The US Securities and Exchange Commission announced this week that public companies will be required to disclose the ratio of their CEO’s annual total compensation paid to that of a median worker (e.g. 200 to one). One consultant estimated in a guest lecture for me that ratios could be as high as 1,000 to one. (Here is a list of eight companies apparently with this ratio.)
Other compensation consultants and lawyers have commented on the new CEO to median worker pay ratio. They warn about the “law of unintended consequences” in this ratio, and how societal wealth disparity should not be laid on the doorstep of companies.
But perhaps these advisors share part of the blame for creating these unintended consequences. “Peer groups” and “benchmarking” – which is how most public company CEOs are paid – are inventions of compensation consultants. So are stock options. These concepts did not exist prior to the U.S. Congress requiring greater pay disclosure.
“Peer groups” is a basket of similar or larger companies compared to one company, and “benchmarking” is a decision to pay a CEO at the 50th, 75th or 90th percentile of other CEOs. It is not in any executive’s interest to be paid compared to CEOs at smaller or less complex companies, nor to be paid as a “below average” CEO, even though by definition 50% of CEOs must be below average.
This one issue – benchmarking against peer groups – has been responsible for CEO pay increases more than any other. Other academics have found that using benchmarked peer data results in a 17% structural year-over-year increase in CEO pay, unrelated to his or her actual performance. This structural advantage, compounded annually, has caused the wealth disparity between CEOs and the average worker.
The pay consultants may be grinning behind closed doors because the above pay ratio will provide further built-in annuities for their firms beyond peer benchmarking and say on pay. What I predict is that compensation consultants and lawyers will do the following:
(i) Assist companies in determining and interpreting their ratio (revenue stream number one);
(ii) Sell the data back to companies to compare and explain ratios among their peers on an industry-by-industry basis, because average worker compensation for Bank of America will be different than that of Apple, for example (revenue stream number two); and
(iii) Sell the data to labor groups to assist them in collective bargaining (revenue stream number three).
What happens with disclosure and data sales back to the company is that people see what others are making and the competitive rivalry creates upwards pressure on all pay. The pay consultants’ business model is predicated on comparables and this exacerbates upwards pressure because data is now provided to justify approval by boards. Thus, the law of unintended consequences is perpetuated by the very people benefitting from it: executives and pay consultants.
Boards seem powerless because the entire industry is predicated on a flawed method of paying CEOs. Downward discretion is met by threats to leave, which is also a myth. Having independent compensation committee members and independent compensation consultants, which was also recently mandated, doesn’t change the way CEOs are actually paid.
Therefore, what should a compensation committee do to prepare for the onslaught of pay ratios to come? Three things.
First, don’t let the ratio, the CEO, or the workers drive pay in either direction. Focus on governance and the actual performance within the company. An anomalous ratio could indicate CEO entrenchment or lack of succession. It could also indicate worker retention, morale, or productivity issues.
Second, resist being overwhelmed by pay data and complexity. You are elected by shareholders to exercise your business judgment and discretion. I have interviewed numerous compensation committee members who are overwhelmed and intimidated by the glossy reports, the expertise of advisors, and the sheer complexity of how pay has morphed. Have a sense of self and the heft and confidence – and competence – to simplify, understand, and push back when you need to. You are driving the bus. Be fearless and do the right thing, as one director recently said.
Third, appreciate the vested interests of pay advisors. You are not obligated to have them. If you ask a barber if you need a haircut, you know what the answer will be. Consultants, when or if needed, work for you, the compensation committee––or at least they should.
Richard Leblanc is a governance lawyer, academic, speaker and independent advisor to leading Canadian and international boards of directors. He can be reached at firstname.lastname@example.org.