Internal Pay Equity: The Basic Benchmark

Excerpt from the September-October 2005 issue of The Corporate Counsel

Just as tally sheets are gaining hold as an essential tool (Tool #1) for compensation committees, we expect to see many more companies implement internal pay equity (Tool #2) policies and procedures. Internal pay equity is fundamental. As Fred Cook and other respected consultants have now advocated, compensation committees should now task their HR people to provide them with internal pay equity “audits.”

This should give many compensation committee members the ammunition they have been looking for to supplant external survey numbers with an essential internal benchmark. When compensation committee members have before them a chart that shows graphically how, over time, the CEO’s total compensation has gotten out of line within the company—with ever widening gaps between the CEO and other levels of executives within the company—it becomes clearer and easier for a board to say “we have reached a point where enough is enough, and instead of blindly chasing survey numbers, we must return to our own company’s values and roots.”

Companies like Dupont and Intel have been using an internal pay equity approach for years. At DuPont, the ratio between the CEO and the next highest executive stayed at 1.5x for years (since 1990, when former CEO Ed Woolard instituted the approach) and is now closer to 2x. We suspect that many companies, as they conduct their own internal pay equity audits going back several years, will find that they, too, were operating with similar ratios that have only gotten out of line over the last 10 years or so.

The internal pay equity audit can help a compensation committee see, for example, how it may have unwittingly added components of compensation to the mix without fully appreciating the need to reduce other components and without appreciating how large the total numbers (and the internal gaps) had become.

Implementing Internal Pay Equity—How To Do It

An internal pay equity audit is primarily an in-house project. The compensation committee tasks HR to provide a historical chart showing the compensation of the CEO and other levels of executives. The study at some companies may need to go back to the 1980s to see where the divergences within the company began; at other companies it may be over the last 10 or 15 years. Key to the study will be the need to include all the components (showing the impact of stock option and other equity grants and the addition of retirement and severance arrangements and perks, etc). Many companies will find that it is those components, particularly the stock option and restricted stock grants, that have widened the gaps even farther—especially from middle and lower level executives. (At DuPont, the size of the CEO’s option grants and other benefits has remained within the same ratio as the cash compensation, perhaps because grants and other benefits were based on multiples of the cash compensation.)

Two Cautions

No Place For Surveys Here. Beware that internal pay equity is an internal exercise and there is no reason to use external surveys or comparisons as part of the process. Each company will have its own unique circumstances and culture.

Surveys of others’ practices will both distort the true numbers and take the focus away from within the company. Indeed, if a survey were to be done today showing companies that now have huge gaps between their CEOs and other levels within their companies, this could be used to attempt to justify those inappropriate ratios. Instead, those very companies—after conducting their own historical internal pay equity audit going back several years within their own company—might conclude that their ratios need to be brought back in line within the company. [To keep the focus clear, we urge compensation committees to emphasize to whomever is preparing the internal pay equity chart that you do not want to see surveys or comparisons of other companies’ ratios—and to let consultants know that they may not use or share your company’s ratios, even on a no-name basis, with others.]

Don’t Game the Numbers. It has been pointed out to us that some companies could claim to have a 2x ratio between the CEO and the CFO simply by elevating the CFO’s total compensation. (That’s why it is essential to test the ratios against different levels of executives and employees down the line.) Also, cherry picking to leave out components (like the CEO’s perks and stealth components like above market interest on deferred compensation and SERPs and severance amounts—and leaving out dividends on restricted stock grants) can distort the CEO’s real total compensation, and hence the ratios.