CEO-NEO Pay Ratio Better Than the Alternative

CEO-NEO Pay Ratio Better Than the Alternative

March 23 2015

Agenda Logoby Nora McCord & Steven Hall Jr.

While the impending SEC rules on disclosure of the ratio of CEO to median worker pay may generate more headlines, compensation committees should focus more on the ratio of CEO pay to the average of other named executive officers (NEOs).

The CEO-to-median-employee ratio disclosures required under the Dodd-Frank Act will probably be more illustrative of the type of business and the number of overseas workers than it will be about whether or not the company is providing fair pay to employees. For example, companies in the manufacturing industry tend to have a significant portion of their workforce overseas, so they will likely have a high ratio. On the other hand, professional service companies are likely to have a more homogeneous workforce and thus less dramatic disparities in internal pay equity. And unfortunately, because of the magnitude of these ratios, there is very little that companies can do on a practical basis to affect the ratios. Instead, the best course of action is to disclose the ratio along with sufficient context to provide investors with insight into what drives the ratio and why it might differ from that of its competitors.

Ratio_3As for CEO-to-other-NEOs ratios, many compensation committee members have a general sense of these numbers, but few have integrated an explicit review of this data into their annual agendas. In our experience, most companies informally review this relationship as a way to get a reality check on pay levels that are determined based on the competitive marketplace and the relative strength of the incumbent executive to peers.

To help directors orient themselves, we have examined the ratio of CEO pay to the average of other NEOs for companies in the S&P 500. We found that the median CEO pay is 2.93 times that of the other NEOs, and CEO pay is 2.98 times that of CFOs at the same companies.

We calculated these ratios using the same methodology as the pending CEO-to-median-employee ratio, using a definition of total pay consistent with that currently used in the summary compensation table of the proxy statement. However, this definition includes changes in pension and deferred compensation values, which are generally more reflective of executive tenure and actuarial assumptions than they are about take-home pay. In instances where executives have large balances in pensions or deferred compensation arrangements, it may make sense to remove these values from the calculation of the ratio. This process will help ensure a true apples-to-apples comparison across the executive management team.

To make use of this ratio, compensation committees can look at the numbers as a starting point to consider and assess issues such as talent development, succession planning and retention. A high ratio, for example, may be indicative of an imperious CEO or a lack of a viable CEO successor among the management team. Additionally, high ratios can be harbingers of retention concerns, as it may suggest that members of the management team may not have sufficient long-term awards with retention value. If NEOs start to leave to find greener pastures elsewhere, companies may face the more expensive task of making an external hire, rather than promoting from within.

In order to help identify and address these concerns before complications occur, compensation committees would benefit from a regular review of these ratios.