

NOTE: This post, in particular, is my opinion. It may not be the opinion of my employer, and advertisers, or anyone else, for that matter.


There has to be a stupidest rule. I think I know what it is. You probably disagree, and if you do, you are free to ignore me, comment, or blog about your own choice. But, with apologies to Leslie Gore, it's my blog and I'll give my opinion if I want to.

So, what is it? It's Section 953(b) of the Dodd-Frank Act, sometimes known as the pay ratio rule. Before we talk about what's in this dreaded, or should I say dreadful, subsection, let's understand how it got there. It wasn't in the original language developed by Rep. Barney Frank (D-MA), but Sen. Robert Menendez (D-NJ) insisted that this was an important provision of financial reform. We'll return to this later.

What does this subsection require SEC registrants to do? It requires them to disclose the total annual compensation of the Chief Executive Officer (CEO) and that of the median employee of the employer when ranked by compensation, and then to disclose the ratio of the pay of the median employee to that of the CEO. Now, understand, total annual compensation isn't just cash. It's also the value of equity compensation, the value of pension accruals, the value of perquisites, and pretty much everything else that has value. Calculating this for the CEO is not an easy task, but companies have to do it anyway as part of their proxy reporting for the CEO and four other generally very well-paid employees. So, that part is done.

Now let's return to Senator Menendez. Many people upon reading the law said that Senator Menendez must have meant that this exercise was only to include full-time US employees. According to the senator, they were wrong. He said that when he wrote every employee of the employer, he meant every employee of the employer.

Now, I'm sure that Senator Menendez is a smart man. Like many of his brethren in the US Senate, he graduated from law school. And, in the House of Representatives (before being appointed to the US Senate by then Governor Corzine), he rose quickly through the ranks of Democratic Congressman to assume a key leadership role. But, I wonder if he understands what he hath wrought.

For the mathematically challenged among us, let me digress. What exactly is a median, other than the center of a highway where some governing entities let pretty things like wildflowers grow? You find the median of a set of data by ranking all the data points from top to bottom and picking the one exactly in the middle. So, if you have 101 employees, this would be the 51st when ranked, because 50 would be higher-paid and 50 would be lower-paid. If you have 100,001 employees, this would be the 50,001st when ranked, and so forth. OK, that sounds easy enough, but first you have to rank them. And, in order to rank them, you need to, at least in theory, determine the total annual compensation of each person who works for your company.

Let's consider some of the challenges. If your company has a defined benefit pension plan, then you need to determine the increase during the year in the actuarial present value of accumulated plan benefits for each individual from one year to the next using a set of pretty much prescribed actuarial assumptions. With apologies to Ringo Starr, this don't come easy, you know it don't come easy. Maybe you grant broad-based stock options. If so, have you calculated the grant date value of all the options that vested in that year? That don't come easy either. And, then, let's assume that you are a multinational corporation -- not one of those that many think are evil because they ship jobs oversees -- that has employees in various countries around the world both for distribution purposes and for purposes of harvesting the raw materials that you use to make your products. You have to determine the compensation of each of those non-resident aliens as they are known in the Internal Revenue Code. Hmm, how do you do that? Suppose you pay some of your people in Slovakian Koruny (how else would you pay your Slovakian employees). Do you convert all of their Koruny to US dollars on one date, and if so, at which exchange rate? Or, do you do it separately using a then current exchange rate for each pay period? Perhaps if I asked Senator Menendez, he would know which method he intended. On the other hand, could it be that he didn't consider this complication?

So, now we have calculated this obviously very useful number for all of our employees who worked for us during the year. We rank them and count them. And we find the monkey in the middle (that was a childhood game where I grew up and we all took turns at being the monkey), so to speak. Finally, we take the total annual compensation for that person and divide it by the total annual compensation for the CEO.

Let's consider some possible numbers that might not be unusual for a Fortune 100 company. The CEO was rewarded with $7,685,249 in total compensation for the year while Ms. Median earned 54,992. I punch these numbers into my handy-dandy HP-12C calculator (as my brain has gotten too rusty to do the math in my head) and I get .007156, at least that's what I get when I round to 6 decimal places. Hmm, is that the correct number of decimal places? I don't know. If I round it to 2 decimal places, I get .01 (that's the same result that I would get for every ratio from .005000 up to .014999, so I don't think that is what was intended). Maybe Senator Menendez wanted 4 decimal places. If so, I'll report .0072.

I wonder if that's right. Perhaps I'll ask Senator Menendez. Well, unfortunately, I don't have ready access to him, and in any event, the law gives the wonderful mathematicians (oops, they're not mathematicians) at the Securities and Exchange Commission (SEC) the obligation to regulate this oh so important provision.

So now that I have decided to report my result as 0.0072, what gets done with this? Is that a good result? Will our shareholders be impressed? Will they think this is horrible? Will they wonder how much money it cost us to determine this number (probably not)? How about the shareholder advisory service firms? Will this number be important to them (I certainly hope not)? Perhaps instead of reporting this silly number, I should report its reciprocal (approximately 140, meaning that on this basis, the CEO made 140 times as much as the median employee). Nope, that's not what the rule says, even though this number would mean more to most observers.

Before concluding, I need to note that I do think that lots of CEOs are paid far more than they are worth. Yes, executive compensation has gotten out of hand, but this is not the answer. I consider myself far more informed than the typical shareholder on this issue, and I can assure you that the first time that I see a proxy statement including this ratio, I won't know if it's too high or too low, and frankly, I won't care. But, I do fear that some person with too much time on their hands is going to get this number for each company in, for example, the Fortune 500, and rank the Fortune 500 companies by this number. Surely, some reporter who is looking for an inflammatory story will take those rankings and tell us how some executives and compensation committees are evil. Frankly, they might be, but this isn't the way to determine.

And, finally, Senator Menendez, do you know what I would like to be able to do with those numbers. I'd like to find out what each Fortune 500 company's compliance burden is to do the work necessary to comply with Dodd-Frank Section 953(b). And, I'd like to compare that to CEO pay, and tell you how many companies in the Fortune 500 I have found whose cost of complying with your pet provision exceeds the total annual compensation for their CEO.

Perhaps that is what was really intended for this, the stupidest rule ...