Chaya Cooperberg
This year’s annual report and proxy season in the U.S. brings new disclosure that is making for some interesting headlines. This is the first year of required pay ratio disclosure under the Dodd-Frank Act. The rule is designed to shine light on the dark shadow of income inequality between Wall Street’s top executives and their workers, the people who produce the goods and services generating returns. Although the pay ratio disclosure is not yet required under Canadian securities law, CEO compensation is a lightning rod for controversy in this country as well.
Over the past few years, both U.S. and Canadian public companies have adopted ‘say-on-pay’ advisory voting. Although non-binding, this voting mechanism provides shareholders with an outlet to voice concern over executive compensation. Boards and their compensation committees take these advisory votes under review and might succumb to the shareholder pressure to adjust compensation schemes in the future.
In one recent example, Ontario's Liberal government advised it would oppose Hydro One’s CEO compensation plan at the upcoming shareholder meeting. As a 49% shareholder in the utility, the government only needed to flex its governance muscle for the Hydro One Board to agree to review the CEO’s annual $6 million compensation package.
The pay ratio disclosure layers another dimension of scrutiny onto the existing say-on-pay regime.
Pay Ratio
The pay ratio formula compares the CEO’s annual total compensation to the median of the annual total compensation of all employees of a company. Some CEO pay packets are several hundred times larger than their median employee’s salary.
Tipping the scales at a pay ratio of 4,987 to one is new Mattel CEO Margo Georgiadis, with total compensation of $31.28 million in 2017, which included a salary of $1.34 million and stock and option awards totaling $28.05 million, versus median employee pay of $6,271. At the other end of the spectrum is CEO and co-founder of Alphabet Larry Page, with an annual salary of $1, which resulted in a pay ratio near zero. Alphabet said its median employee made $197,274 last year. In between Georgiadis and Page are many CEOs whose salaries seem out of touch with the working reality of their employees.
From a communications standpoint, this new disclosure can leave IROs scrambling to justify and defend their chief executive’s pay. It is important to fully explain the calculation methodology and rationale for the median wage clearly in the annual meeting material.
For one thing, the industry makes a difference. Companies with a large number of minimum wage or near minimum wage employees, such as large retailers with cashiers and shop floors, will have a greater disparity than companies in sectors that require more specialized and highly skilled labour. Location matters as well. Employees located in smaller metropolitan areas will, on average, garner lower wages than employees located in major cities, where costs of living are higher. In the case of Mattel, the low median employee pay reflected its use of temporary and seasonal workers. As a result of job function and location, there can be wide variability in compensation among employees and providing this context in the disclosure document will help deliver an effective shareholder communication.
Employees are also a critical stakeholder audience for this disclosure and companies must consider how the pay ratio gap will be regarded internally, particularly by those employees below the median salary. Here again, the more context in the disclosure the better the stage is set for this conversation.
Linking Pay to Performance
Shareholders will continue watching for outsize ratios relative to a company’s peer group, particularly when the compensation appears to be out of step with a company’s performance.
Investors want to see CEO compensation packages that are aligned with performance and, therefore, aligned with shareholder interests. But how should performance be measured, when shareholders assess value in many different ways, both quantitative and qualitative?
Recently, proxy advisor Institutional Shareholder Services (ISS) updated its approach to measuring performance, which drives its vote recommendations for say-on-pay. ISS used to define performance only as Total Shareholder Return, or TSR, but this metric is influenced by many external factors. For 2018, ISS is applying an additional financial screen, which compares CEO pay to the peer group and tracks against financial metrics such as return on invested capital (ROIC), return on assets (ROA), return on equity (ROE), earnings growth and cash flow growth.
From a qualitative standpoint, shareholders are increasingly considering environmental, social and governance factors in their investment decision-making. Some of the world’s largest institutional investors, such as BlackRock, believe a company’s approach to sustainability is a critical indicator of management effectiveness and ability to create long-term value. While few companies include sustainability metrics in their compensation formulas, they are certainly considering the impact of reputation risk on the company’s performance and, therefore, the CEO’s performance as well.
It is the obligation of the Board’s compensation committee to establish a CEO compensation package that incorporates short-term and long-term incentives tied to key metrics driven by strategy. For IROs, it is important to be prepared to explain CEO compensation and to engage with shareholders on this issue in the spotlight.
Chaya Cooperberg is Chief Communications Officer and Senior Vice President, Corporate Affairs, AmTrust Financial Services, Inc.