As the SEC Prepares Pay Ratio Rule, Companies Look for Solutions

Among the most contentious demands of the Dodd-Frank Act is one of its briefest additions.

In just 140 words, a last-minute addition by Sen. Robert Menendez (D-N.J.) instructs the Securities and Exchange Commission to require companies to report the median annual total compensation of all employees, compared as a ratio to the CEO's total pay.

Supported by financial watchdogs, activists, and unions, the measure aims to reveal exorbitant pay imbalances, which some claim led to excessive risk taking and have long affected company performance, employee morale, and shareholder value. CEO pay has risen to 273 times the average workers' pay in 2012, up from 20 times in 1965, according to research by the Economic Policy Institute.

In Congressional testimony, SEC Chairman Mary Jo White has pledged that rulemaking on the matter will arrive soon. Sources familiar with the Commission's deliberations say the proposal on CEO pay ratios could come on or near Sept. 21. Many companies, however, aren't waiting for the regulations, however, and are already working on what could be a far more complex and costly undertaking than first thought.

At first blush, the requirement to compare what the CEO makes to employee wages makes may not seem very onerous. But the devilish details could make compliance with the rule difficult, say compensation advisers.

“If you are an American company that pays people cash, and that's about it, you are fine and it is a fairly easy calculation,” says John Lowell, an actuary and independent executive compensation adviser. “As soon as you have equity compensation, global employees, seasonal employees, part-time employees, or a defined benefit pension plan, you have a mess. The more of those things you have, the bigger mess you have.”

The timing of the regulation could also cause problems for companies, especially if the SEC puts the rule into effect for fiscal years ending Dec. 31, 2013. “A lot of companies would have to jump through a lot of hoops” to make that happen, says Lowell. A better scenario is a proposed rule that requires a good faith effort to comply, he says, with no strict requirements or penalties enforced for another year.

When it does take effect, just how onerous it will be depends on how much flexibility the SEC offers in its interpretation of the law, says Steve Seelig, a senior executive compensation consultant at Towers Watson. Will it issue a directive, perhaps simplifying the process, or take a principles-based approach that leaves it largely up to companies to decide what is material and develop their own methodologies?

 “If you have to come up with a methodology on your own, and need to justify it, that's going to take a lot more effort,” Seelig says. “It is not only the SEC companies have to worry about, it is also anyone who might sue them for potentially inaccurate disclosures.”

What worries companies about the regulation is that apples-to-apples comparisons can be difficult to make with compensation, and defining an employee and the exact pay figure for each one isn't easy.  CEO pay is multi-tiered and constantly shifting, Lowell says. There is base pay, bonuses, long-term-incentives (such as stock grants), and the changing present value of accumulated benefits in pension plans to consider.

“As soon as you have equity compensation, global employees, seasonal employees, part-time employees, or a defined benefit pension plan, you have a mess. The more of those things you have, the bigger mess you have.”

—John Lowell,

Executive Compensation Advisory,

& Actuary

Employee pay isn't all that simple either, especially if there are thousands of them scattered around the globe. Many companies may have to collect, sort, and analyze salary, bonuses, stock options, perquisites, changes in pension value, non-qualified deferred compensation earnings, 401(k) matches, health insurance, transportation and parking allowances, meals, and other benefits for a shifting workforce of thousands.

How to Get Started

One of the first tasks to do to get started on computing the ratio, says Seelig, is to figure out where are all the payroll systems are located. Who are the departments and contacts needed to pull all this information? Can payroll functions be centralized and consolidate into a single feed to make the forthcoming calculations more bearable?

Taking a close look at pension plans is another crucial step, Lowell says. Companies with multiple defined benefit plans will have some work to do to sort through the compensation data, especially if they are not just within the United States.

Seelig also flags pension calculations as a trouble spot. “It is not simply taking the [lump sum] expense that you've put down on your financial statement and dividing it,” he says. “These are calculations that have to be done for each individual that has a pension. No one is just pressing a button to come up with what that number is going to be.”

Given the intricacies of foreign employee benefits, many companies are hoping that the SEC makes things easier by only requiring a calculation based on the domestic workforce, Seelig says.

Companies must also account for foreign exchange rates and their fluctuations. Lowell details some of the scenarios to consider for currency conversions. Will you be required to use an average number for the year, or a translation on a snapshot date? Depending on how many employees you have, and how many foreign countries they are in, how much does that skew things?

Because the SEC may ultimately exempt certain employees, companies should start creating a usable breakdown of which employees are part-time, seasonal, or work limited hours and the documentation to support the assessment.

Apples to Oranges

Still unknown is how investors, analyst, activists, regulators, and proxy advisory firms will use the pay ratio data. Some compensation consultants say that comparisons between different types of companies could be very difficult and lead to misperceptions about CEO pay.

Dodd-Frank Act Tasks SEC With Pay Issues

The Security and Exchange Commission's forthcoming rule on CEO/employee pay ratios isn't the only effort underway on the compensation front. The following are other pay-related mandates of Title IX of the Dodd-Frank Act.

Section 951 requires advisory votes of shareholders about executive compensation and golden parachutes, including specific disclosure of golden parachutes in merger proxies. Institutional investment managers are required to report, at least annually, how they voted on these advisory shareholder votes. The Commission adopted rules on Jan. 25, 2011.

Section 952 requires disclosure about the role of, and potential conflicts involving, compensation consultants. This statute also requires the Commission to direct that the exchanges adopt listing standards that include enhanced independence requirements for members of issuers' compensation committees. The Commission adopted rules on June 20, 2012.

Section 953 requires additional disclosure about certain compensation matters, including pay-for-performance.

Section 954 requires the Commission to direct the exchanges to prohibit the listing of securities of issuers that have not developed and implemented compensation claw-back policies.

Section 955 requires additional disclosure about whether directors and employees are permitted to hedge any decrease in market value of the company's stock.

Source: Dodd-Frank Act.

Some fear that the ratios could be used to justify “no” votes during “say-on-pay” votes. That could be problematic, say compensation consultants, since the figures can easily be affected by influences that companies don't necessarily control, such as exchange rates, interest rates, and global economic trends. Among the biggest factors is the industry that the company operates in.

“Is it better to be working for a big bank where the CEO may make a lot of money, but the average employee may make six figures, or work for a chicken distributor where the CEO may not get paid as much and the workers get paid very little?” asks Alan Johnson, managing director of compensation consultant Johnson Associates. “I can think of many situations where a low ratio is actually bad,” he says. Johnson advises companies to prepare other information that will shed more light on the compensation environment at the company, such as how the company's average pay compares to the rest of the industry, or how the CEO's pay compares to the company's performance over a certain period.  

The AFL-CIO, among the union leaders that pushed for the pay ratio, also says companies could do more to shed light on pay practices. “A company that has many offshore employees could provide a compensation breakdown of its U.S. and international workforces,” it wrote in a recent statement. Companies that have a large number of part-time employees could provide a similar breakdown.

Another AFL-CIO suggestion that might find favor with companies is a pitch to the SEC to permit statistical sampling.

In a recent policy statement, it pointed out that other federal agencies, including the Census Bureau and Bureau of Labor Statistics, calculate do so and “this approach will minimize compliance costs”  with a high degree of statistical accuracy.

Beyond the pay ratio rule, what's next? One person familiar with the SEC's deliberations, who spoke privately, says it is merely the start of something bigger.

“There is no secret as to why this is out there,” they said. “It is to cause more mischief in the future, and there will be a lot more political pressure if it goes through. Then the question becomes whether Congress decides they are going to try to legislate executive pay.”

For now, riled-up compensation executives continue to lament the rules under SEC review, and an eventual legal challenge to the regulation is all but assured.

 “This is just one more tax imposed by the federal government on public companies,” Johnson says. “It's kind of the illegitimate child of say-on-pay, which also was not intended to make public companies better, but to create a political environment.”