The Advisors' Blog

– Broc Romanek

Here’s a recent “Heard On The Street” column by the WSJ’s Stephen Wilmot:

A controversial new metric on executive pay is on Congress’s chopping block. Shareholders should want it to survive, even if it only provides a sliver of insight into the companies they own. Beginning next spring, possible repeal notwithstanding, companies will be required to publish a Bigwig vs. Regular Joe pay ratio, or the total earnings of the chief executive compared with those of the median employee.

Supporters of the rule, part of the post-financial crisis Dodd-Frank Act, hope disclosure at an individual-company level might focus more attention on inequality and sky-high CEO pay. The ratio has ballooned since the 1970s: The bosses of America’s 350 largest companies made on average 276 times the money of their rank-and-file subordinates in 2015, up from 30 times in 1978, according to the left-leaning Economic Policy Institute. Republicans want to repeal the requirement, along with other controversial bits of Dodd-Frank, as a way to trim compliance costs for companies. Some also argue the ratio isn’t instructive: Wal-Mart will have a higher one than Goldman Sachs , but that only indicates that Wal-Mart employs more unskilled workers than Goldman Sachs. Comparisons within the same sector are likely to get bogged down in discussions of how one company’s business model or geographic scope is different from another’s. The rollback made it through a House of Representatives bill in June. Whether it can clear the Senate in time for next spring’s proxy-statement season is anyone’s guess.

If the ratio survives, however, shareholders might find it a modestly useful addition to their analytical toolbox. The key insights will come from seeing how it evolves for a specific company over time. A widening ratio could be a warning flag that a management team is getting greedy. Executive pay ballooned in the financial sector before the 2008 banking crisis. Those companies that went bankrupt were particularly guilty of deteriorating pay practices, according to an analysis of governance ratings by analysts at Bank of America Merrill Lynch. Pay ratios could have made this more obvious at the time—and may help bring subsequent lapses to wider attention.

Knowing what the median employee at a company makes would also fill gaps in investors’ understanding, such as how the wage bill compares with other costs. Admittedly, the SEC only requires companies to update the calculation once every three years, so useful insights into how the median wage changes relative to profit, say, would take years to emerge.

That said, investors shouldn’t assume more thriftily paid bosses offer value for money. Simplistic studies can show an association between lower pay and higher returns, but this is partly because larger companies pay better while small-caps usually outperform large-caps. Adjusting for size, using actual realized rather than the estimated target pay disclosed in proxy filings, and factoring in the performance of previously awarded shares, PricewaterhouseCoopers found a strongly positive correlation between executive pay and three-year total returns for big U.K. companies. This is logical, given how much executive pay is triggered by return thresholds these days.

Investors should welcome any move toward greater transparency, but wield their new analytical tool with caution.

Coming Next Week! “Annotated Model Pay Ratio Disclosures”: For those registered for the upcoming “Pay Ratio & Proxy Disclosure Conference,” tune in on July 20th – next Thursday! – for the first in a series of three monthly webcasts that serve as a pre-conference: “Pay Ratio Workshop: What You Need to Do Now.”

When you go to the webcast page on July 20th, you will be able to download a set of “Annotated Model Pay Ratio Disclosures“ in both PDF & Word format. The second webcast is on August 15th; the third webcast is September 27th. Register for the “Pay Ratio & Proxy Disclosure Conference” to be able to access these webcasts.