Talking Points - Internal Pay Equity: Conducting a Historical Internal Equity Audit

Blair Jones is a Partner of Semler Brossy Consulting Group

• An internal pay equity audit can be a good complement to the analyses companies are conducting around tally sheets and the pay/performance relationship: the audit helps further increase transparency and perhaps, uncovers unintended consequences of historical executive compensation decisions.

• An internal pay equity audit evaluates the historical relationship between the CEO’s pay and that of other executive officers. The analysis should be conducted for the CEO relative to other key roles in the company – this may be the named executive officers or a more select group of key line officers. Companies 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.

• Companies will want to choose a relevant time period for the audit to cover. In some cases, companies may choose to go back 10 to 20 years (e.g., although this won’t be possible in all companies since some companies and many executive teams have not been around since the mid- 1980s; in addition, some companies’ business models have changed so dramatically that too far a look-back may not be relevant). The important point is to choose a time frame that will allow a good understanding of how the current pay program and pay for individual executive officers came to be, and the changes that have evolved over time. Some companies are already looking at multi-year tally sheets and can use this data in this analysis.

• Once a company has conducted an internal pay equity audit, management and the Compensation Committee need to determine whether they feel comfortable both with the internal pay equity relationships that exist today and the changes in that relationship that have taken place over time. Please note: the audit is intended to be an internal look, not something that is benchmarked across companies. In addition, it is a diagnostic, but because company situations are different, it should provoke conversation but is not prescriptive

• Questions to ask once the analysis has been completed:

 
• Has the ratio of CEO pay to pay for other executives remained stable over time?
• If not, at what points did the relationship between CEO pay and pay for other executives diverge?
• What were the primary contributors to the divergence?
• Which pay components, and why were they changed?
• Are the reasons for the change still valid today?
• Do the current ratios make sense given the company’s business characteristics, talent, and operating style?
• If not, what would the characteristics suggest are more ideal ratios, and what opportunities exist to readjust the ratios over time?
   
• Organization structure and culture will influence the appropriate internal pay equity ratio. For example:
   
  • Team-oriented  vs. hierarchical (team-oriented would have a tighter ratio)
  • High vs. low number of general managers (high number could lead to lower ratio)
  • Presence of a COO (if COO is absent, ratio of CEO to 2^nd highest paid may be higher)
  • Number of CEOs over time period (a higher number might lead to a higher ratio)
  • CEO hired from the outside, while rest of team is internal ( might lead to higher ratio)
     
• Examples of things to look for that may lead to unintended changes in the relationship

 
• Special annual bonus or equity grants made for one-time events that became built in
• Contract renewal grants
• Increases to long-term incentive grants put in place when retirement benefits were non-existent or below market, even though retirement benefits have since been increased
• Special insurance arrangements that were eliminated and bought out
• Changes in pay mix or composition following a transaction
   
• If management and the Compensation Committee feel the ratio is inappropriate for the business characteristics and organization culture, corrective actions may need to be taken, particularly if other issues have arisen through other analyses (e.g., tally sheets and pay/performance analyses). For example, plans may need to be redesigned or eliminated, or rollbacks may need to occur over time.

ACTION ITEMS

• Determine what analysis, if any, has been conducted by the company of internal pay equity over time and what conclusions have been reached
• Hypothesize how you would expect the ratios for your company to turn out based on organization structure, operating style, business situation and history. (Ultimately, these hypotheses could be evolved into philosophy statements)
• Test whether the actual ratios are consistent with these hypotheses. If they are not, examine what influences over time have prevented the outcomes you expected.