The Advisors' Blog

This blog features wisdom from respected compensation consultants and lawyers

April 27, 2016

Pay Ratio: How Will Investors Really React (To a True Internal Look)

Broc Romanek, CompensationStandards.com

Leading up to the SEC’s adoption of its pay ratio rules, a familiar refrain was that shareholders didn’t care about ratio disclosure. This new study by Professors Khim Kelly and Jean Lin Seow reveals what we have been pushing for a long time – that the most meaningful disclosure about ratios is when you compare a company’s own ratios over time – rather than comparing ratios to peers.

This is exactly what we wrote about over a decade ago – that internal pay equity is an internal look. Here’s an excerpt from our thinking:

To start the internal pay process, boards should start by evaluating the relationships for both total direct compensation and total remuneration (i.e., including special executive benefits and perquisites, assuming these are significant). Then, if these analyses raise red flags, the analysis can be pursued by component of total compensation, including a break out by long-term incentive component.

Boards should choose a relevant time period for the internal pay audit to cover. In some cases, companies may choose to go back 10 to 20 years (e.g., although this won’t be possible for all companies, since some companies and managers have not been around since the mid-80s; in addition, some business models have changed so dramatically that too far a look-back may not be sufficiently relevant).

It is important to choose a time frame that will allow a good understanding of how the current pay program and pay for particular executive officers came to be, and the changes that have evolved over time. For companies that are already looking at multi-year tally sheets, they can use this data for this analysis.

Once a company has conducted an internal pay equity audit, management and the board should determine whether they feel comfortable both with the internal pay equity relationships that exist today and the changes in those relationships that have taken place over time.

It is important to note that the internal pay audit is intended to be an internal look, not something that is benchmarked across companies. This might be one reason why the practice has diminished in recent years – benchmarking databases maintained by compensation consultants provide no help here. This is an exercise that must be undertaken internally, although guidance from experienced consultants can help guide you through the process

The new study is based on an experiment in which MBA students were asked to make judgments about a hypothetical company. Those to whom high CEO-to-employee pay ratios were disclosed were significantly more likely than others to regard the CEO’s pay as unfair – and the more unfair they regarded it, the less likely they were to view the firm as a worthy investment. This latter finding is particularly noteworthy, the professors believe, because one of the criticisms leveled against Section 953(b) is that it engenders overreach by the SEC, requiring it to meddle in issues of income inequality rather than stick to its intended job of protecting investors.

Here’s more from a press release about the new study:

Says Prof. Kelly: “Here were men and women with an average of six years’ work experience and a fair degree of sophistication about business and accounting, and clearly disclosure of a lopsided CEO-to-employee pay ratio turned out to be relevant to an investment decision. Actually it would be surprising if it didn’t. As a recent nationwide survey conducted by Stanford University suggests, the whole issue of CEO pay is in bad odor. Seventy-four percent of the respondents to that survey said CEOs were overpaid relative to the average worker; yet, ironically, when asked what they believed the pay of Fortune-500 CEOs to be, they vastly underestimated the amount. In this climate of opinion, how could perceiving the CEO-to-employee pay ratio as unfair not be relevant to investment decisions?”

The 75 participants in the experiment were asked to assume they worked in the investment department of a corporation and were assigned to assess the potential of a fictional firm in which their company was considering making a medium- to long-term investment. They were informed that the firm was in the semiconductor industry and was regarded a leader in market share and innovation. The subjects were provided with company financial data and information on CEO compensation, both of which were adapted from an actual NASDAQ-listed semiconductor firm.

One third of the subjects were informed that the CEO’s total compensation in the most recent year was about $4.3 million and that this amount was roughly the average for CEOs in the company’s industry.

A second group was informed that the CEO’s total compensation was about $7.4 million, and that this amount was higher than the pay of three fourths of the CEOs in the industry.

A third group was provided the same information as the second group plus the fact that the median pay for employees of the company (other than the CEO) was about $45,000 and, additionally, that this meant the CEO-to-employee pay ratio was about 162-1, well above the average industry ratio of about 96-1.

Asked their opinion of the CEO’s level of compensation, on a scale of -7 (very unfair) to +7 (very fair), the groups offered significantly different views, as follows:

– The first group produced an average positive fairness rating of +1.12.

– The second group, on average, bestowed a neutral fairness rating of +0.12.

– The third group rated fairness negatively at -1.32.

Statistical analysis indicated opinion of CEO pay fairness to be significantly related to assessment of the company’s investment worthiness. In other words, the less fair the chief executive’s compensation was perceived to be, the less potential the company was judged to have as an investment.

Why didn’t comparatively high CEO pay by itself push fairness ratings into negative territory? One important reason, the researchers found, was that participants viewed high compensation levels as beneficial in attracting executive talent. But this belief is evidently outweighed by the sense of unfairness created by the additional disclosure of a lopsided CEO-to-employee pay ratio.

Further research by Profs. Kelly and Seow has resulted in still another intriguing finding from a similar experiment, this one involving 100 MBA students who were asked to assess a hypothetical company in the restaurant industry. The experiment, reported in a working paper, tests not only the three conditions described in the JMAR study but a fourth condition in which both the CEO’s compensation ($4.3 million) and the CEO-to-employee pay ratio (96-1) are average for the industry. The professors find that the combination of the lower CEO compensation level and lower pay ratio evokes a fairness rating that is just as negative as the one produced by above-industry averages of $7.4 million and 162-1. In short, in the words of the study, “pay-ratio disclosures, even when they reveal less extreme CEO-to-employee pay multiples that are comparable to those in peer companies, can result in negative perceptions of CEO pay fairness and workplace climate that indirectly reduce perceived investment potential of companies.”

Prof. Kelly sums up: “High CEO-to-employee pay ratios, whether 100-1 or 200-1, clearly made a special impression on the participants in our experiments. It seems eminently plausible that high ratios will also impress actual investors, with concomitant effects on companies, when they stare out from proxy statements.”