With new rules on CEO pay ratios, the U.S. is taking a key step forward in teaching companies and their employees a little financial literacy.
There may be less grumbling in the executive and managerial ranks soon. In 2018, companies will start reporting the ratio of the full compensation of their CEOs (cash and stock, etc.) to a measure of other workers’ pay, called the median. The new bit here is median worker pay. And the fact that it took five years after Dodd-Frank passed to put this disclosure in place demonstrates not only a fear of the ratio, but a frightening lack of math and financial literacy among many walks of business life.
Median is a statistical term referring to the middle point in a range of numbers. In broad strokes, a company of 10,002 employees will measure median worker pay by looking at the pay of the 10,001 employees who aren’t the CEO. The company will be looking for the employee—let’s call that person Blaine—whose total pay is higher than that earned by 5,000 other employees at the company and is at the same time less than what 5,000 other employees make. In computing the CEO-to-worker pay ratio, they’ll use Blaine’s full compensation in the denominator, calculated on the same basis that companies calculate total compensation for the CEO today. The exact calculation required by the rule will allow companies that don’t have their data and processes well-organized to make approximations and take shortcuts of various sorts to make it easier.
Some employees are likely to be curious about their own and other companies’ CEO-to-worker pay ratios—and whether that ratio is modest or 100 times or more. But other managers and workers may find the median more interesting on its own. Companies are required to report the median separately—and it will tell you whether you make more or less than half of the company’s staff. If your pay is below what 50% of people at your firm make and you are in your twenties, this may not bother you at all. But if you’ve been slaving away 10 hours a day for decades, you may not be so pleased. On the other hand, for those above the median, this new knowledge could create the kind of self-satisfaction people have when they compare themselves to others and realize that by some tiny measure they seem to be superior.
Others may be astonished because, in absolute terms, they aren’t making that much. But once the figures are published, they’ll realize they are still making more than that earned by half of all workers at their company—or more than what half of employees at other companies in their own or other industries earn. According to data from the National Employment Law Project and reporting by Fortune’s Claire Zillman earlier this year, a whopping 42% of all Americans make less than $15 an hour. If white males are excluded, the numbers are worse. Nearly half of women workers (48%), and 54% of African Americans and 60% of Latinos, don’t make that much.
But as self-satisfying as the new data may be to some, the hullabaloo about the ratio is sobering. In the run-up to the rulemaking and since, some of the critical comments lead one to the conclusion that statistics isn’t the strong suit of the commentators.
Their faulty analyses are all the more serious when we consider that a lack of math and financial literacy helped to fuel the need for the rule in the first place. Despite the promise of big data, the measures used to judge corporate and CEO performance remain antiquated. And the measurement of individual employee performance is still in the dark ages, relegated to internal politics in far too many cases.
In 2006, I co-authored an article in Directors Monthly with Blythe McGarvie, who sits on the boards of Viacom, Sunoco, and Accenture, on the importance of financial acumen in companies and on boards of directors. You might think this was a no-brainer. But it is as important an issue now as it was then.
Without basic math literacy, it’s impossible to possess good financial acuity. In my book, Economic Value Management: Applications and Techniques, I discuss the importance of using basic statistics to understand and measure a business from many angles, including simple measures like variance and standard deviation that tell you something about the variability of the company’s performance.
But even ignoring rudimentary statistics, it’s frightening that so many board members today still don’t really understand what the stock price of their company represents. They don’t fully grasp that there is no direct causal relationship between the actions of the CEO and share movements. This omission in awareness puts too many boards in a weak position to defend against their own consultants or misguided shareholders who argue that total shareholder return is the best way to judge the chief executive.
A vast sea of board members must not recognize the harms of using a measure like earnings per share (EPS) to reward the top dog because so many of them use it. EPS rises when shares outstanding decrease. It’s curious to find these companies looking outside to blame shareholder activists for stock buybacks and short-term thinking when the problem starts with the board’s own choice to reward based on EPS. Short-term measures just embolden short-term activists. When boards act like mathematical neophytes who lack financial literacy, they don’t stand a chance when high-spirited activists come knocking.
Financial literacy, like it or not, is necessary in guiding a company forward. Let’s take return on equity as an example. In real life in banks, this shortsighted measure has caused managers at financial institutions to take on the riskiest endeavors while eschewing value-creating ones of a more conservative variety. That’s why using risk-adjusted returns to judge performance is so important. Not only in banks—but everywhere.
Financial literacy is also important in making merger and acquisition decisions. The academic literature that claims these transactions usually fail comes as no surprise. When board members lack financial acumen, they can’t discern whether non-objective parties, like internal managers seeking golden parachutes or investment bankers seeking fees, have really dug into the numbers to understand the true values on both sides.
The U.S. has a fount of talent, but the educational systems in other countries are surpassing ours. It’s terrifically hard to solve a problem you can’t understand. In putting forth the new rule on reporting CEO pay ratios, the SEC is taking one step forward to teach not only investors, but also U.S. companies and their boards how useful a statistic like the median can be. Who knows? The metric might begin to pop up in other corporate reporting. And for that, we owe Congress and the SEC thanks for yeoman’s work.
Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://www.thevaluealliance.com), an independent board education and advisory firm she founded in 1999. She has been a regular contributor to Fortune since April 2010 and is the author of two books on corporate governance and valuation.