Disclosing pay ratios - hindrance or help? by Katharine Turner

Pay caps and the disclosure of pay multiples for senior executives have been much talked about in the last few months. Will Hutton has been asked by Government if a ratio of 20 to 1 will promote fairness in public sector pay. In the US, the Dodd-Frank Act intends that listed companies should disclose the ratio of the CEO’s pay to the median (yes, the median) pay of all employees in the company.  

But pay ratios are by no means a new idea.  Retailer John Lewis’s current constitution says that: “The pay of the highest-paid partner will be no more than 75 times the average base pay of non-management partners on an hourly basis.”  And long before John Spedan Lewis set up the Partnership in the late 1920s, Plato in The Laws (see Book 5 and his chapter on the four property classes) opined that extremes of poverty and wealth were the enemy of the state and argued that there should be both a lower and an upper limit on wealth. Every man should hold a unit of land and the richest only up to four times more. He goes on to say that, if, through good fortune, anyone acquires more, he should hand over the surplus to the state and to the gods ‘thereby escaping punishment and getting a good name for himself”.

So why is this age-old thinking resurfacing now? Executive pay has been increasing as a faster rate than all employee pay for several years. The reasons for this have come under intense scrutiny as a result of the economic crisis. The start of public service cost cutting and the consequential effects on jobs and services has only added further to the sense that ‘something must be done’. When times are hard, it helps when everyone is demonstrably in the same boat.

On the other hand, many argue that caps on top pay smack of social engineering which could sabotage fragile recovery by driving away talent. Has executive pay in the UK reached the point at which chief executives risk becoming aliens in their own land, as the outgoing Director-General of the CBI put it last year?

We have been thinking about this question back at the ranch and identified twelve primary causes of why executive pay has accelerated over the last thirty years after the compression that followed the Second World War.  All the causes fall into one of the following categories – the changing nature of companies and the role of executive directors; changing labour markets; remuneration structures and the impact of corporate governance.

But I might venture to say that it also owes something to political will which has had an impact from 1979 through to the noughties. The pattern re-set in the 1980s by falling rates of income tax and new incentives for share ownership has continued. So, if the political will today is to ensure disclosure of pay ratios to bring pressure to bear to decrease differentials, what purpose will it serve?  Will Hutton is clear. He says that it links directly to fairness, combats incorrect perceptions, and enables comparability.

Never mind the technicalities of calculating it in the first place, who is to say what is the right relationship? The Church Investors Group say 75 times is the limit. It is the same as John Lewis. Ben & Jerry’s ratio didn’t get into double figures before it was scrapped when the company recruited its first chief executive from outside the company. Do wide or narrow differentials tell you more about the skills profile of a business, its international coverage and whether or not low-paid work has been outsourced than it does about the efficacy of executive pay decisions?

Bizarrely, pay ratios could also trigger an alternative arms race. Those organisations with low ratios may see themselves with room to increase pay at the top. Ratios create another benchmark to focus on, to anguish about, to interpret if you can and to measure against.

Decision makers on top pay – whether in the public sector or the private sector – already have to be accountable for their decisions and show why executives represent value for money and their pay is reasonable. Perhaps the disclosures need to be significantly better at showing us - as tax payers and/or shareholders – why we are getting value for money. We may be less subject to the temptations of pay ratios which could be falsely comforting but sadly meaningless.