The Fix for Misleading ‘CEO Pay Ratios’ – Robert Pozen and Kashif Qadeer

MIT Sloan Senior Lecturer Robert Pozen

MIT Sloan Senior Lecturer Robert Pozen

MIT Sloan MBA ’18, Kashif Qadeer

From The Wall Street Journal

In the coming weeks, many public companies in the U.S. will disclose for the first time their “pay ratios”—the CEO’s compensation divided by the median employee’s. The requirement to provide this ratio was included in the Dodd-Frank Act of 2010. But comparing the figures among different companies—and particularly different industries—will hardly be a straightforward task.

The consulting firm Equilar estimates that the pay ratio will be two or three times as high for retailers as for drug, financial or tech companies. But the reason isn’t soaring CEO pay in the retail industry. For one thing, midlevel retail workers simply make less, on average, than their peers in pharma, finance and tech, which skews the ratio.

Another issue is that 31% of retail employees work part-time, compared with 17% for the rest of American employees. When computing the CEO pay ratio, the Securities and Exchange Commission prohibits companies from adjusting part-time earnings to “annualize” them—to show what these employees would have earned if working full-time. The SEC also bars companies from counting several part-time employees as a single full-time equivalent. Because of this, having many employees who work only a few days each week drags down the median.

To understand how much this might overstate the pay ratio, we examined data for a midsize retail company that operates about 1,200 stores, primarily in the U.S. The company had more than 25,000 employees in 2017. Almost half worked less than 30 hours a week. The median pay of these part-timers (without annualizing) was less than $6,000 a year. By contrast, the median pay of full-time employees who worked for the whole year was approximately $30,000.

Under the SEC’s methodology, the median pay of all the company’s employees would be $14,928. Since the CEO reportedly earned a little more than $6 million, the ratio would have been 408.

This is hardly a fair measure of the company’s compensation structure. The CEO was paid for full-time work during 52 weeks. Annualizing the pay of part-time workers is the only way to make an apples-to-apples comparison. And converting them into full-time equivalents is a better way to represent the median.

In other contexts, the SEC recognizes these issues. Companies are allowed, for example, to annualize the pay of a full-time employee who starts midyear. Otherwise, a company’s pay ratio would jump if it went on a summer hiring binge. The same rationale should apply to the treatment of part-time workers.

How much difference would these two adjustments make? For our retailer, we identified all part-time employees and multiplied their hourly wage by the company’s definition of full-time work—1,560 hours, based on 30 hours a week for 52 weeks. The result was an adjusted median pay of $17,160 and a new pay ratio of 355.

Read the full post at The Wall Street Journal.

Robert C. Pozen is currently a Senior Lecturer at MIT Sloan School of Management and a Senior Fellow at the Brookings Institution.

Kashif Qadeer is a fellow at MIT Sloan School of Management.

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