This new detail may be the talk of shareholder season.
This year investors can add a new set of numbers to their repertoire of knowledge: the CEO pay ratio. The Securities and Exchange Commission now requires public companies in the U.S. to disclose in their filings the ratio of the CEO’s compensation to that of the median employee — the compensation level where half of the employees make more and half make less. As new earnings reports are rolling out and with them companies’ CEO pay ratios, you may wonder what to make of the numbers and if they even matter. Here are 13 things to know about the CEO pay ratio.
You may have to hunt for the information.
Ratios are disclosed in annual reports and proxy or information statements, found on the SEC’s website under the Filings tab, but the information can appear anywhere in these documents. The best way to find it may be to “open the document and hit command F” to bring up a search box, says Ethan Rouen, an assistant professor of business administration at Harvard Business School. Bloomberg is compiling ratios in a free online tracker where investors can search for companies by name. But you may not want to miss seeing the ratio disclosed on the company’s documents. “How companies present it will be a signal of how they think about it,” Rouen says.
Companies can crunch the numbers how they want.
The SEC has also given companies discretion over how they determine the median employee and calculate the compensations used in the ratio. What’s more, companies don’t need to disclose the method they use. The SEC says it “expressly sought to provide flexibility to registrants” so that the company can “determine the method that best suits its own facts and circumstances.” For instance, how part-time or temporary workers are factored in can drastically lower the median pay, as ManpowerGroup (ticker: MAN) shows with its whopping 2,483-to-1 ratio based on its largely temporary staff. Excluding temporary employees, the ratio drops to 276-to-1.
Comparisons to other companies are misleading.
“Pay ratios give the impression of being comparable across companies when they’re not,” says Florian Ederer, assistant professor of economics at the Yale School of Management. They vary by industry and even among companies in the same industry based on how they structure their workforce. “For example, it’s lower in investment banks than supermarkets, but [that’s] because mid-level bankers are well-paid, rather than because executives are not,” he says. Similarly, a median salary in the Midwest is less than in San Francisco. Since contract and outsourced workers aren’t included in the ratio, a firm that outsources “operations or moves them overseas will have a lower ratio than one with a strong U.S. workforce,” he says.
Excessive may be impossible to define.
Given the disparities across companies and industries, an excessive ratio is hard to define. According to Bloomberg’s ratio tracker, the median ratio of all companies with published ratios so far is 130-to-1. But with extremes such as ManpowerGroup (2,483-to-1) and Berkshire Hathaway (BRK.A, BRK.B; 1.87-to-1), the lowest ratio yet thanks to Warren Buffett‘s $100,000 salary and zero bonuses, what yardstick should investors use? A 2016 study by the AFL-CIO estimates the average pay ratio of S&P 500 companies is 347-to-1. Meanwhile, a 2014 study by the Association for Psychological Science calculated the ideal ratio as 7-to-1 based on what 55,000 respondents from 40 countries said a CEO should earn.
How companies explain the ratios is revealing.
The explanations companies provide for their ratios — or lack thereof — could be more meaningful to investors than the ratios themselves. Companies that are confident about how they treat their employees should share this information by saying, “Our ratio is 300-to-1 and this is why,” Rouen says. Socially responsible investors may want to target companies that put time and thought into explaining their ratio. “If they just publish a number and say nothing else about it, I’d be hesitant to invest in it” as a socially responsible investor, he says.
Higher ratios are associated with higher returns.
Investors who want better returns may want to target high-ratio firms, research suggests. High pay ratios are associated with higher long-term profitability, firm value and stock returns, according to research published in the Review of Financial Studies, which found that a portfolio of high-ratio firms outperformed one of low-ratio firms, and a hedge portfolio long on high-ratio firms and short on low-ratio firms significantly outperformed both. So if increasing investment returns is your sole objective, look for firms with high CEO pay ratios.
The media will have a field day.
The ratio “lends itself very well to the media,” says Brian Tayan, a researcher at the Stanford Graduate School of Business. Naturally, companies with high ratios will attract negative scrutiny, and there will be a subset of vocal shareholders who object to these large ratios, he says. But whether this creates share price backlash and hurts investor returns remains to be seen. The CEO pay ratio is “a political disclosure more than anything,” he says.
CEO compensation is more critical.
To avoid getting swept up in the hype, Steven Kaplan, a finance professor at the University of Chicago Booth School of Business, tells investors to review the CEO’s pay instead. He says to look for three things: First, is the CEO paid for performance? You want a CEO whose compensation is linked to company performance. That way, executive incentives match shareholder interests. Second, is the CEO’s compensation reasonable? This is much harder to determine and can be a function of the third item: Is the CEO delivering? In other words, has the CEO increased company value and shareholder return enough to justify the salary?
The ratios are no help with say-on-pay.
Public companies are required to receive shareholder approval of executive compensation at least once every three years through the say-on-pay vote. Proponents of the pay ratio disclosure say it helps investors make their say-on-pay determination. But opponents say the ratios are so unclear as to be meaningless. “What does [a ratio of 220] really mean from an economic standpoint?” Tayan asks. Is it that the CEO is worth 220 times more than the median employee? Or that the CEO adds 220 times more value than the median worker? “It’s not really information you can draw an economic conclusion from,” he says.
Employees aren’t likely to care.
We aren’t likely to see a big reaction to the pay ratio from employees, experts say. “If you’re an employee, you know what you make, and if you read the proxy materials [where CEO pay has been disclosed since 1938], you know what the CEO makes,” so the ratio shouldn’t be a big surprise, Kaplan says. The only new information is what the median employee makes. Depending on where an employee falls in relation to that could ruffle someone’s feathers, but “worker compensation is set through very efficient markets,” Tayan says. If employees can go to a comparable firm and earn more, they’ll do it, so companies keep compensation competitive.
Low ratios don’t equate to pay fairness.
“Research demonstrates substantial benefits to firms treating their workers fairly,” Ederer says. “Firms with high employee satisfaction outperform their peers by 2.3 percent to 3.8 percent per year in long-run stock returns, even after controlling for other factors that drive returns.” That said, the CEO pay ratio doesn’t measure pay fairness. The fact that the CEO earns 300 times more than the median worker doesn’t mean the median worker is underpaid. Similarly, U.S. researchers have found that “employees don’t perceive higher pay ratios as an inequality outcome,” Ederer says.
It misses the real issue.
Pay fairness is the real issue here. “We’re disclosing something that’s not that helpful when we could have disclosed information about the pay biases inherently embedded in race and gender,” Rouen says. The ratio doesn’t tell you if a company pays men more than women or certain races more than others. When there are these observable fairness issues, we’re more likely to see performance suffer, he says. “Let’s hope that’s next on Congress’ to-do list,” he says.
Next year will be the real test.
More interesting than this year’s disclosures will be seeing how the ratios might change. “Companies will likely take action,” Rouen says. But Tayan warns these actions may backfire. He and his co-author, David F. Larcker, note in their paper “Seven Myths of Executive Compensation,” published in the Stanford Closer Look Series, that eliminating appropriate pay incentives, such as stock options, or capping executive bonuses could result in “less innovation and lower investment returns.” A good CEO is hard to come by, as Ben & Jerry’s realized when it had to relinquish its 5-to-1 ratio after failing to find an executive willing to accept its cap. The challenge is finding the right balance between equal pay and company performance.
More from U.S. News
8 ETFs for Investors Who Love Value
7 ETFs That Let You Invest With the ‘Smart Money’
10 Skills the Best Investors Have
13 Things to Know About CEO Pay Ratios originally appeared on usnews.com
