• Pietro Marchesano

Executive pay: an expert’s insights

In a world of increasing inequalities, executive pay is one of the most topical issues in corporate governance.


Some say head-hunting follows market rules and companies need to bid high to attract top talents. Others argue a CEO-to-median-employee pay ratio over 200 times is not only morally inadmissible but also very much against the creation of long-term shareholders value.


The recent need for public emergency liquidity schemes to support firms in the midst of the coronavirus pandemic increased the scrutiny on the way companies spend money, further exacerbating the debate.


An expert’s insight is highly valuable to reconcile these opposing views. To navigate such tumultuous waters, I interviewed Johanna Schmidt, Corporate Governance Specialist at ISS ESG.



Johanna Schmidt, ISS ESG

1. Why is it important to monitor companies’ CEO pay ratio?


CEO pay ratio disclosure is important to increase accountability through transparency. When monitored and put into context, the ratio can give investors an indication as to whether a business strategy is aimed at increasing long-term performance based on the well-being and the engagement of all stakeholders of the company, or rather at short-term gains or even personal enrichment of the management.


A low pay ratio shows that the management is willing to invest in a highly skilled and motivated workforce making a long-term contribution to company success. Governments, as well as societies, also have an interest in knowing whether a management is sharing the benefits of a company’s success with its employees.


To put it simply: more money for the CEO means less money for the employees. Lower or less well-distributed wages lead to less money entering the economic cycle, potentially less taxes being paid and a higher vulnerability of the broader population to economic shocks. Admittedly, this effect strongly depends on the local tax and welfare system.


Last but not least, pay ratios are an indicator of fairness. A low pay ratio hints to a corporate culture that recognizes and values the average employees’ contribution to a company’s success. It is difficult to argue that any CEO deserves to earn an average employee’s annual income in just one or two days.


2. How has the ratio evolved through time in the ISS ESG universe? How does it vary across countries?


As still very few companies are publishing their pay ratios voluntarily, the pay ratio assessment in the ISS ESG Corporate Rating is focused on the quality of disclosure rather than the fairness or suitability of the pay ratios. In addition, the limited transparency makes it difficult to derive meaningful statements regarding the development of ratios over time.


There is, however, a notable regional variation in the size of pay ratios. In 2018, US companies in our ESG Corporate Rating Universe reported an average CEO pay ratio of about 210:1 and a median of 100:1. In the same year, European companies reported ratios of about 80:1 and 30:1, respectively (this only includes transparently reported ratios).

The size of pay ratios is influenced by factors such as Say-on-Pay rules in the respective jurisdiction (shareholders have the right to vote on executive compensation packages), company size (larger companies tend to have larger pay ratios), as well as corporate culture and general levels of equality within a society.


Source: CNN [1]

3. Does the level of transparency regarding the CEO pay ratio significantly differ across countries? If so, what determines such differences?


The level of transparency varies greatly across countries. Disclosure levels first and foremost depend on whether regulations are in place that mandate a disclosure. Since 2018, the U.S. Security and Exchange Commission requires public companies to compare the compensation of their CEOs to the median compensation of their other employees. This has led to a sharp increase of pay ratio disclosures in the United States.


For the 2020 reporting cycle, we expect a similar effect on companies incorporated in the UK. Starting with the accounting period 2019, UK companies with more than 250 employees are required to disclose data on the CEO to median employee compensation ratio. In reaction to the new regulation, disclosure rates already started to increase significantly in 2018.


Other countries with a relatively large share of companies reporting on the pay ratio include India, Sweden and the Netherlands. Here as well, legislation appears to be by far the most important factor impacting reporting on the pay ratio.


4. Why should companies disclose the CEO pay ratio?


So far, the main driver for increasing pay ratio disclosure has been regulation, very few companies are disclosing their ratio voluntarily. If a company has a low pay ratio, disclosing it could serve as a public statement on how the company defines its role in society and its corporate culture. If communicated well, it could positively influence public opinion, attract talent, and increase interest of investors.


In contrast, there probably is no benefit in disclosing an excessively large pay ratio. While potential candidates for the position of the CEO are attracted by large compensation packages, they will not base their search for job opportunities on disclosed pay ratios.


5. What elements shall be considered when judging the fairness of a CEO pay ratio?


Judging the fairness of a CEO pay ratio is complex and inherently subjective. It starts with the problem that there is no universal definition of fairness. Is it fair to pay the same wages to all employees who show the same effort? Or to all employees with the same actual performance? Or should wages rather be determined by an employee’s value for the company, which is also be driven by external factors, such as labor market competition?


Let’s assume efficiency, performance, responsibility and market value are important factors to determine how much an employee should earn. In order to test what a fair CEO pay ratio is, it is helpful to rephrase the question: what is the highest CEO pay ratio that can reasonably be justified using those factors?

Taking effectiveness and performance, there are clear limits to what is humanly possible. Can a CEO be 10 times as effective or 10 times as good in his or her job as the median employee? Surely not. Can he or she have 10 times more responsibility? Maybe, if responsibility is measured by how many people are affected by the extent to which the CEO is doing a good job. But can the CEO have 50 or 100 times more responsibility than the median employee? This also seems unlikely.


The destiny of a company is not solely dependent on the performance of its CEO. Numerous people on an executive level and below are involved in taking decision and implementing them. Remains the market value of a skilled CEO: labor market competition is the most common argument used to justify excessive CEO pay. Many companies are afraid that they will not be able to attract people qualified for the job if they pay less than their peers.


However, this argument shows that large pay ratios are often the result of a market system fostering unfair levels of CEO pay, rather than being based on what investors or the board of directors think to be appropriate. In addition, it suggests that increased transparency and regulation can help companies to adopt pay structures which are perceived as fair by investors, employees and the general public.


6. How often has criticism from the public opinion induced companies to revise an excessive CEO pay ratio?


It is difficult to attribute any such revisions of remuneration policies to public criticism. It is unlikely that a company would publicly state that it adjusted its CEO pay as a reaction to public pressure. However, in jurisdictions where shareholders have a Say-on-Pay and express disapproval of remuneration packages, companies regularly react by removing criticized pay practices, which leads to a better alignment of CEO pay with company performance.


Di Pietro Marchesano

Sources

[1] CNN, 2019. Why CEOs are paid so much? Jeanne Sehadi. 24.10.2019. Available here: https://dynaimage.cdn.cnn.com/cnn/c_fill,g_auto,w_1200,h_675,ar_16:9/https%3A%2F%2Fcdn.cnn.com%2Fcnnnext%2Fdam%2Fassets%2F191023181654-20191023-ceo-pay-gfx.jpg