Wait and see on pay ratios

RATIO OF MEDIAN SALARY WITHIN A COMPANY AND THAT OF THE CEO HAS JUST EXPLODED

Starting in 2018, the American Securities and Exchange Commission (SEC) is requiring companies to declare the ratio of CEO pay to median worker pay and the results are predictably eye popping. Given the high levels of inequality in SA, should we be doing the same?

The new rule was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was legislated after the financial crisis in 2009. The implementation has been repeatedly delayed following opposition from business groups. But it is now in force, and among the notable names that have reported on CEO pay in 2018 PepsiCo revealed a ratio of 650 to 1, Citigroup a ratio of 369 to 1 and Johnson & Johnson a ratio of 452 to 1.

Various surveys in SA appear to show even larger disparities. One survey on this basis suggests the average ratio in SA between median salaries of workers in locally listed companies and CEO pay is about 500 to 1. In SA, the JSE does not require the publication of an intracompany Gini coefficient of salaries. It does have detailed disclosure requirements for directors’ remuneration and this has been in place since the early 2000s.

Some international research on public attitudes to the idea of publishing median-to-CEO pay ratios suggests most people support the idea, which stands to reason. However, there are some strong arguments against the idea.

In theory, the publication of directors’ remuneration was supposed to achieve the same aim as the new measure: reduce the growing gap between those at the top of the organisation and those at the bottom. But the publication of directors’ remuneration arguably had one of the largest unintended consequences in all of corporate governance history: it increased directors’ salaries enormously. Quite why this happened is still a major debating point. To some extent, it could have been caused not so much by publication itself but by the simultaneous decision to link directors’ remuneration to share-price performance. The idea was to ensure directors had skin in the game and link more strongly the interests of shareholders and directors.

Since stock markets have generally risen strongly since the early 2000s, there may be a disjuncture between correlation and causation. Whatever the case, the ratio of median salary within a company and that of the CEO has just exploded globally from about 30 to 1 to about 300 to 1.

Another reason for CEO remuneration rising so fast was that publication gave recruitment companies a target at which to aim. CEOs would not want to be paid less then their rivals, and publication gave ammunition to salary-lagging CEOs to demand more. Iconic investor Warren Buffett memorably described the process as the “ever-accommodating firm of Ratchet, Ratchet and Bingo”.

After the financial crisis, attitudes to CEO salaries hardened and the result was this new requirement, which advocates hope will act as a brake on the rising levels of disparity. But will it?

The measure incorporates new possible unintended consequences. Clearly, if companies are judged negatively, as research suggests they might be if the ratio becomes very high, companies will have an incentive to outsource the lowest-paid jobs. That’s probably not what the drafters of the measure intend.

There are, of course, many other problems with calculating the number. In the US, it became clear the largest disparities are not where you might expect in merchant banks, which often have very high remuneration levels. They are most profound in the retail sector, where a higher proportion of employees are low paid and part time. It turns out comparing companies across sectors is a bit redundant, although comparing them within sectors, of course, remains interesting.

The argument in favour of requiring companies to publish effectively their internal Gini coefficient does have merit from a shareholder point of view. It seems reasonable to expect that customers would prefer buying products from a company perceived as fair to its employees and that employees will be more effective in this environment. In fact, in SA some companies have voluntarily calculated their internal Gini coefficients, partly to demonstrate how much better they are than that of the country as a whole, which is influenced by SA’s high unemployment levels.

It’s an interesting idea, but it might be worth holding off until the consequences of the US action are clear.