Our thinking

How to weather CEO compensation disclosures

The new year brought new rules requiring disclosure on CEO compensation. What have you done about it?

The consequences of a rule quietly adopted by the SEC in August 2015 has already become noisily apparent in 2018. Effective January 1, U.S.-listed companies were required to disclose CEO compensation, median employee pay, and the pay ratio between the two.

While the SEC expects these disclosures will “help inform shareholders when voting on ‘say on pay’” proposals, it is hardly surprising that public comments on the matter reflect concerns that there could be “potential impact on employee morale,” “a negative internal and external public relations impact,” and a high cost of compliance. In response to those comments, the SEC has provided guidance on how the rule should be interpreted.

Comments from a group of asset owners and managers with $3 trillion under management and from CalSTRS (which has more than $200 billion under management) suggest that shareholders will use the data to ensure executive compensation is linked to corporate strategy, and as a broader measure of how companies manage human capital. In this latter regard, this initiative follows growing institutional shareholder demand for improved diversity disclosure.

As the asset managers say in their letter: “Companies are not currently required to disclose data on their employees’ compensation, and the required disclosure of median employee pay will encourage greater transparency of human capital metrics. In the absence of company specific disclosures, investors are attempting to obtain human capital management data from companies.”

Executive compensation and human capital management are part of a broader investor push to encourage companies to focus on Environmental, Social and (especially) Governance (ESG) issues. There are many reasons why shareholders are focused on this, including:

  • Demand from individuals
  • Pressure from regulators and advocacy groups
  • The fact that operational crises often become governance crises.

The pace of ESG adoption and implementation by shareholders in their investment process is accelerating. This primarily reflects fund flows: 20 years ago, 5% of the stock market was owned by passive index funds; today the indexers own 25% of U.S. equities. Extrapolate from current trends, and you conclude that passive funds will own 50% of the stock market within 10 years. In other words, a decade from now, passive funds will own half of your company. And they really, really care about (and vote on) ESG.

As F. William McNabb III, Chairman and CEO of Vanguard, said: “We’re going to hold your stock when you hit your quarterly earnings target and we’ll hold it when you don’t. We’re going to hold your stock if we like you. And if we don’t. We’re going to hold your stock when everyone else is piling in. And when everyone else is running for the exits. That is precisely why we care so much about good governance.”

Companies have a huge opportunity to define themselves in this debate through proactive and compelling communication on ESG issues and using it to build trusted and enduring relationships with their shareholders. The ESG framework can also provide the cornerstone of a broad “license to operate” narrative reflecting not just the company’s business model, but how it improves the environment and contributes to society while holding itself to account. This narrative can help with employee recruitment, engagement and retention; and become a critical element of media, customer and government communication. Without it, companies risk being defined by a single number: how much more does your CEO earn than your median employee.

This article was originally published by the National Investor Relations Institute on January 22 2018.