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CEO Pay Ratio: Will Year 2 Be More Complex?

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October 11, 2018 | Jennifer Namazi

CEO Pay Ratio: Will Year 2 Be More Complex?

With much buildup to the first year of disclosing in the company's proxy statement the CEO's ratio of pay (to that of the company's median employee), the wrangling over how to determine the median employee and navigating the optics of the disclosure are finally over. Since reporting companies have already settled on a methodology to identify their median employee, this means that next year's pay ratio disclosure should be MUCH easier, right? Or does it? A new set of challenges is surfacing for year 2. 

The core question in the second year of determining the CEO pay ratio is whether or not the company can (or should) use the same median employee that was used in year 1. On a surface basis, this seems like a simple question. Dig a little deeper and the complexities begin to emerge. 

"Whoa," you say. Aren't companies required to revisit the median employee determination only once every three years? The general answer is yes (per Instruction 2 to Item 402(u) which says that companies are required to identify the median employee only once every three years and calculate the total compensation for that employee each year). However, there are circumstances that would trigger re-evaluation and/or additional explanation in the proxy disclosure earlier than the three year mark. Some of those scenarios include:
  • Employee population changes (could trigger new median employee determination)
  • Employee compensation arrangements (could trigger new median employee determination)
  • Changes in the median employee's circumstances/pay/employment status (a substitution of another similar employee may be needed, using the same compensation factors used to decide the original median employee, with disclosure of such substitution in the proxy statement.)
Not all employee population, status, and compensation changes automatically result in the need to change the median employee. However, the company must evaluate these variables and determine whether there is a significant impact to their pay ratio disclosure. If there is such impact, then a new determination (or substitution) may be needed.

Evaluate Employee Population Changes

According to Steve Seelig, Jamie Teo and Rich Luss (Willis Towers Watson) in a recent blog "Year 2 CEO Pay Ratio decisions may be more complicated than first thought" (September 25, 2018), "As a first step, companies will need to review how extensively their populations have changed from Year 1." This includes changes that occur as a result of the ordinary course of business as well as divestitures and acquisitions. Note that those activities don't necessarily mean a company will have to change the median employee - but the devil is in the details here and an analysis should be done to see if the changes impact the type of employee who would be selected as a median employee.  A recent blog by Kevin Wells and Laura Wanless of Aon ("What to Consider When Calculating Your CEO Pay Ratio in Year 2" September, 2018) suggests some questions to ask in evaluating employee population changes:
  • Has there been a significant acquisition or divestiture that impacted the employee population?
  • Has there been a reduction in force or notable employee turnover during the past year
Wells and Wanlass note that "these questions are not as simple as they may sound, as not all acquisitions or reductions have the same impact."

Pay Program Changes

Sometimes, the employee population of a company will remain largely the same, but pay practices or structure have changed. According to Seelig et al (Willis Towers Watson), "Organizations that made changes to pay programs for individuals at or near the median pay that is likely to cause employees paid below the median to now be paid above the median, and vice versa, will need to do more work to determine if these changes make it appropriate to continue using the Year 1 median employee."

Wells and Wanless suggest that "changes to compensation arrangements that would alter relevancy of the median employee are less likely. Still, they should be considered. The most likely scenario would be if a company either eliminated or introduced a broad-based equity program. Another possible scenario would be a wholesale change from a bonus program based on company performance to one based on individual performance. Ultimately, the question remains: Does the change impact your median employee?"

But wait...we had no population or compensation changes, so we're off the hook, right?

Even if a registrant decides to use the same median employee in year 2, the company will still need to address that decision in their proxy statement. While the related explanation that ends up in the proxy may be brief, the road to get to that explanation may be (and likely should be) more involved. According to a number of compensation resources, it's probably not enough to just outright assume that the median employee decision you made in year 1 will stand with no further evaluation for three years. Companies should still do the legwork to evaluate the factors mentioned above and make a proactive determination that no change is needed. 

What seems certain at this point is that year 2 of the pay ratio disclosure contains new layers of complexity that will require effort, evaluation and analysis on the part of reporting companies.


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