The pay environment in the UK is changing. We’re seeing tougher reporting requirements and repeated calls for increased pay transparency. Theresa May recently said, “There is an unhealthy and growing gap between what these companies pay their workers and what they pay their bosses,” while investors are questioning the discrepancy between big pay deals and lower returns.

Latest figures from the High Pay Centre think-tank show in 2015, the ratio of pay between the CEO and average employees in FTSE 100 companies was 147:1. That is, for every £1 the average employee earns, the CEO was paid £146 more. There is concern that the gap is growing. The average FTSE 100 CEO was paid £5.5m in 2015, up 10% from 2014, while average wage growth across the whole UK economy in 2015, was around 2%. It was hoped the national living wage would force pay up from the bottom to help close the gap between the lowest and highest paid, but could publishing CEO pay ratios be the answer to restraint at the top?

Why have ratios?

Pay ratios are an important first step in understanding and contextualising executive pay packages. Being able to clearly see the relationship between the highest paid individual and the rest of the workforce, brings executive pay back down to a comparable level. It also reinforces the ‘all in it together’ belief, rather than a ‘them and us’ culture.

We’ve recently seen CEO pay deals rejected at a number of high profile companies; Burberry, BP, Anglo American and Deutsche Bank. In these instances, it’s unlikely that a pay ratio calculation would have had a significant influence on the shareholder’s vote, given the level of sophistication of investors. But there will be some remuneration committees or investors that would benefit from this increased understanding of pay in their organisation. Pay ratios allow for a yard stick of pay comparison between similar organisations and the benefit of comparison against competitors should not be underestimated.

It can be argued that fixed pay gaps are a positive influence on motivation and act as incentive for career progression. The implementation of pay ratios adds definition and a quantum of reward for progression. As reporting requirements become more detailed and pay becomes more transparent, it’s becoming easier for individuals to understand their reward packages in comparison to their peers. We can compare ourselves against a broad spectrum of pay in our organisations. We know the NMW i.e. lowest possible pay and if your employers publish annual accounts, directors’ pay i.e. the highest point. You might be lucky enough to have a transparent pay scale, but plotting your value somewhere on a spectrum without that is quite difficult. Am I paid well compared to my peers? How can my pay progress over the next few years?

However, when we add the gender pay reporting detail that is due next year, all of a sudden, an employee can build a much clearer picture of how pay is structured and can readily see where their pay sits in the spectrum. The potential reward for moving up the career ladder is much more quantifiable. Pay ratios provide another measurement to understand the potential reward and enable pay gaps to be monitored and managed in an organisation.

The problem with pay ratios

While some of the benefits of pay ratios are about increasing understanding and providing a consistent method of comparison, this can also be a key downfall. It’s very difficult to establish a recommended, ‘one size fits all’ ratio that businesses should be achieving. Pay ratios do not take into account business complexity or the sector a business is operating in. Retail organisations like Tesco or Sainsbury’s have a higher proportion of low-skilled employees, but are large and complex organisations at a senior level. They will inevitably have a higher ratio than say, Rolls Royce that has an overall higher-skilled employee base. Does the fact that the CEO of Tesco earns more as a ratio of the average Tesco employee mean pay is less controlled or unfair?

Looking at our clients there is a clear difference between sectors. Ignoring that our charity based clients have the lowest ratios for obvious reasons, the second lowest sector is pharmaceutical and bio-technology, while our clients with the highest pay ratios are all in the retail sector. There is a clear correlation between the proximity to customers and the complexity of the product or service provided. The closer you are to your customers for simple transactional business, the higher your pay ratio will be.

What this shows is that actually, the biggest influence on an organisation’s pay ratio is not the pay of the CEO, but the pay of the average employee. The pay of the average employee is ultimately governed by the business model i.e. what skill set employees need. So while a pay ratio is an important piece of evidence for CEO pay, it is only part of the picture and it’s more important to ensure that the pay reflects the business’ operating model and value of return. Where pay ratios are used it will require discipline to ensure they are being compared against like-for-like businesses and not setting unrealistic expectations of pay levels.

What are the other options?

Rather than using pay ratios, it might be more appropriate to use other measures that look at the value generated by an organisation or the size and complexity of the business. For example, comparing a CEO’s pay against the business' turnover, would give an indication of the complexity and scale of the business they’re heading up. If there are two CEOs, each with a total pay of £500,000, but one leads a company with £500m revenue and the other £50m revenue, which shareholders are getting a better return on their investment? Alternatively, a similar comparison could be made based on total payroll costs, where a CEO’s pay is shown as a percentage of total payroll costs to indicate the scale of their role.

Ultimately, pay needs to be comparable to a sector. There are a vast number of metrics that can be used to determine this. When we are doing pay benchmarking at Innecto, at all role levels, a key discussion we have with clients is to identify their comparators. Where do they recruit from? Where do they lose people to? What business are they trying to grow? Many of our clients find themselves in a rapid growth curve, so their competitors now might not be the same competitors in 12 months’ time. The business could change significantly in that period, so reward might be targeted towards the aspirational business model to ensure the right talent is in place, to make it a reality.

This article was originally publised in Personnel Today. Click here to read...

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