Executive pay ratio reporting: Six issues for employers to consider now
On 1 January 2019, legislation comes into force requiring UK quoted companies with more than 250 employees to publish the pay ratio between their CEO and "average" employees. Jo Faragher investigates the issues related to mandatory executive pay ratio reports that employers should be thinking about now.
Executive pay ratio reporting: legislation and guidance
The new executive pay ratio reporting rules are part of a broader suite of corporate governance reforms that are being introduced amidst a number of high-profile scandals and a growing climate of investor pressure on companies to reward staff fairly.
These scandals include the collapse of BHS following mismanagement of the retailer's pension scheme and an investor revolt against a multi-million-pound payout for Royal Dutch Shell's CEO Ben van Beurden.
As well as their pay ratio, companies must publish supporting information, including the methodology they have used to calculate the ratio and the reasons for any changes year on year.
The Companies (Miscellaneous Reporting) Regulations 2018 (SI 2018/860) come into force on 1 January 2019. This means that we are likely to see large numbers of reports published in early 2020, when the companies covered by the legislation issue their 2019 annual reports.
1. How will the legislation work?
Executive pay ratio reporting will apply to companies with an average of more than 250 employees in the relevant financial year that are quoted on the London Stock Exchange, New York Stock Exchange, NASDAQ or a regulated stock exchange within the European Economic Area. The new rules will cover around 900 publicly listed companies, which will be required to report the ratio for their UK-based workforce.
Executive pay ratio reporting: three calculation options
Option A: The company calculates the pay and benefits of all its UK employees for the relevant financial year to identify those on the 25th, 50th and 75th percentiles, and then uses the pay data for those employees as the comparator with the CEO.
Option B: The company identifies those on the 25th, 50th and 75th percentiles using its most recent gender pay gap data, to come up with "best equivalents" for those percentiles. They must then "make any necessary adjustment to the pay and benefit figures to ensure that the best equivalents are reasonably representative for the relevant financial year".
Option C: The company uses data "other than, or in addition to", its gender pay gap information to identify the "best equivalents" of the three percentiles. If using gender pay gap data, it cannot use additional data that is older than this information, and must make any necessary adjustments to find the most reasonable figures.
Companies must identify employees on the 25th, 50th and 75th quartile of pay when comparing employees' pay to the CEO's pay. The CEO's figure must be the "single figure" total remuneration that these companies are already legally obliged to publish in their annual report. The employees' pay figure should include salary, taxable benefits, annual bonus, share-based remuneration and any other incentive or pension plans.
There are three potential calculation methodologies (A, B and C - see box on right), one of which involves taking the gender pay gap data already submitted and extrapolating a single figure relevant for that financial year for employees at each level.
When setting out their figures, companies must also state which option they have chosen. In their accompanying notes, they must provide an explanation of why they chose A, B or C as their preferred method for the relevant financial year.
However, there is still some work involved, according to Tom Gosling, leader of the UK's reward practice at PwC. "Once you've identified the employees at each percentile, you'll need to estimate their single figure of pay - but it's possible that bonus decisions might not have been signed off, or there may have been material changes to their pay since you submitted the gender pay data. Also, gender pay gap is calculated by legal entity and [executive pay ratio reporting] only applies to the UK workforce, so it's not as straightforward as it could be," he explains.
While companies will not be legally obliged to report until they publish their 2019 annual report, some will report early. Gosling says: "A lot of larger organisations will choose to disclose voluntarily for 2018. The advantage of this is that they can make comparisons in their narrative when the first 'official' ratio report comes around."
2. Who will crunch the numbers?
As executive pay ratio reporting falls under the Companies Act 2006, involvement in the calculation and preparation of the numbers is likely to extend beyond HR, and more so than was the case for gender pay gap reporting.
"HR and the reward function will be proactive in looking at this, but this will ultimately feed into the remuneration committee, as they'll be signing it off," says Dennis Patrickson, who is a director in the executive remuneration practice at Deloitte.
One of the first tasks will be to choose which of the three options for calculation to use, advises Yvonne Gallagher, a partner at law firm Harbottle & Lewis. "They'll need to work out which they're going to use and why. Companies can explain why they used a particular methodology in their notes."
Consistency will be important too - chopping and changing between methodologies across the years will not provide an accurate comparison and may lead to questions from investors and employees.
HR and payroll will feed in the UK employee figures for calculation, but there will also be work for:
- internal communications departments, to build a story around the published ratio, particularly if it is high and likely to elicit questions from employees; and
- PR and investor relations departments, to deal with scrutiny from the press and industry analysts.
The new laws will require the figures to be published in the company's directors' remuneration report, rather than on a government portal. But the figures are still likely to attract attention and lead to comparisons between employers.
Dennis Patrickson at Deloitte adds: "If CEOs can't answer questions on issues such as pay ratios, gender pay gap, and whether they pay the living wage, they might not be perceived as good corporate citizens. They'll be answerable to their wider stakeholders and the general public."
3. What problems might employers encounter?
On the surface, the calculation itself may appear uncomplicated - it is a case of showing the ratio between the CEO pay figure and "average" employees at different points on the pay scale. But one of the issues that employers may encounter is that the nature of CEO pay is very different from that of the average employees.
"At the top, pay structure is more complex and at the bottom, people's working patterns are much more varied," says Gallagher from Harbottle & Lewis. "As working arrangements become more complex and companies increasingly use freelancers and contractors, will this comparison still get to the point?"
An obligation to include bonus payments and share-based incentives could further complicate the calculation, particularly where share value has increased or a long-term incentive vests in a certain year, skewing the ratio.
Companies with complex pay structures should not underestimate how long it could take to gather and compute the data, argues Ruth Buchanan, an employment partner at Ashurst. "If you have a complex workforce, for example with lots of different pay scales, or where there's been a transfer of people, you need to build in enough time to do the calculation."
Companies are also required to report on full-time-equivalent (FTE) pay for their UK workforce, so those that outsource certain aspects of their business or use lots of self-employed individuals could end up with a ratio that is not necessarily a true comparison between the highest and lowest paid.
4. Could executive pay ratio reporting affect a company's reputation?
As with the gender pay gap, the obligation to publish executive pay ratios will inevitably lead to certain companies being perceived as "fairer" than others if their ratio is small and reduces over time.
Executive pay ratio reporting: timeline
- 12 June 2018 Draft Companies (Miscellaneous Reporting) Regulations 2018 published.
- 16 July 2018 Financial Reporting Council's updated UK Corporate Governance Code published.
- 19 July 2018 Final version of Companies (Miscellaneous Reporting) Regulations 2018 published, following parliamentary approval.
- 1 January 2019 Regulations come into force, with new requirements applying to company reporting on financial years starting on or after this date.
- Early 2020 First companies expected to publish mandatory executive pay ratio reports.
Bettina Bender, an employment lawyer at Winckworth Sherwood, explains: "The main issue for many companies will be publishing the pay ratio to staff and dealing with any PR consequences. There will be companies where the ratio looks good, for example in financial services where a lot of staff are well paid. But if you have a lot of staff on the minimum wage, for example in retail, your ratio will be greater, even though it's not necessarily saying anything about how well the CEO runs the company."
Bender adds: "Being able to show the ratio has improved will look good, or if you can say pay has gone up in line with performance. If you can show that pay has increased across the board - not just for the CEO - this is even more persuasive."
Tom Gosling at PwC agrees: "Employers in the same sector could be posting different ratios dependent on their structure - so you could have a hotel company that owns its hotels and employs all of its staff directly compared with a chain that runs as a franchise. Their respective ratio reports say nothing about their approach to pay fairness."
Charles Cotton, performance and reward specialist at the CIPD, says that this is where supporting comments will help set the raw numbers in context. "What we've learnt from gender pay gap reporting is the importance of the narrative - this is an opportunity to show people how success is recognised in your organisation. Is it focused on just one individual or are there more individuals involved in the success of your business? Employees want to know more about pay decisions and outcomes, and are suspicious that businesses that are less transparent may have something to hide."
5. What can companies do now?
The parameters for reporting are available in the final version of the legislation and the Government has published some answers to frequently asked questions on the new laws. It is also worth getting a grip on how the ratio will be perceived by employees and the wider public sooner rather than later.
As Bettina Bender of Winckworth Sherwood says: "It's good to get an idea now of what your ratio might be. Think about when your remuneration committee sits, as this will need to be a consideration when setting pay awards for coming years. Are there other ways to incentivise top executives that don't involve huge pay increases? We may see enthusiasm dampened for huge pay awards when committees imagine the potential headlines."
6. What impact will the new laws have in the future?
Currently the requirements only apply to listed companies with an average of more than 250 employees in the relevant financial year. However, with corporate fairness and transparency firmly on the Government's agenda, an extension of this requirement in the future should not be ruled out.
Mark Crail, content director for XpertHR, argues that executive pay ratio reporting should be brought more in line with gender pay gap reporting requirements, and applicable to more companies. He says: "Something that could be considered by the Government is a 'fairness at work' portal where all of this data could be published: gender pay gap, executive pay ratios, details of companies that don't comply with the national living wage, plus any future reporting requirements."
The aim is to build up a picture over time of executive pay and how it evolves in line with employees' salaries. As with gender pay gap reporting, the scrutiny the ratios are likely to attract will at the very least provoke debate.
Yvonne Gallagher at Harbottle & Lewis concludes: "Gender pay gap reporting focused the debate on pay inequality and in some cases led to action - look at the BBC. If a ratio doesn't look good, it's a positive thing to shine a light on it. These corporate governance Regulations are a start."