16 May 2019 by Stephen Ratcliffe, Sinead Kelly, Laura Bentham, Gemma Taylor
Both the US and the UK have experienced an increasing trend towards pay transparency, and with it a need to prepare for compliance with regulatory or shareholder demands and defense in the court of public opinion
Our experience of the first year of reporting under the UK gender pay and US CEO pay ratio regimes offers a number of (sometimes painful) lessons which may be of interest to any company preparing for future pay reporting on a voluntary or mandatory basis. In this article, we focus on the following four:
• Company ratios may not be rationally comparable; the media will compare them nonetheless
• Pay reporting will reveal workforce demographics, which may need to be explained and may become a political issue
• Shareholders and employees require immediate action on gender pay; CEO pay ratio issues may evolve over time
• Regulators may tie punitive sanctions to pay reporting regimes.
Pay Ratio. After years of anticipation and much speculation over the fate of the rule, in 2018 we have finally seen US listed companies’ first public disclosures of the ratio of their CEO’s annual total compensation to the median annual total compensation of all employees. The disclosures reflect compliance with Securities and Exchange Commission (SEC) rules adopted in 2015 to implement Section 953(b) of the Dodd Frank Act, enacted in 2010. The disclosures are typically the product of a major, months-long effort, which involved collecting and analyzing employee data and compensation information from multiple jurisdictions worldwide.
Gender Pay. Gender pay reporting in the US is on hold following the federal government’s suspension of an Obama-era rule, requiring private employers with more than 100 employees to report how much they pay employees by race, ethnicity and gender on their required annual EEO-1 reports. However, shareholder activism is increasingly important on the US gender pay front. Over the past two to three years, many US public companies have received shareholder proposals seeking reporting on their gender pay gap, and several well-known companies in both the IT and financial services sectors have committed to provide such disclosures (including six major US banks in 2018). In the Institutional Shareholder Services (ISS) 2017-2018 Global Policy Survey, 60% of investor respondents stated that companies should be disclosing gender pay gap information. If this trend continues, voluntary gender pay reporting may become market practice in the US, notwithstanding the lack of mandatory reporting requirements.
Pay Ratio. New regulations will require listed UK PLCs with more than 250 UK employees to report the ratio of their CEO’s total annual compensation to the median annual compensation of their UK employees, and to that of the UK employee at the 25th and 75th percentile. The first reports complying with the new legislation are due to be published from 1 January 2020, but certain listed UK PLCs have already included some disclosure on their CEO pay ratio in their 2017 annual reports and more may do so in their 2018 annual reports to test market reaction. Interestingly, the CEO pay ratio reporting regulations give companies the option of leveraging their gender pay gap data to calculate their CEO pay ratios.
Gender Pay. Gender pay gap reporting has been mandatory for employers with at least 250 employees in Great Britain since 2017. Gender pay gap reports for the first year of reporting were due by 4 April 2018 and covered businesses are now into the second year of reporting.
1. Company ratios may not be rationally comparable; the media will compare them nonetheless
In adopting the US CEO pay ratio rule, the SEC stated that the primary benefit of the disclosure is to provide shareholders with a company-specific metric that they can use to evaluate the CEO’s compensation within the context of their company, not to facilitate comparisons across companies. The design of the rule reflects this, as it does not mandate any particular methodology for identifying the median employee and permits companies to use reasonable estimates in doing so, and in calculating annual total compensation. The substantial flexibility in the rule has indeed contributed to disclosed ratios that are not readily comparable between companies, even for otherwise comparable companies within the same industry sector.
In the UK, it has also been difficult to draw rational comparisons between the gender pay gap reports published by employers within the same industry sector. However, this was not due to flexibility within the rules, or the underlying policy objective. The UK gender pay gap reporting regulations set out an inflexible methodology for calculating gender pay gaps and the UK government explicitly stated that it expected to see competition within sectors. However, differences in corporate structure, location of head office and outsourcing or offshoring of manufacturing or support services tends to drive differences in gender pay gaps even within the same industry sector. As a result, despite the lack of flexibility in the rules and the initial expectation of comparability, intra-sector comparisons are often a case of comparing apples and oranges.
However, the fact that pay reporting rules may not reveal rational norms or benchmarks has not stemmed the tide of media comparisons. For example, in the US, Bloomberg has launched an online tracker of CEO pay ratios, in which it keeps a log of the median average pay and the highest and the lowest CEO pay ratios. In the UK, in the first year of reporting, the media continually drew comparisons between the gender pay gaps reported by companies in the same industry and there was extensive (mostly negative) media coverage throughout that first year. A similar approach will likely be taken with the first UK CEO pay ratio reports. As a precursor, Manifest has already published a table setting out the CEO pay ratio of many listed UK PLCs, based on publicly available information on the mean average pay of each company’s employees.
Employers preparing for pay reporting requirements in other jurisdictions should be prepared for similarly extensive media coverage, which may not always be balanced or well-informed. A proactive media message is essential to avoid common misunderstandings as to
what can, and cannot, be discerned from the bare data.
2. Pay reporting will reveal workforce demographics, which may need to be explained (and may become a political issue)UK gender pay gap reporting revealed the widespread underrepresentation of women in senior and higher paid jobs. Media criticism was directed at employers for blaming demographics or accepting them as an adequate explanation of the gender pay gap with the result that, as the second year of UK reporting gets underway, companies are preparing to focus on the underlying female representation gap and on describing what they are doing to narrow it.
In contrast, most companies complying with the US CEO pay ratio rule in 2018 chose not to provide supplemental disclosure to rationalize their ratio, or explain the underlying workforce demographics. However, many companies provided context on the job title and location of the median employee, pointing out that the median employee was, for example, a part-time factory worker in a non-US jurisdiction. The income of an overseas workforce may be less of a political issue than that of the domestic workforce. It will be interesting to see how UK listed PLCs choose to contextualize their numbers with explanatory disclosure, since the UK requirements focus only on UK employees, and may therefore reveal more sensitive UK workforce demographics such as areas of low pay within the UK workforce.
3. Shareholders and employees require immediate action on gender pay; CEO pay ratio issues may evolve over time.
Shareholder activism on gender and diversity has already driven US companies to report on their gender pay gap despite the absence of governmental requirements. Similarly, the gender pay gap is emerging as an investor issue in the UK, where 79 major investors are backing the Workforce Disclosure Initiative, calling on UK FTSE 50 companies and 25 mega cap multinationals to address their gender pay gap. There was also a strong employee reaction to gender pay gap reporting in the UK, with statistical analysis becoming the watercooler conversation for what may be the very first time, and evidence that not addressing a gender pay gap could have a negative impact on attracting talent.
In contrast, in its first year, US CEO pay ratio disclosure has had a limited impact on shareholder ‘say on pay’ voting on executive officer compensation. Employee reaction to the CEO pay ratio disclosure was similarly anticlimactic. As the 2018 proxy season got underway, companies in the US increasingly stated that their main concern regarding the CEO pay ratio disclosure was a decrease in morale of the half of the workforce who discover they are paid less than the company’s median annual employee compensation (not the gap between CEO pay and worker pay). Many companies prepared employee FAQs and trained managers to answer questions on the pay ratio disclosure and median employee pay number. After reporting, companies generally tell us that they received few (if any) questions from employees about their ratio. This was true despite the regular presentation of pay ratio-related headlines in the media.
However, 63% of investor respondents to ISS’s 2017-2018 ISS Global Policy Survey stated that they plan to compare the ratios across companies/industry sectors and/or assess year-on-year changes in the ratio in individual companies. The ISS has stated that it will review how a company’s ratio changes from year to year. CEO pay ratio issues may therefore receive greater scrutiny from investors and institutional shareholders in future years. This, in turn, will drive more media coverage, potentially resulting in a heightened employee reaction in years to come.
This difference in reaction may reflect the profound difference between the two reporting regimes. While there is broad consensus that the long-term goal for companies is a gender-balanced workforce with a gender pay gap near to zero, it is less clear what a ‘good’ CEO pay ratio should look like. Although a large CEO pay ratio cannot be ignored over the long term, it is easier to explain and companies may be given more time to address problematic results.
4. Regulators may tie punitive sanctions to pay reporting regimes
Perhaps the most tangible practical impact of the US CEO pay ratio disclosure (so far) is that it has inspired a number of state and local governments to propose new taxes, generally if the ratio between CEO pay and median employee pay exceeds a certain amount.
At present, the only such proposal to take effect is in Portland, which applies a 10% surcharge on a company’s business license liability if its pay ratio exceeds 100:1 and a 25% surcharge if the ratio exceeds 250:1. It is not expected that the other proposals will pass (the California proposal is on its third iteration), so they are mostly symbolic. However, should the US introduce gender pay reporting, it is entirely predictable that similar taxes may be introduced based on the size of a company’s gender pay gap.
The UK government is currently relying on pressure from the public, media, employees, potential recruits and other stakeholders to drive employer efforts to narrow the gender pay gap, as well as applying direct pressure on some organisations.
However, the Scottish government has recently announced plans to make a company’s action on the gender pay gap a consideration when granting access to public sector contracts and grants, suggesting that access to public sector contracts could be denied to a company with an unjustified pay gap.
Outside of the US and UK, it is predictable that regulators may be even more inclined to tie punitive sanctions to undesirable pay gaps. What began as a set of transparency measures may, therefore, eventually lead to punitive sanctions.