This article was first published in the December 2018 issue of PLC Magazine.
Ever since Theresa May first announced the government's intention to require companies to disclose the ratio of CEO pay to employee pay in 2016, the pros and cons have generated much debate. Companies with highly remunerated staff, an overseas-based workforce or contracted-out services will fare better than others, and unfair comparisons may also be drawn between companies in different sectors and of different sizes.
Ever since Theresa May first announced the government’s intention to require companies to disclose the ratio of CEO pay to employee pay in 2016, the pros and cons of disclosure have generated much debate (see Practical Law's News briefs“Corporate governance reforms: government proposals published” and “Corporate governance green paper: restoring trust and confidence?”).
Companies with highly remunerated staff, an overseas-based workforce or contracted-out services will fare better than others, and unfair comparisons may also be drawn between companies in different sectors and of different sizes.
Whatever the merits of the ratios disclosure, companies need to prepare for their first disclosures, which will have to be made for financial years starting on or after 1 January 2019.
The new rules
The ratios of total CEO pay must be calculated against the 25th, median and 75th percentile of UK employees’ pay. Companies must choose one of three methods, called Options A, B and C, to calculate employees’ pay (see box “The Options for calculating employee pay
CEO pay is to be taken from the single figure table included in the remuneration report (see “Pay information” below). There are complicated rules on identifying and calculating employees’ pay. The figures should be calculated on a full-time equivalent basis, and include wages and salary. Benefits, pension contributions and variable pay, such as bonuses, may also be included.
The ratios are to be disclosed in a prescribed table, building up to ten years, including years in which the company was outside the scope for reporting. There is no obligation to report pay ratios going back beyond ten years. Therefore, the 2019 pay ratios will drop off the table in the 2029 remuneration report, which will be published in 2030. However, companies can voluntarily keep pay ratios for earlier years on the table.
Companies will also have to explain the numbers. There is significant prescribed narrative disclosure, including justifying and explaining the employee pay calculations, and the reasons for changing the Option used to calculate them. Companies will also have to explain changes in the pay ratios; for example, changes to employees’ pay, CEO pay, employment models or calculation methods. There is greater focus on the median pay ratio as companies will need to explain any developing trend in this ratio, and its consistency with wider company pay, and with reward and progression policies for UK employees. Changes in ratios, trends and any explanations will only apply from the second year of ratios disclosure.
Like the rest of the directors’ remuneration reports requirements, the new rules apply to UK-incorporated companies that are quoted; that is, listed on the London Stock Exchange, an exchange in an EEA member state, the New York Stock Exchange or NASDAQ.
In addition, because the government is focused on fairness in the UK workplace, the new rules only apply to quoted companies that have an average number of UK employees above 250 in their group. This average is worked out by determining the number of UK employees for each month of the reporting year, and then dividing by the total number of months, usually 12. UK employees who are employed at any time during the month must be included, not just those employed for the whole month. The rules do not limit the count to full-time equivalent employees, so it is a straight headcount.
If there are more than 250 UK employees in the first reporting year, the company will have to report the ratios for that year, and its subsequent reporting year. Complicated “smoothing” provisions will apply from the third year to work out whether companies moving across the 250 UK employees threshold must still disclose.
The new rules define UK employees as persons under a contract of service, except those employed to work wholly or mainly outside of the UK. In practice, this is likely to be a narrower definition than for the gender pay gap calculations, but it is on a group-wide basis (see Practical Law's feature article “Gender pay gap reporting: reflections on a gap year
Companies will have to decide, using general employment law principles, whether zero-hours workers, agency workers and contractors are caught. Companies also need to check if the CEO is a UK employee. If so, the CEO will count toward the UK employees’ total when working out scope and identifying the quartile employees. If not, they are not part of the total for scope and do not count when identifying the quartile employees.
Testing and voluntary disclosure
Companies should consider doing a test run for the 2018 reporting year. This will enable them to check their access to pay data, whether their choice of Option for calculating employees’ pay is practical, and whether they will have the data in time between the year-end and the reporting deadline for the annual report. They can also start considering how to explain the outcomes.
Pay ratios for the 2018 reporting year do not have to be published, although some companies may choose to do so (see Practical Law's News brief “Annual reporting and AGMs: trends emerging from the 2018 AGM season
”). If the 2018 ratios are published, companies will need to consider whether to follow the prescribed statutory rules and how the ratios will look alongside the statutory disclosure for 2019.
Companies that are not in scope, such as those that are not UK-incorporated or are below the thresholds, should still consider whether to comply on a voluntary basis. This will depend, for example, on the expectations of investors or the market.
Additional disclosures and impact
Companies should also consider whether they wish to report additional pay ratios alongside the mandatory disclosure, for example, disclosures based on global group employees or calculated on another basis. If this is part of the published disclosures, companies should plan the presentation and consider the impact alongside the mandatory ratio disclosures. Alternatively, they could use the additional ratios only in their internal communications.
As with gender pay gap disclosures, companies should consider the potential impact of the ratio disclosures on UK and other employees. They should carefully plan the explanations and internal communication process.
The pay ratios disclosure will not be within the audited information of the remuneration report. However, it is still important to ensure that the pay figures are calculated correctly.
CEO pay. The new rules require use of the single figure table information for CEO pay. Where there are promotions or successive CEOs in one reporting year, it will be necessary to aggregate the figures, but only pay for the CEO role should be included. This may mean that, in some years, the CEO pay figure may be inflated if it includes termination packages or buy-out awards. This should be signposted early and fed into the explanations section of the ratios disclosure.
UK employee pay. There are three Options for identifying each relevant quartile employee and calculating their pay for the ratio disclosure. The Option chosen is crucial as it can have a profound effect on the resulting ratios.
Quartile employees’ pay and benefits. Whichever Option is being used, all pay should be adjusted to full-time equivalent, with an appropriate explanation. The starting point is to use the same calculation method as the directors’ single figure disclosure; that is, to include salary, fees, taxable benefits, cash bonuses, share-based incentives, and pension-related benefits.
Companies can omit any component other than salary but must disclose the reason for this and should bear in mind that the greater the number of excluded components, the bigger the resulting ratios. Salary can be projected before the end of the year (in the last quarter) to have a full-year figure. Companies can also use a different method from the single figure table method, but must explain the reason for this. For Options B and C, companies can use reasonable estimates for any component other than salary.
Salary figures. As well as the mandatory narrative disclosure mentioned above, companies must include the actual salary figure for the three quartiles of employees and their total pay and benefits figures, but the employees themselves are not identified.
Impact of the ratios disclosure
UK companies have had to disclose, since 2013, the percentage changes in CEO pay and group employees’ pay from the previous year. However, this has not had the desired effect and some companies have been heavily criticised for choosing to compare against senior employees only (see Practical Law's feature article “Directors’ remuneration reports: the final picture
The scepticism about the usefulness of the new ratios disclosure is likely to persist. In 2018, US public companies have published for the first time the ratio of CEO to median employee pay. US companies have considerable flexibility in calculating the employee pay figures. For example, they can exclude a proportion of the workforce and choose the methodology and date for the pay figure. This may have robbed their disclosures of much meaning.
It remains to be seen whether the UK ratios disclosure will be of any use to investors or effect changes in behaviour. But there is no doubt that this is a significant additional disclosure burden on companies, which will require careful planning and will continue to fuel the fairness debate in the UK.
View details of the Options for calculating employee pay