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Executive pay ratio reporting – sound familiar?

04 September 2017

The Government has recently announced it will take forward a number of proposals for corporate governance reform relating to employment. Media reports have focused on the watering down of earlier plans for worker representation on boards, which has predictably been attacked by unions.

Suggestions such as setting a maximum executive pay threshold and having a binding shareholder vote on pay were also ruled out.  Proposals on executive pay ratio reporting remain eye catching, however – particularly for anyone who has spent much of 2017 dealing with the new gender pay gap reporting requirements, with which there are a number of echoes.

The Government says it will introduce new legislation to require quoted companies to produce an annual report on the ratio of “CEO pay” to the “average pay” of the UK workforce, along with a narrative explaining the changes to the ratio from year to year.  The backdrop is public discontent about widening gaps – the Government notes that “FTSE100 CEO total pay has increased from an average of around £1m in 1998 to over £4m today, fuelling a widespread perception that boardroom remuneration is increasingly disconnected from the pay of ordinary working people”.  It can be assumed that, as with gender pay reporting, the intention is to prompt companies to take action to ensure that gaps narrow from one year to the next, rather than widening.

The Government’s response to its consultation summarises concerns raised by respondents which have a familiar ring to them.  For example, it states “those opposed to pay ratios expressed concern that they would add little value and lead to misleading comparisons between companies in different sectors and with different skill and wage profiles. A supermarket group, for example, would have a significantly wider pay ratio than an investment bank, because of a prevalence of low paid workers in the former, yet the CEO roles might be equally demanding. Opponents also suggested it could provide an incentive to companies to off-shore or out-source employment in order to achieve a better balanced pay ratio.” 

Much the same has been said, and continues to be said, about gender pay gap reporting.  In industries where particular high paid employee groups are overwhelmingly male – traders in financial services, software developers and construction engineers are all good examples – and other lower paid groups predominantly female (PAs and administrative staff, for example), companies face the frustration of having to report significant “headline” pay gaps even where an analysis of employees doing comparable roles suggests little or no gender bias.  The consequences of a decision to outsource or not to outsource can have a similarly arbitrary effect: for example, an employer which has outsourced a predominantly male, low paid distribution centre or warehouse but kept a predominantly female, low paid retail operation in-house is likely to report a much larger gender pay gap than a comparable company which has outsourced neither.

Acknowledging the potential for arbitrariness, the Government notes that “a number of investor responses called for pay ratio reporting to be extended to compare the pay of the CEO and other board members with the remuneration of senior managers in the tier immediately below the board. Those making this suggestion said that it would help investors identify governance issues since a big gap could be an indicator of an over-powerful CEO or of inadequate attention being paid to succession planning.”  However, as with gender pay reporting the Government concludes that the right way forward is to give employers a free hand to publish a “narrative” explaining changes to the ratio from year to year, setting the ratio in the context of pay and conditions across the wider workforce. 

While it confirms that the new pay ratio reporting requirements should “for reasons of consistency and simplicity” cover UK employees only, the Government comments that multinational companies would “be free to publish a broader ratio alongside, covering all employees in their group”.  The gender pay gap reporting requirements cover all legal entities with 250 or more staff; many groups of companies have concluded that group wide reports will make more sense to their employees and decided to publish this voluntarily as part of their narrative.

The Government also acknowledges “questions about how the ratio should be calculated… Recommendations included that it should not be a single figure, but split into three distinct categories: fixed pay; expected value of variable pay; and actual value of variable pay received. Guidance on how pay ratios should be calculated was requested by a number of respondents.

The question of what exactly should be included in the definitions of “ordinary pay” and “bonus pay” has been a vexed issue in gender pay gap reporting: organisations with complex pay structures have had to devote significant amounts of time to unpicking this.  For executive pay reporting, the Government says simply that it will “give further consideration to the methodology for calculating the ratio as well as including the option of reporting ratios by pay quartile” (another echo – reporting on the number of male and female employees in each pay quartile is a requirement of the gender pay legislation).  It proposes that “the ratio should be calculated based on the CEO’s total annual remuneration (as set out in the existing ‘Single Figure’ in the Directors’ Remuneration Report) relative to the average total remuneration of the company’s UK workforce. This will enable the new reporting requirement to be based in most cases on existing pay roll data, while also complementing the existing legislative requirement for companies to report the annual increase in CEO pay compared to the annual increase across the average of the workforce.”  The reference to basing reporting “on existing pay roll data” may provide little comfort to those who heard similar things about gender pay gap reporting, only to find that the complexity of the Regulations meant that pay roll data only provided part of the solution.

Draft legislation on pay ratio reporting is promised before the end of the year, with the law coming into force by June 2018.  It remains to be seen whether the Government will seek to take on board some of the lessons of gender pay gap reporting – or whether this becomes another public policy initiative which creates work for companies and produces somewhat misleading results, whilst potentially doing little to tackle the perceived underlying problem.

A quick canter through the other key proposed changes…

  • Changes to the Corporate Governance Code will “be more specific” about the steps that premium listed companies should take when they encounter significant shareholder opposition to executive pay policies and awards, as well as giving remuneration committees “broader responsibility” for overseeing pay and incentives across companies and requiring them to engage with the wider workforce to explain how executive remuneration aligns with wider company pay policy. 
  • The recommended minimum vesting and post-vesting holding period for executive share awards will be increased from 3 to 5 years.
  • The Investment Association will be invited to implement a proposal to maintain a public register of listed companies encountering shareholder opposition of 20% or more to pay awards, along with a record of what these companies say they are doing to address shareholder concerns.
  • New legislation will require all companies of significant size (private as well as public) to explain how their directors comply with their statutory duties to have regard to employee and other interests.
  • The Government will invite the Financial Reporting Council (FRC) to consult on a requirement for premium listed companies to adopt, on a “comply or explain” basis, one of three employee engagement mechanisms: a designated non-executive director for employees; a formal employee advisory council; or a director from the workforce. 
  • Industry bodies will be invited to develop guidance on “practical ways” in which companies can engage with their employees and other stakeholders. 
  • The General Counsels of the FTSE 100 will be invited to complete and publish new advice and guidance on the practical interpretation of the directors’ duties in section 172 of the Companies Act 2006.
  • A new “voluntary approach” for large private companies will be adopted, with the FRC and other bodies being invited to develop a voluntary set of corporate governance principles, with firms required to state on their website whether they follow any formal code or not.

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