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Finance and Economics Discussion Series
Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C.
A New View from a Long-Term Perspective, 1936-2005
Carola Frydman and Raven E. Saks
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A New View from a Long-Term Perspective, 1936-2005 Carola Frydman* and Raven E. Saks** July 6, 2007 Abstract We analyze the long-run trends in executive compensation using a new panel dataset of top executives in large firms from 1936 to 2005. In sharp contrast to the well-known steep upward trajectory of pay of the past 30 years, the median real value of compensation was remarkably flat from the late 1940s to the mid-1970s, highlighting a weak relationship between compensation and aggregate firm size. While this correlation has changed considerably over the century, the cross-sectional relationship between pay and firm size has remained stable. Another surprising finding is that the sensitivity of changes in an executive’s wealth to firm performance was not inconsequentially small for most of our sample period. Thus, recent years were not the first time when compensation arrangements served to align managerial incentives with those of shareholders. Overall, these trends pose a challenge to several common explanations for the recent surge in executive pay.
* M.I.T. Sloan School of Management. firstname.lastname@example.org ** Federal Reserve Board of Governors. email@example.com.
We would like to thank George Baker, Edward Glaeser, Claudia Goldin, Caroline Hoxby, Lawrence Katz, and Robert Margo for their advice and encouragement throughout this project. Very helpful comments have also been received from Doug Elmendorf, Eric Hilt, Antoinette Schoar, Dan Sichel, and seminar participants at the NBER Summer Institute, AEA meetings, EHA meetings, and Rutgers University. We would also like to thank the staff at the Historical Collections and Danielle Barney of Baker Library for making the data collection possible and Brian Hall and Jeff Liebman for providing us with their data. Yoon Chang, Yao Huang, Michele McAteer, Timothy Schwuchow, James Sigel, and Athanasios Vorvis provided outstanding research assistance. We gratefully acknowledge financial support from the Economic History Association, the Multidisciplinary Program in Inequality & Social Policy at Harvard University, and the National Science Foundation’s Dissertation Completion Fellowship.
The views in this paper do not necessarily reflect those of the Board of Governors of the Federal Reserve System or its staff.
1. Introduction The compensation paid to CEOs of large publicly-traded corporations rose dramatically during the 1980s and 1990s, stimulating much debate on the determinants of managerial pay (Murphy 1999, Hall and Murphy 2003). The discussion has been largely inconclusive, due partly to the short time span of available data. By setting forth the trends in the level and composition of executive pay over most of the twentieth century, this paper provides new insight into three popular explanations for the recent surge in compensation: managerial rent-seeking, a competitive labor market for executives, and increases in managerial incentives.
Although prior studies have reported information on managerial pay for earlier time periods, these data cannot provide a consistent description of the long-run evolution of executive compensation because they are based on short sample periods with different sample designs and employ different methodologies to value the components of pay.1 Instead, we document these trends by constructing a comprehensive panel dataset on the compensation of individual executives that extends from 1936 to 2005. We hand-collected this information from the proxy statements and 10-K reports of publicly-held firms, which have been required to disclose the remuneration of their top officers ever since the Securities and Exchange Commission (SEC) was established in 1934. Although our sample is mainly composed of executives employed in the largest corporations in the economy, our results are broadly characteristic of the largest 300 publicly-traded firms.
Consistent with previous studies, we find that executive pay increased moderately during the mid-1970s and rose at a faster rate in the subsequent two decades, reaching an average growth rate of more than 10 percent per year from 1995 to 1999. This acceleration represents a marked departure from the trend in compensation in the past. Following a sharp decline in the A few examples include Baker (1938), Roberts (1959), Lewellen (1968), Wattel (1978), and Murphy (1985).
real value of pay during World War II, the level of executive compensation exhibited little change during the following 30 years, rising at a sluggish rate of 0.8 percent per year. The remarkable stability in the level of executive compensation from the end of World War II to the mid-1970s is surprising in light of the robust economic activity and considerable growth of firms during most of this period. Several studies have documented a strong correlation between executive compensation and the aggregate market value of firms in recent decades (Hall and Murphy 2003, Jensen and Murphy 2004, Gabaix and Landier 2007). This correlation is present in our data as well for recent years, but it was much smaller prior to the mid-1970s.
Another surprising finding in our data is that stock option grants have been an important part of the compensation package since the 1950s. Even though the value of option grants was low prior to the 1980s, executives have owned a substantial number of stock options for the past 50 years. Using a measure of an executive’s firm-related wealth that includes changes in the value of his holdings of stock and stock options, we calculate consistent measures of the correlation between wealth and firm performance (often called “pay-to-performance”) over the past 70 years. Similar to prior research, we find that this relationship strengthened considerably from the 1980s to the present (Hall and Liebman 1998, Murphy 1999). However, this increase was not part of a long-run upward trend. The sensitivity of changes in wealth to firm performance was about the same in the 1930s, 1950s and 1960s as it was in the 1980s, but somewhat lower in the 1940s and 1970s. Although the strength of the incentives provided by these correlations is difficult to assess, we come to a similar conclusion as Hall and Liebman that the magnitude of the correlation for most of our sample was not inconsequentially small. Thus, recent decades were not the first period in which compensation arrangements generated a strong link between the executives’ wealth and firm value.
Although a comprehensive analysis of the causes of these trends is beyond the scope of the present paper, the long-run data provide new evidence to evaluate some of the major hypotheses for the recent surge in executive compensation. First, the run-up in CEO pay and expanded use of stock options have been linked to managers’ ability to extract rents from the firm (Bebchuk and Fried 2003, Bebchuk and Fried 2004, Kuhnen and Zwiebel 2007). However, both the level of pay and the use of options were lower from the 1950s to the 1970s than in more recent years, even though corporate governance was arguably weaker in the earlier period. Thus, this explanation does not seem to fit well with the changes in executive pay over time.
A second set of explanations relate executive pay to changes in firm size. High levels of pay may be the result of firms’ competition for scarce managerial talent (Lucas 1978, Rosen 1981, Rosen 1982, Tervio 2007), leading to higher compensation in larger firms. Consistent with this prediction, the cross-sectional correlation between the level of pay and a firm’s position in the distribution of firm size was about 0.3 for most of our sample period. Extensions of this theory also predict that compensation should rise along with increases in the size of the typical firm in the market (Gabaix and Landier 2007). However, we find that shifts in the distribution of firms’ market values over time were only weakly correlated with compensation prior to the mids, casting doubt on the validity of this theory for earlier time periods. In addition, the appearance of a strong correlation in more recent decades may be spurious, suggesting that this model may not even explain the post-1970 run-up in executive pay.
Another explanation is that the recent high level of pay could be the result of compensating executives for the risk generated by the greater use of incentive pay since the 1980s.2 However, we find a considerable sensitivity of managerial wealth to firm performance The optimal sensitivity of managerial wealth to firm performance may have increased in recent decades due to rising business risk (Inderst and Mueller 2006) or greater international competition (Cuñat and Guadalupe 2006) in the 1950s and 1960s and much weaker incentives in the 1970s without notable changes in the level of pay. Thus, changes in pay-to-performance were not always accompanied by changes in the level of compensation.
It seems unlikely that these explanations can account for the long-run trends that we document in this paper, suggesting that the major determinants of pay may have changed over time. It is possible that the labor market for corporate executives operated differently in the past.
Other factors, such as improvements in board monitoring and changes in social norms, may also have altered compensation arrangements. Thus, further studies of executive compensation should address these long-run trends to improve our understanding of how the determinants of pay have evolved over time.
2. Executive compensation data Most empirical research on executive compensation has focused on the period after 1992 because data on managerial pay since that date are easily available in Compustat’s Executive Compensation database (ExecuComp). The sources of these data are the proxy statements of publicly-held corporations, which report the remuneration of the firm’s highest-paid officers.
Although ExecuComp does not start until 1992, the SEC has had similar disclosure requirements since its inception in the 1930s.3 Thus, we construct a long-run panel dataset on executive compensation by hand-collecting data for the years 1936 to 1991 from historical proxy statements and 10-K reports, and using ExecuComp from 1992 to 2005.4 Because disclosure requirements have not changed significantly over time, firms’ corporate reports provide a Corporations were required to disclose the compensation of top officers in 10-K reports starting in 1934, but many firms were reluctant to do so in the early years. By 1936 most of the firms included data on remuneration in these reports, and so we start our sample in that year.
Studies that have used proxy statements to study executive pay (although over shorter time periods than our sample) include Roberts (1959), Lewellen (1968), Yermack (1995), and Hall and Liebman (1998).
valuable resource for tracking pay in a consistent manner over the longer run.5 These data are particularly important for constructing consistent measures of stock option use, because options were valued differently in research conducted prior to the 1970s than the common practice today.
To construct our dataset, we select the largest 50 publicly-traded corporations in 1940, 1960 and 1990. We identify the largest firms in 1960 and 1990 by ranking corporations in Standard & Poor’s Compustat database according to their total value of sales. Compustat’s data do not extend back to 1940, so for that year we rank firms in the Center for Research in Security Prices (CRSP) database according to their market value. Because some firms appear among the largest 50 in more than one year, our dataset covers a total of 101 companies. For each firm, we collect annual data on the pay of the top officers for as many years as our sources allow. When a firm in our sample merges with a firm outside of the sample, we continue to follow the executives in the merged firm if the new firm retains the same name or if the industrial classification of the new firm does not change (see Appendix Section 1.1 for details). The resulting dataset is an unbalanced panel as companies enter and leave the sample over time.6 About 75 percent of the firms in our sample are in manufacturing industries, but our dataset also contains communications, public utilities, and retail companies. Appendix Table A1 lists all of the firms in our sample and Appendix Table A2 shows the distribution of firms by 2digit SIC code.
Because our dataset includes firms that were large at different points in time, it captures some of the structural changes that were experienced by the economy over this 70-year period.
Not only do these documents report information on salaries, bonus payments, stock options, and stock holdings, but they also contain detailed descriptions of compensation plans that allow for consistent measurement of each component of pay over time.
Firms enter the sample when they go public or when corporate records become available in the collection at the Baker Library of Harvard Business School (our main source of corporate reports). Companies exit the sample as they go bankrupt, become private, or are acquired by a foreign firm, among other reasons.
Although this sample is not representative of the economy as a whole, it comprises at least 20 percent of the market value of the S&P 500 in every decade, and more than 40 percent prior to 1970 (see Appendix Table A3). Because the sample includes all of the available years for each of the selected firms, it reflects a broader segment of the economy than the largest 50 publiclytraded firms alone. We discuss the representativeness of our sample in Appendix Section 3, and conclude that it is representative of the largest 300 publicly-traded corporations. On the other hand, the sample does not reflect the compensation practices of smaller or private firms.