CEO pay ratio reporting coming soon

As widely reported, the Government is intending to legislate to require all UK-listed companies with more than 250 employees in the UK to report annually on the difference in pay between their chief executive officer (“CEO”) and their average UK worker. 250 is the same threshold as for gender pay gap reporting - although that applied to all companies, not just listed ones.

The plan forms part of the Government’s agenda for corporate governance reform on which we first reported last September. Details are contained in the draft Companies (Miscellaneous Reporting) Regulations 2018 (“the Regulations”).

How will the 250-employee threshold apply?

To decide whether a company exceeds the 250 threshold, it must “find for each month in the financial year the number of persons employed under contracts of service by the company in that month (whether throughout the month or not)”, “add together the monthly totals” and “divide by the number of months in the financial year”. If the listed company is a parent company, the number of UK employees within group companies must be included too, and pay ratio information must relate to the group not the company.

What ratios must be reported?

Reporting will be required reporting on three ratios (under draft regulation 17):

• CEO to the “25^th percentile pay ratio” (called “Y25”)
• CEO to the “median pay ratio” (called “Y50”)
• CEO to the “75th percentile pay ratio” (called “Y75”).

CEO pay is the total remuneration paid to the director carrying out the role of CEO in the relevant financial year. This is to be based on the existing “single figure” in the directors’ remuneration report, and must include all elements of remuneration including salary, fees, benefits, bonuses, share schemes and pension benefits. If more than one person undertakes the role of CEO in the financial year, the total remuneration paid to all persons who held the role must be calculated. 

The 25^th, median and 75^th percentile pay ratios are based on the pay of a representative employee who falls on these pay percentiles. They are called “P25”, “P50” and “P75”. “Employee pay” for these purposes is the employee’s full-time equivalent pay and benefits. 

How should these be calculated?

The Regulations give companies three choices as to how they make these calculations:

• “Option A” is to calculate the pay and benefits of all UK employees for the relevant financial year in order to identify P25, P50 and P75, and use those figures.
• “Option B” is to use the most recent hourly rate gender pay gap information for all UK employees of the company to identify three UK employees as the best equivalents of P25, P50 and P75.
• “Option C” is to use data other than, or in addition to, gender pay gap information to identify three UK employees as the best equivalents of P25, P50 and P75 (but in so doing the company must not use data that relates to any year prior to the preceding financial year or that is less up-to-date than the gender pay gap information).

No doubt employers will be tempted to “crunch the numbers” on all three bases before forming a view on which route is preferable to take, but the directors’ remuneration report must include an explanation of why the company chose the option it did.

There are also some anomalies. For example, the definition of an employee (someone who works under a contract of service) is different from that used in gender pay reporting (the wider definition under the Equality Act, which includes workers and some self-employed contractors). So it is not immediately obvious how any company using contractors as well as employees could safely rely on its gender pay gap data.

Whichever option is used, Y25, Y50 and Y75 must be determined with reference to a day no earlier than three months before the last day of the relevant financial year, using a projected calculation of the salary component of pay and benefits. The company can base the calculation on salary only, or use different methodology in calculating benefits, so long as this is explained in the report. If data is unavailable, the company must use a reasonable estimate. 

What else will the report have to include?

Companies will be compelled to “justify” their CEO’s salary, as well as reporting on how their directors take employee and other stakeholder interests into account. Specifically, the directors’ report for the financial year will need to contain a statement describing the action that has been taken during that year to:

• Introduce, maintain or develop arrangements aimed at providing employees systematically with information on matters of concern to them as employees.
• Consult employees or their representatives on a regular basis so that the views of employees can be taken into account in making decisions which are likely to affect their interests.
• Encourage the involvement of employees in the company’s performance through an employees’ share scheme or by some other means.
• Achieve a common awareness on the part of all employees of the financial and economic factors affecting the performance of the company.

While directors will need to summarise how they have engaged with employees and had regard to their interests, it is made clear that there need be no disclosure of information about impending developments or matters in the course of negotiation if the disclosure would, in the opinion of the directors, be seriously prejudicial to the interests of the company.

Directors will also be required to show what effect an increase in share prices will have on executive pay, in order to inform shareholders when voting on long-term incentive plans.

In each year’s report, companies will be required to report the same ratios for up to nine financial years immediately preceding the relevant financial year. There are also requirements for the report to explain the reasons for any changes from one year to the next. This means that, over time, there will be a ready reference source as to whether a company’s pay gap is narrowing or widening – the implicit intention presumably being that the gap will narrow rather than widen. 

Timetable and implications

If Parliament approves the proposals, the Regulations will come into effect from 1 January 2019, with the first pay ratio reports due to appear in 2020.

The Government has clearly been emboldened by what it sees as the success of the gender pay gap reporting regulations, and hopes to use these new rules as a tool to address public concern over pay inequality. However, compiling the data required for the production of the reports will be another headache for overstretched legal, HR and payroll teams. If the lesson of gender pay gap reporting is anything to go by, this may well turn out to be not as straightforward as the Government intends.