2 | What do pay-ratios tell us about fairness of remuneration?
A balanced pay-ratio in Dutch listed companies seems a far cry from reality
Reported pay-ratios by Dutch listed companies vary greatly. The CEO earns approximately between 3.5 and 215 times as much as the average employee. The Dutch Corporate Governance Code provides little or no guidance on how these pay ratios should be calculated, leaving the interpretation to management. Are the differences in pay-ratio really this big or can this variation in pay-ratios be explained by different calculation methods?
Written by Denise Valkering and Arlette Brouns, Senior Consultants Governance & Strategic Risk
The revised Corporate Governance Code, one year later
This blog is part of Deloitte’s ‘revised Corporate Governance Code, one year later’ series. The blogs address how Dutch listed companies account for their application of the 2016 Corporate Governance Code in their annual report. To improve transparency in remuneration and promote trust the Dutch Corporate Governance Code 2016 requires companies to report on pay-ratios across the enterprise1. However, it does not prescribe how these pay-ratios should be measured. Research into the reported pay-ratios by Dutch listed companies shows that they struggle to find the right way of reporting.
Calculation of the pay-ratio
Dutch listed entities report a pay-ratio somewhere between 3,5 and 215. At first glance this seems disproportioned. Analysis into the way these ratios have been calculated shows that these two numbers should actually not be compared to one another. Since the Code does not prescribe a calculation method, different companies apply their own interpretation, with the comparison the total CEO remuneration to the average employee salary as the most common one.
Whereas the calculation of ‘total CEO remuneration’ is pretty straight forward, it already gets more complex trying to define ‘average employee salary’. For example; which employees should be included in this measurement? And should employees of all business units be included, or is it acceptable to exclude some of the low-cost countries? Or just to focus on the largest revenue generating countries within the group, including a selection from Europe and America only to determine the pay-ratio? The complexity increases further if not just the CEO’s salary but ‘salary of the entire management board’ is taken into the equation.
The different methods of measurement seem endless, making comparing the different pay-ratios like comparing apples and oranges. In their closing report the Monitoring Committee Corporate Governance Code confirmed that pay-ratios of individual companies are not meant to be compared, and that therefore, a calculation method is not provided. The requirement to report on pay-ratios is primarily intended to make companies aware of their remuneration policy and possible implications thereof.
Is the pay-ratio increasing or decreasing?
If we should not compare the actually reported pay-ratio for different companies, is there an alternative to assess the reported figures? If you want to know something about the balance in pay-ratios we can look at the change compared to the previous year, assuming that the company uses the same method each year. Although reporting a pay-ratio was not obligatory last year, the majority of companies (60%) also reported their pay-ratio in 2016. Almost a third of companies (29%) reported a decrease in their pay-ratio. At the same time, a similar percentage (24%) of studied companies saw their pay-ratio increase, meaning that the difference between ‘CEO salary’ and ‘average employee salary (worldwide);’ grew. While this is not necessarily a bad thing, or can even be perfectly legitimate within the company’s remuneration policy, increasing the pay-ratio can spur public debate. As we experienced through multiple example in the media, risking the reputation of the company or even the executive.
The need for transparency
Currently the reported information on remuneration policy lacks transparency and is difficult to understand for people outside of the company. The pay-ratio says little to nothing about the fairness of the remuneration policy and does not contribute to better transparency. Results from our benchmark study even show that some companies do not report a pay-ratio at all (25%). Others only mention the method for calculation, but do not show the actual pay-ratio itself. Leaving it to the reader to find the information and calculate the pay-ratio themselves.
The Dutch Corporate Governance Code gives little to no guidance on how to measure the pay-ratio, and considering all the different interpretations, it begs the question whether current reporting on pay-ratio’s defeats it purpose: enhancing trust and transparency (at least towards the shareholder). Being transparent on pay-ratio’s and development thereof, but more importantly why certain methods are chosen, can strengthen the relationships with shareholders and stakeholders. Allowing them to form an opinion on the fairness of remuneration.
A new EU directive on shareholders rights tries to address this issues of transparency by giving, amongst other things, the shareholder a ‘say on pay’ in the future. By 2019, all EU member states will have to have implement the ‘EU Shareholders Rights Directive’ into their national legislation, giving shareholders a vote in the remuneration report. According to this directive, the remuneration report should include a link between performance and (executive) pay. In addition to this, the report should provide insights into the development of remuneration of both board members and the average employee over the last 5 years2. The Dutch legislator aligns to the EU standpoint as it just introduced legislation that requires large companies (>100 employees) to discuss pay-ratios and balance in remuneration with the works council3.
These developments show the next step towards more transparency on fairness of remuneration. Whether it will also ensure more long term focus and avoid wrong incentives of management remains to be seen.
‘The revised Corporate Governance Code, one year later’ series
This blog is part of a weekly series of blogs on the results of Deloitte’s benchmark study, examining annual reports of Dutch listed companies to assess how implementation of the 2016 Dutch Corporate Governance is accounted for in its first year. This benchmark study included the annual reports of 68 Dutch listed entities.
As the Code is principle based, we know from our own experience and those of our clients that applying it to your organization can be challenge. Through this benchmark and this series of blogs we provide insights into implementation of some of the key elements in the Code. Interested to see how Dutch listed companies deal with Diversity in the Boardroom?
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Would you like to consult an expert on your considerations regarding the pay-ratio? Or how we can help your organization design an efficient remuneration policy? Please contact Caroline Zegers, Partner at Deloitte Risk Advisory. Together with Arjan ten Cate she aims for a practical application of and reporting on the Dutch Corporate Governance Code.