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Transparency - the way forward for reporting the CEO pay ratio

Peter Smith, Head of Executive Reward here at Mercer|Kepler hosted a recent breakfast discussing recent executive pay trends. The requirement to report the CEO pay ratio was an area of focus:

In the current commercial climate that places CEO pay in the spotlight, high profile scandals involving large organisations coupled with constant scrutiny coming from commentators ranging from the press to the Government, means that organisations in every sector are under more pressure than ever to get it right. With the Government’s recently announced CEO pay ratio disclosure requirement coming into force in 2019, the narrative adopted by companies when reporting CEO pay could have a profound effect on a company’s reputation. Irrespective of the figures themselves companies should adopt an attitude of transparency and openness when reporting executive pay. So, what does transparency mean in practical terms?

First, in their Director Remuneration Reports, companies must outline exactly what the CEO pay figure represents. The CEO pay ratio is not a definitive measure of the difference in an organisation’s pay – it is in many ways an imperfect system which ignores key variables such as organisation size and sector. Some sectors for instance will have more established bonus offerings than others and therefore higher CEO pay ratios. Performance based incentive plans are a clear example of a factor which can wildly affect CEO pay ratios. A CEO receiving higher remuneration as a result of better performance does not always reflect inequality within an organisation. In contrast, salary is a fixed cost and tends to reflect competence rather than the achievement of specific performance goals. This means that companies need to be cautious when deciding to increase CEO base pay, as an increased salary without sufficient explanation or justification could negatively impact a company’s reputation.

Secondly, if a company’s CEO pay ratio is disproportionately large compared to companies of a similar size or sector, the CEO pay report must acknowledge this fact. From this position of acceptance the company can then explain or justify the figures and, if necessary, communicate the actions which it plans to take in order to address any concerns. By addressing any issues related to CEO pay, companies will be able to limit any negative reaction to their CEO pay figures, which will be inevitable due to the press spotlight focused on CEO pay ratio disclosure. A good example of where a wide discrepancy between pay levels might be expected is in an industry that uses predominantly unskilled part-time or temporary staff – catering and hospitality businesses might be a good example. Perhaps one of the useful outcomes of the new pay ratio may come from monitoring the ratio from year to year to map changes in the differentials.

Shareholders may conclude that consistency or fluctuations purely linked to performance levels are a healthy indicator that a fair pay policy applies to all levels of employees. What would be unhelpful is if shareholders become prescriptive about the approach that companies should take in addressing any large pay gaps. Companies need to be flexible in their approach to designing senior executive pay packages. Taking a prescriptive approach formulated around standard pay principles may be simple to understand but it can make a company’s incentive plans less effective in stimulating strong performance.

To conclude, in adopting an open approach to CEO pay, much like the approach used when reporting the gender pay gap, companies will be able to limit any negative reaction to their figures. Some companies have elected to be early adopters of the new ratio in a bid to demonstrate their bona fides. A transparent narrative surrounding CEO pay ratios will be crucial in allowing companies to maintain a strong relationship between corporate governance, stakeholders and the public.

Omar Bhatti

This briefing is for general guidance and does not necessarily cover all areas of the topics included in this briefing. It is not designed to give legal or other professional advice.

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