CEO Pay Ratio Year 2: Retain or Revisit the Median Employee?

The dust has settled. Nearly every company has filed its first pay ratio disclosure. Companies have learned much in the process—not just what they pay their median employee and peers, but also where their global pay data sits, who in the organization has access, and where they can improve data quality or accessibility. In addition, companies have made their decisions on factors like the consistently applied compensation measure (or “CACM”), de minimis exemptions (used frequently), and cost of living adjustments (used very infrequently).

Although pay ratio disclosures received less press coverage than many had feared, three lessons remain for companies to take into the second year of disclosures:

• The rule is still here. Pay ratio disclosures are again required for proxies being filed in 2019.
• Care is still necessary. Some companies did get bad press and/or internal strife among employees as a result of their disclosures.
• Stability is key. Stakeholders can now compare changes in a company’s ratio over time as another data point in considering a company’s compensation strategy.

With that in mind, here are the most material methodology decisions most companies will face in their second disclosure.

The Biggest Year 2 Decision

For year 2, most companies we’ve talked to plan to keep their methodology and significant assumptions—such as determination date, CACM, and the use of exemptions and adjustments—consistent with year 1. However, one new decision has entered into everyone’s second pay ratio calculation: Do I select a new median or keep last year’s?

That’s not an easy question to answer, so let’s break it down. Here are the relevant parts from the final pay ratio rule [Instruction 2 to Item 402(u) of Regulation S-K § 229.402(u)]:

The company is allowed to retain the median if they reasonably believe that individual would still be applicable.

A registrant is required to identify its median employee only once every three years and calculate total compensation for that employee each year; provided that, during a registrant’s last completed fiscal year there has been no change in its employee population or employee compensation arrangements that it reasonably believes would result in a significant change to its pay ratio disclosure. If there have been no changes that the registrant reasonably believes would significantly affect its pay ratio disclosure, the registrant shall disclose that it is using the same median employee in its pay ratio calculation and describe briefly the basis for its reasonable belief. [emphasis in original]

If there has been a change in the population which would likely result in a change in the ratio, the company must reperform the median identification analysis.

If there has been a change in the registrant’s employee population or employee compensation arrangements that the registrant reasonably believes would result in a significant change in its pay ratio disclosure, the registrant shall re-identify the median employee for that fiscal year.

The company may substitute another employee in cases where the original median no longer applies (e.g., promoted, changed roles, separated from the company, etc.).

If it is no longer appropriate for the registrant to use the median employee identified in year one as the median employee in years two or three because of a change in the original median employee’s circumstances that the registrant reasonably believes would result in a significant change in its pay ratio disclosure, the registrant may use another employee whose compensation is substantially similar to the original median employee based on the compensation measure used to select the original median employee.

For companies with significant changes—such as mergers, spinoffs, layoffs, hiring growth, or reorganizations—the answer is obvious. The analysis must almost certainly be reperformed.

On the other hand, imagine a hypothetical company, StableCorp. At Stablecorp, no employees came or left during the year, and everyone got a 3% raise on January 1, 2018.[1] For them, it’s readily apparent that Jim, their year 1 median, would still hold that position in year 2.

Companies with similarly minor workforce changes might find little need to determine a new median. Most companies aren’t StableCorp, however. They find themselves with a decision to make.

Reasons for an Annual Pay Ratio Analysis

Even companies who can elect to retain their median have good reasons to reperform the pay ratio analysis every year. First, consider the benefits of having new data and calculations:

• Avoid uncertainty. The pay ratio rule doesn’t explicitly define “reasonable belief,” and many companies effectively perform the full analysis anyway in order to gain comfort. Rerunning the calculation alleviates any concerns with consistency.

• Prevent concerns about changes affecting the median individual. Remember, the median is one person…and for one person, anything could happen. This creates potential tracking issues over time. While employees who get a promotion or leave the firm raise obvious red flags, even an employee who stops participating in the ESPP—or stops contributing to their 401(k) and forgoes the match—can materially change the ratio.

• Head off wage drift issues. If the median employee receives even modest raises, this can cause a material overall drift over time. After three years, selecting a new median can create a seemingly dramatic shift, as your old median may have traveled up in the pay distribution.

• Monitor the population and statistics. Some companies have identified compensation anomalies or equity issues via work related to the pay ratio analysis. Followup analyses help to track and manage these issues.

Next, think about the process issues, any of which could prompt even StableCorp to reperform their analysis:

• Maintain momentum and eliminate future startup costs. Global companies may have identified payroll contacts across the world for the previous year’s exercise. By 2021, though, these contacts—or even the headquarters staff who owns the analysis and disclosure—may be completely different. This would mean a company has to start from scratch, potentially reencountering all of the first year’s challenges and being less likely to do things consistently. Maintaining the procedures from year to year will make this part of an annual process, cultivating an institutional memory among teams.

• Leverage your experience for an easier calculation. Much of the difficulty of the first analysis and disclosure stemmed from uncertainty and methodology testing and selection. In year 2, the recalculation is a relatively straightforward analysis based on gathering updated data.

• Simplify the calculation. Some companies may be able to streamline their methodology with assumptions based on the prior year’s data. For example, if they’re now sure that the maximum wage for employees in a certain country was $15,000 below the global median in 2017, they may be able to assume that all employees in that country are still below the median. This would allow them to avoid gathering data from that country again (which may have been difficult). Instead they can to use placeholder data to streamline the calculations.

In short, we believe the overall benefits of a comprehensive analysis outweigh the costs for most companies. Further, we’ve already seen a lot of companies collecting data for this year’s analysis, so companies who reidentify the median won’t be alone.

If you have any questions or concerns about updating your CEO pay ratio calculation, please feel free to reach out.

[1] StableCorp is headquartered in Lake Wobegon, and all of their employees have always rated above average.