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Article | Executive Pay Memo North America

Reasons to consider expanded Year 2 CEO pay ratio disclosures

Executive Compensation

By Steve Seelig , Jamie Teo and Rich Luss | December 11, 2018

Companies preparing for Year 2 CEO pay ratio disclosures now have more questions to consider. Recently, Fortune 500 company compensation committees began receiving a letter from a group of 48 institutional investors requesting that they disclose more so that shareholders have additional information on workforce compensation practices. This is the first of two blog posts that consider how companies should respond.

The letter posits that since “disclosure of the median employee’s pay provides a reference point for understanding the company’s workforce,” companies should move “to help investors put this pay information into the context of your company’s overall approach to human capital management” with more expansive disclosure.

The timing of this letter coincides with companies’ efforts to answer questions about how their disclosure will change from that in Year 1 to satisfy embedded requirements in SEC guidance (see “Executive Compensation Bulletin: Year 2 CEO Pay Ratio decisions may be more complicated than first thought”, Executive Pay Matters, September 25, 2018). Companies now have two potential reasons to reconsider if their Year 2 disclosure remains consistent:

  • Do the SEC disclosure rules require them to provide more information on why their pay ratio changed or stayed the same?
  • Does the shareholder letter provide an opportunity to provide useful context to shareholders about workforce pay practices that can enhance a company’s communication efforts to shareholder, their employees and the media?

The answer may converge or diverge with other companies based on individual company circumstances. This is the first of 2 blog posts that will consider these issues. 

Year 2 disclosures and the SEC regulations

Conceptually, the initial question companies will need to resolve is whether they are required to use a new median employee in Year 2, or whether they can retain the Year 1 median employee, whose Summary Compensation Table pay will be recalculated for the Year 2 disclosure. Here is how we view the decision tree for Year 2:

Population changes that require a reexamination of pay demographics: As an initial matter, employee populations must be examined by comparing Year 1 and Year 2 head counts and demographics to determine the Year 2 approach. Regardless of whether a new median employee must be selected, companies must understand any changes that have taken place with some degree of assurance, and the corresponding impact on the median pay level.

  1. Population changes in the ordinary course of business: We believe a description of the static or fluid nature of the employee workforce composition is important to shareholders reviewing the pay ratio disclosure. A company in a steady state, where hiring and promotion patterns approximate attrition, would want to portray that as a reason the median worker remains the same in Year 2. Others that are staffing up or are amid layoffs should consider describing those impacts even if the median employee will be the same. 
  2. De minimis exemption (5% of non-U.S. population): Similar to Year 1, changes in the identity or head counts of countries excluded under the 5% allowance are required to be disclosed, with the jurisdiction excluded and with corresponding head counts. It is highly likely that companies that have excluded lower-wage countries under this rule in Year 1 will similarly substitute other low-wage countries in Year 2 so that the effect on where the median employee is found remains consistent. However, there may be circumstances where changes in pay demographics overall (e.g., offshoring of higher wage away from the U.S.) may influence this calculation, and may warrant discussion.
  3. Acquisitions and divestitures: Changes in global pay demographics can be influenced by the acquired or divested population, and may require companies to identify a new median employee in Year 2. Even if it does not, we believe companies should offer some description of how the transactions impacted their workforce and pay demographic to support their decision. Similar to Year 1, while divestitures must be reflected in the pay ratio calculation as of the determination date, acquisitions that occurred during the year can be exempted with the required disclosure of entities acquired and corresponding head counts.

Changes in pay programs:  This may take place in connection with, or separate from, a change in employee population, and have a large influence on the determination of the median employee. Where there have been no changes, companies will now need to consider the shareholder letter when deciding if they should take the opportunity to tell more of their pay story in Year 2. Let’s focus on the possible changes:

  1. Pay levels for employees at or near the median:  As a statistical matter, pay levels for employees at or near the median may have changed substantially enough to require the determination of a new median employee in Year 2. In this circumstance, a company would need to describe why a recalculation is needed. The more difficult issue is whether a company would feel compelled to offer details on why that is the case. For example, if the company raised pay by 10% for employees at or near the median, would it want to offer those details in the proxy? Or would a company that shifted a portion of its workforce overseas want to provide those details?
  2. Pay level changes for employees above the median:  Pay level increases for employees above the median will rarely influence the determination of the median employee as they will continue to be above the median. However, a company that lays off many of its middle managers may have enough churn to cause the median pay level to drop significantly, requiring a decision on how much detail of the cause for the recalculation should be disclosed.
  3. Pay level changes for employees below the median:  When a company increases its minimum wage or commits to hiring more full-time, rather than part-time workers, it may be disclosing this fact in other forums than the proxy. To the extent this change in employee mix raises median pay levels, you may determine that it should be included as part of the pay ratio disclosure.

However, if there is reason to believe that the pay ratio disclosure would not be significantly impacted by demographic or pay changes, the more vexing question becomes what additional information should be disclosed, if any.

Change in median employee’s circumstances/termination:  When the Year 1 median employee has not terminated, a company will need to consider why it reasonably believes a change in employee’s circumstances would not result in a significant change in its pay ratio disclosure. The SEC instructions don’t mandate that the company explain why it has a reasonable belief - only that one exists. 

If the Year 1 median employee’s pay does cause a significant change in the pay ratio disclosure, it appears that a further description of those circumstances is warranted.  That change may apply only to the median employee, or it also may impact other employees at or near the median. Our view is that, in either case, a company would include more detail of the reasons. For example, if a company gave an across-the-board 5% pay increase to full-time workers, of which the median employee is one, this would be an issue we’d presume a company would disclose, rather than simply stating that the median employee got a raise. 

If the median employee terminates so that an employee whose compensation is substantially similar is substituted using the same consistently applied compensation measure, the company must then describe briefly how this was done. As we noted in our September 25 blog post, this may be a circumstance where the company would use statistical sampling to demonstrate its claim that the Year 2 employee is substantially similar, or it may make the argument that it selected another employee in the same country as the Year 1 median employee for consistency purposes. In either case, the company would need to discuss why not selecting someone in a different country was their chosen approach, which raises collateral questions about how additions to SCT compensation might differ in different locations. 

We would argue that if statistical sampling was used, companies might simply state they selected the next person in line using that sampling approach, which might be a preferred disclosure. We discussed this approach in more detail in our September 25 blog post.

Inclusion of personal and nondiscriminatory benefits:  We believe companies can decide again in Year 2 whether or not to include the value of nondiscriminatory benefit plans. The institutional shareholder letter  suggests that investors would want companies to show the value of health care coverage in the median employee pay levels as a better indication of the employee value proposition, although data suggests that less than 15% of companies did so. 

If a company decides to include these values, we do not see the need for an expansive disclosure. Rather, it could be stated that the company determined that showing those values provides additional insights into the total pay and benefits received by the median employee.

Our next blog post will focus on how to respond to the above referenced institutional shareholder letter.

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