What Is CEO Pay Ratio?
The CEO pay ratio is a financial metric that compares the annual total compensation of a company's chief executive officer (CEO) to the median annual total compensation of all its other employees. This ratio is a key component of corporate governance and falls under the broader category of executive compensation within finance. Publicly traded companies are required to disclose this ratio, aiming to provide greater transparency regarding compensation structures. The CEO pay ratio helps shareholders and other stakeholders assess the fairness and equity of pay practices within an organization.
History and Origin
The disclosure of the CEO pay ratio stems from Section 953(b) of the Dodd-Frank Act, officially known as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This legislative mandate required the U.S. Securities and Exchange Commission (SEC) to adopt rules necessitating public companies to disclose the ratio between CEO compensation and the median employee's compensation. The SEC adopted the final rules for this disclosure on August 5, 2015, after a lengthy comment period that saw significant public and corporate input.13 Companies were required to begin reporting their CEO pay ratio for their first fiscal year beginning on or after January 1, 2017, meaning the data first became publicly available during the 2018 proxy season.12 The intention behind this mandate was to provide investors with information that could be used to evaluate a CEO's compensation package in the context of the broader workforce.11 Historically, CEO compensation has seen significant increases compared to typical worker pay. For example, the Economic Policy Institute (EPI) reported that average CEO compensation at the top 350 U.S. firms skyrocketed 1,085% from 1978 to 2023, while a typical worker's compensation grew by only 24% over the same period.10
Key Takeaways
- The CEO pay ratio compares the annual total compensation of a company's CEO to that of its median employee.
- Publicly traded companies in the U.S. are mandated to disclose this ratio under the Dodd-Frank Act, enforced by the SEC.
- The disclosure aims to enhance transparency in executive compensation and provide context for shareholders.
- The ratio can highlight significant disparities in pay within an organization, contributing to discussions around income inequality.
- Calculating the median employee's compensation involves specific methodologies and may allow for certain exclusions.
Formula and Calculation
The formula for the CEO pay ratio is straightforward, representing the CEO's total annual compensation as a multiple of the median employee's total annual compensation.
Where:
- CEO Annual Total Compensation refers to the total compensation reported for the CEO in the Summary Compensation Table of the company's proxy statement. This typically includes salary, bonus, stock awards, option awards, non-equity incentive plan compensation, and other compensation.
- Median Employee Annual Total Compensation is the total annual compensation of the employee whose compensation is at the middle point when all employees (excluding the CEO) are ranked by their compensation. Companies are allowed flexibility in determining this median employee, and can use consistent methodologies such as total compensation for the most recently completed fiscal year, or other consistently applied compensation measures like W-2 wages, for initial identification.9
The rules for calculating the CEO pay ratio are detailed in Item 402(u) of Regulation S-K and permit companies some flexibility, such as identifying the median employee once every three years, and excluding a small percentage of non-U.S. employees under specific conditions.8
Interpreting the CEO Pay Ratio
Interpreting the CEO pay ratio requires careful consideration beyond just the numerical value. A high ratio indicates a significant disparity between the CEO's pay and that of the typical employee, while a lower ratio suggests a more compressed pay scale. For instance, in 2023, CEOs at the top 350 U.S. firms were paid 290 times as much as a typical worker, a stark contrast to the 21-to-1 ratio observed in 1965.7
When evaluating a company's CEO pay ratio, it is important to consider factors such as the company's industry, size (e.g., market capitalization or revenue), and geographical scope. Industries with highly specialized labor or global operations might naturally have different compensation structures. The ratio can be used by shareholders to inform their voting decisions on "say on pay" proposals, which allow investors to cast an advisory vote on executive compensation. Additionally, a company's CEO pay ratio can influence public perception and employee morale.
Hypothetical Example
Consider a hypothetical publicly traded company, "Diversified Solutions Inc." For its most recent fiscal year, the CEO, Ms. Evelyn Reed, had a total compensation of $15,000,000.
To determine the median employee's compensation, Diversified Solutions Inc. gathers the annual total compensation data for all its employees worldwide, excluding Ms. Reed. After compiling and ranking this data from lowest to highest, the employee in the exact middle of this sorted list is identified. Let's assume this median employee, a project coordinator, had an annual total compensation of $75,000.
Using the formula:
Diversified Solutions Inc. would report a CEO pay ratio of 200:1. This means that Ms. Reed's total compensation for the fiscal year was 200 times that of the company's median employee. This disclosure would be included in the company's annual financial reporting.
Practical Applications
The CEO pay ratio has several practical applications across various facets of the financial world:
- Shareholder Engagement: Investors and activist shareholders use the CEO pay ratio to gauge pay equity and influence decisions related to executive compensation. It can become a point of discussion during annual general meetings and "say on pay" votes.
- Public and Employee Relations: The disclosure of the ratio can impact a company's public image and internal employee morale. Companies with perceived excessively high ratios might face scrutiny from media, labor organizations, and the general public, potentially affecting recruitment and retention. For instance, a Reuters article noted that some companies, like Wells Fargo, faced internal pushback from employees after their pay ratio disclosures.6
- ESG Investing: Environmental, Social, and Governance (ESG) investors increasingly consider executive compensation practices, including pay ratios, as part of their assessment of a company's social responsibility and governance standards.
- Academic and Policy Research: Researchers and policymakers utilize CEO pay ratio data to study trends in income inequality, analyze the effectiveness of compensation structures, and inform potential legislative efforts related to corporate remuneration.
Limitations and Criticisms
Despite its intended purpose of increasing transparency, the CEO pay ratio has faced several limitations and criticisms:
- Comparability Issues: Critics argue that comparing CEO pay ratios across different companies can be challenging due to the flexibility in calculation methodologies permitted by the SEC rules. Companies can choose various dates to identify the median employee, use different consistently applied compensation measures, and apply permissible exclusions for non-U.S. employees, making direct comparisons difficult.5
- Industry and Company Size Variations: The ratio can vary significantly based on industry and company size. A large, multinational corporation might naturally have a higher ratio than a smaller, domestically focused one due to differing employee bases and compensation structures, making cross-industry comparisons less meaningful.4
- Impact on Behavior: There is debate about whether the disclosure of the CEO pay ratio actually influences executive compensation decisions or corporate behavior. Some analysis suggests that after several years of disclosure, the CEO pay ratio has had minimal weight in decision-making regarding CEO compensation by corporate boards or influence on proxy advisory firm recommendations.3
- Focus on a Single Metric: The ratio is a single metric that may not capture the full complexity of a company's compensation philosophy, performance metrics, or the global nature of its workforce.
CEO Pay Ratio vs. Executive Compensation
The terms CEO pay ratio and executive compensation are related but distinct concepts. Executive compensation is a broad term encompassing all forms of payment and benefits provided to a company's senior management team, including the CEO, other named executive officers, and sometimes other key leaders. This includes base salary, bonuses, stock options, restricted stock units, performance-based incentives, and various perks and benefits.
The CEO pay ratio, on the other hand, is a specific metric derived from the CEO's total compensation in relation to the median employee's compensation. While executive compensation focuses on the aggregate remuneration package for top executives, the CEO pay ratio provides a comparative perspective, highlighting the proportional difference in pay between the highest-paid individual (the CEO) and the typical employee within the organization. The CEO pay ratio is a component of executive compensation disclosure, but it is not synonymous with the entire compensation package itself.
FAQs
What does a high CEO pay ratio indicate?
A high CEO pay ratio generally indicates a significant gap between the compensation of the company's chief executive officer and the median pay of its workforce. It suggests that the CEO earns a substantially larger amount compared to the typical employee.
Is the CEO pay ratio mandatory for all companies?
In the United States, the CEO pay ratio disclosure is mandatory for most publicly traded companies under SEC rules, a requirement stemming from the Dodd-Frank Act. However, certain exemptions apply, such as for smaller reporting companies, emerging growth companies, and foreign private issuers.2
How often is the CEO pay ratio disclosed?
The CEO pay ratio is disclosed annually in a company's proxy statement or annual report (Form 10-K) that includes executive compensation information. Companies are generally required to report the ratio for their last completed fiscal year.
Can companies choose how to calculate the median employee's compensation?
Yes, the SEC rules provide companies with some flexibility in determining the median employee's total annual compensation. Companies can use a consistently applied compensation measure (e.g., W-2 wages) for identifying the median employee and are not required to calculate the full total compensation for every employee. They can also generally exclude employees in certain non-U.S. jurisdictions, subject to limits.1