Asset owners and other institutional shareholders face a new corporate governance issue to wrestle with as a result of a proposed Securities and Exchange Commission rule dealing with corporate compensation.
The proposal will focus attention on the compensation of all employees at corporations, not just that of the CEOs and other top executives. Fiduciary shareholders must address the issue from the perspective of what is best for their funds invested on behalf of plan participants and beneficiaries in the long run.
The proposed SEC rule — to require companies to show in 10-K reports the annual pay of the CEO, the median pay of all employees, including part-time employees, except the CEO, and the ratio of the two — will drive academics and analysts to drill deeper into corporate pay practices, from the highest to the lowest level.
Fiduciaries at a few pension funds are not waiting for a final rule before entering the fray in raising concern about pay disparity at corporations.
Four officials of major public funds in California, New York state, New York City and Chicago, whose combined assets total $860 billion, last month sent letters to companies in their investment portfolios. They called for the companies to reassess their distribution of profit to shareholders, saying “many companies have lost their balance” in capital allocation, and should better align business growth with commensurate wage growth. The officials timed the appeal to coincide with McDonald's Corp's. annual meeting, where its board came under fire from hundreds of protesters demanding much higher pay for the company's employees.
In addition, the Council of Institutional Investors conference in March, looking beyond executive compensation, featured on its agenda Zeynep Ton, an adjunct associate professor in the operations management group at the Sloan School of Management, Massachusetts Institute of Technology, to discuss her research, whose focus includes raising lower-level pay.
Ms. Ton has developed what she calls the “good jobs strategy,” according to her website. Looking at the retail sector, her research has shown that “even in the lowest-price segment of retail, bad jobs are not a cost-driven necessity but a choice.”
“When backed up with a specific set of operating practices, investing in employees can boost customer experience and decrease costs,” she wrote. “Companies can compete successfully on the basis of low prices and simultaneously keep their customers and employees happy.”
But pension fund fiduciaries must keep their attention on their duty to invest solely in the interest of their participants, just as other asset owners must invest in the interest of their beneficiaries.
Concern about pay disparities shouldn't become a distraction, taking asset owners off course in their fiduciary responsibility to focus on better aligning the interests of companies with the interests of shareholders. Through pension funds, and mutual funds in defined contribution plans, these shareholders often are plan beneficiaries.
Companies base capital allocation strategies on the long-term needs of the businesses to ensure their growth and sustainability. Those needs could force decisions to automate or outsource functions, adding or reducing employment, or adjusting pay, often depending on competition for talent and skills.
However: “If the pendulum swings too far in favor of returning capital to shareowners, the future viability of the companies in which we invest may be placed at risk,” the joint statement by the four pension fund officials said.
The asset owners are within their rights to ask companies to reassess their policies. But if they were to demand specific actions, such as changes in dividend policies, or across-the-board pay increases for lower-paid employees, they would be usurping the responsibilities of management and the board of directors. Such shareholder intervention would demand an extremely high level of analysis that included not only current earnings, but also the impact of other factors outside corporate control that influence competitive dynamics and business capital allocation strategy.
The compensation of CEOs and other executives often swings depending on the performance of the company, a relationship many of these fiduciaries — concerned about broader compensation issues — have demanded. But the pay of lower-level employees generally isn't subject to performance swings, and thus is more stable.
Besides engaging with their portfolio companies about business concerns, fiduciaries that are concerned about wage and employment levels also should engage with legislators about economic development issues that affect pay and jobs.
Corporate taxes take away earnings that would be allocated for some combination of capital investment, research and development, higher dividend payments and higher wages for employees.
The SEC hasn't voted on its proposal, which when adopted will implement a requirement in the Dodd-Frank Wall Street Reform and Consumer Protection Act for companies to make such disclosure, barring any successful judicial challenge.
It will add a new variable for institutional investors to include in their evaluations of companies for fundamental investment analysis and corporate governance oversight.
But how important it should become in their evaluation depends on the evidence of its impact as a determinant of corporate performance and valuation, and alignment with the interests of shareholders.
Asset owners should encourage research on the issue, which no doubt will lead to academics and other analysts building databases of CEO pay ratios and median pay levels, and allow uniform comparisons of pay. Fiduciaries shouldn't get distracted by the populism of the ratio. They have to focus on research that will tell whether that ratio has value for use in evaluating the role of pay in corporate valuation and sustainability.
The compensation of CEOs and other top executive provides a window to how boards and management oversee their corporations. But fiduciaries should have evidence on how the pay policies at companies align with shareholder interests and relate to corporate value. Otherwise it becomes a distraction, taking asset owner resources from other more important issues they should pursue.
