Pay Ratios and Ratcheting

Daniel F. Pedrotty, AFL-CIO, posted Why CEO-to-Worker Pay Ratios Matter to Investors to the Harvard Law School Forum on Corporate Governance and Financial Regulations on Thursday August 11. I’ve been meaning to mention it since then, mostly so that I have it file on my blog for future reference. I’ve got almost 16 years of corporate governance history on my blog (and more from my old site on my laptop, still waiting to migrate). This is one document I think people will be coming back to in the future.

Pedrotty’s post references Section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires public companies to disclose the ratio of compensation between their CEO and their median employee. He says the SEC will propose regulations to implement this requirement later this year. Of course, many in Congress are trying to kill the provision, but let’s hope they are unsuccessful. See Oct. 3 progress report from the law firm of Davis Polk & Wardwell.

Pedrotty goes on to list a few reasons why the provision is useful:

  1. Changes in CEO-to-worker pay ratios are a useful measure of growing CEO pay levels, having gone from 42 in 1980 to 343 times in 2010.
  2. Disclosure will help reduce CEO pay levels. Existing disclosure rules encourage setting CEO pay levels based on “peer group analysis” that has contributed to CEO pay inflation. Pay ratio disclosure will encourage Boards to also consider the relationship of CEO pay to other company employees.
  3. High CEO-to-worker pay ratios can hurt employee morale and productivity.

There is no one-size-fits-all answer for the ideal ratio of CEO-to-worker compensation. Rather, disclosure of CEO-to-worker pay ratios will permit investors to compare the employee compensation structures of companies over time and to their competitors. Such disclosure will provide valuable information about which companies are investing in their human capital, an increasingly important contributor to shareholder value.

The brief post was based on a much more extensive and well researched paper Why CEO-to-Worker Pay Ratios Matter For Investors. Because people may want to find the paper sometime in the future and because such addresses tend to shift on the Internet, I’ve also uploaded to my site here: Why-CEO-to-Worker-Pay-Ratios-Matter-For-Investors.

We tried to cover some of the same ground our work with the US Proxy Exchange as we wrote a simple set of guidelines, mostly aimed at retail shareowners and institutional investors with limited resources, to determine how to vote say on pay proposals. (see Shareowner Guidelines for Say-on-Pay Voting) One of our main concerns was and remains that few investors or advisors are attempting to address the continuous ratcheting up of CEO pay. We covered this Lake Woebegone Effect but I’m glad to see the AFL-CIO paper also addressing this concern. Here’s an excerpt from the AFL-CIO paper. (I’ve substituted embedded links, rather displaying URLs in footnotes.)

Peer group benchmarking has contributed substantially to CEO pay inflation. Not every CEO can be paid above average, yet no CEO wants to be in the “below average” category. Boards and compensation committees likewise often want to avoid being seen as “below average,” whether out of concern for company prestige or fear that the CEO will leave. Thus, as each member of a peer group of companies seeks to raise its CEO compensation above the average, the net effect is a ratcheting up of executive compensation for the entire group. (Thomas A. DiPrete, Greg Eirich, and Matthew Pittinsky, Compensation Benchmarking, Leapfrogs, and The Surge in Executive Pay, November 23, 2009) This spiraling effect is further exacerbated because some companies aim their compensation target at the 75th percentile, (Abercrombie and Fitch, 2010 Proxy Statement, page 39) while other companies choose as their peer group companies that are larger than them and have higher CEO pay to start with. (Cari Tuna, Picking Big ‘Peers’ to Set Pay, Executive Compensation Is Often Skewed by Comparisons, The Wall Street Journal, August 17, 2009)

Much more good information in the AFL-CIO study. If I ever get to revising the voting advice paper with members of the USPX, I will draw from their excellent work.

, , , , ,

One Response to Pay Ratios and Ratcheting

  1. Glyn A. Holton 10/18/2011 at 1:09 am #

    The AFL-CIO does a lot of good work, and this paper is an example. We definitely need to keep working on our say-on-pay guidelines, which are somewhat in a prototype stage at this point. Although they are simple but meaningful, they are still too cumbersome for average individual investors. And we need to add some adjustment for company size (we discussed some options back in the spring, but made no decisions). When we have guidelines ready for prime time, we should see about partnering with the AFL-CIO to promote them to individual investors.

Powered by WordPress. Designed by WooThemes