«Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Executive ...»
Furthermore, the following back-of-the-envelope calculation suggests that the combined value of pensions, perquisites and other untaxed benefits would need to have been implausibly large to explain the low growth rate of pay during the 1950s and 1960s. For the observable types of compensation in our dataset, median pay increased from $0.74 million in 1950 to $0.82 million in 1970, an annual average growth rate of 0.5 percent. By contrast, median pay increased by a factor of 4.4 from 1980 to 2000. If we assume that the value of unobserved forms of pay was zero in 1950, these unobserved benefits would need to have amounted to $2.4 million in 1970 in order to achieve a rate of increase in total compensation similar to the 1980 to 2000 period ($0.74*4.4-$0.82=$2.4 million). This amount is almost three times higher than the median level of salaries, bonuses and stock options at that time and strikes us as implausibly large. Moreover, this number underestimates the necessary value of non-taxable benefits in 1970 if the actual level of unobserved benefits was greater than zero in 1950. Thus, while pensions and perks may partly explain the slow growth rate of pay documented during the 1950s and 1960s, it is doubtful that including these benefits would alter our finding of a much lower rate of increase in total pay during this period relative to later decades.
3.4 Differences among executives Table 3 shows total compensation at the 10th, 25th, 50th, 75th and 90th percentiles of our sample.
The general pattern over time is similar across all groups, with relatively slow growth from the 1950s to the 1970s followed by large increases in the past 25 years. In contrast, the decline in real pay that occurred during the 1940s was experienced only by executives at the higher end of the distribution. Thus, this sharp contraction in the income distribution of executives suggests that the “Great Compression” (Goldin and Margo 1992) occurred even among some of the highest-paid individuals in the nation.
Increases in compensation during the last 20 years of our sample were more pronounced for higher-paid executives. Whereas the ratio of pay at the 90th to the 50th percentile fluctuated between 1.8 and 2.4 from 1936 to 1986, by 2005 this gap had risen to more than 3.5. This widening inequality among managers is also reflected in the average level of executive pay (see Table 3), which is more influenced by large outliers than the median. The difference between mean and median compensation was relatively small and stable prior to the 1980s, but grew substantially since then. In the 2000-2005 period, the average executive in our sample earned nearly twice the remuneration of the median officer.
The fanning out of the distribution in executive pay has coincided with an increase in the return to holding the title of “CEO.” The median ratio of a CEO’s total compensation relative to the average pay of the other two highest-paid officers in his firm was 2.6 in the 2000-2005 period, a marked increase from the relatively steady ratio of 1.4 that prevailed prior to 1980 (see Table 3).19 Nevertheless, increases in level of pay for non-CEOs were also substantial.
Therefore, the patterns documented in this paper are not specific to CEOs, but characterize the remuneration of top management more generally.
3.5 Representativeness of the sample Although the trends in pay are roughly similar for all of the executives in our sample, it is not clear how well they reflect more general patterns in the compensation of top officers in the economy. For one reason, the individuals in our sample were employed mainly in the largest publicly-traded firms, where pay tends to be higher (Roberts 1956, Kostiuk 1990, Rosen 1992).
Thus, our data do not necessarily reflect remuneration practices in smaller firms. An added consideration is how to interpret our data at points in time that are not close to 1940, 1960, or 1990—the years in which the firms in our sample were selected to be among the largest in the economy. We evaluate the representativeness of our sample in Appendix Section 3, and highlight the main results of that analysis here.
A simple graph of median pay in firms of different sizes shows that the trends in total pay are similar in both the larger and smaller firms in our sample (see Figure 4). Managers of larger firms were paid more, but compensation increased markedly in all firm-size categories during the last 25 years. Similarly, compensation stagnated from 1950 to 1980 in firms of all sizes in our sample. In Appendix Section 3.1 we evaluate the representativeness of salaries and bonuses in our sample from 1970 to 2005 by comparing them to pay in similar-sized firms from other larger datasets. Our data are similar to the other samples for firms that are among the largest 300 in the economy, suggesting that salaries and bonuses in our sample are representative of this group.
We identify the CEO as the president of the company in firms where the title “CEO” is not used (see footnote 8).
Results are similar if the chairman of the board is used instead.
We also evaluate the representativeness of our data over our entire sample period by assigning a weight to each firm that is inversely proportional to its probability of being selected among the 500 largest publicly-held firms in each year. The unweighted median level of pay in our entire sample closely matches the weighted median of the largest 300 firms in the economy.
In addition to offering a higher level of pay, large firms may also structure the compensation package differently. Somewhat surprisingly, we do not find a strong correlation between firm size and the share of stock options in total pay. Hall and Liebman (1998) find a stronger positive relationship between option use and firm size in a sample that is more representative of publicly-traded firms in the S&P 500 from 1980 to 1994. We attribute this discrepancy to the fact that the smaller firms in our sample are only included if they were large earlier on, if they will grow larger later in the sample, or if they are experiencing a temporary negative shock. Therefore, the structure of pay in these firms may not be representative of the typical small firm in the economy. In Appendix Section 3.3, we use the relationship between option grants and firm size in the Hall-Liebman data to correct the level of total pay for the firms in our sample. This exercise has little effect on the median level of total compensation in our data and does not alter our conclusions about the long-run evolution of executive pay.
3.6 Interpreting the trends in the level of pay It is doubtful that any single factor can explain the long-run trends in executive compensation, and an analysis of all of the potential determinants of pay is beyond the scope of this paper.
Nevertheless, a long-run perspective adds new evidence against which to examine some of the proposed explanations for the recent growth in compensation. We discuss some of these theories below and investigate two in greater detail in the remaining sections of the paper.
Outsized increases in the level of total pay and stock option grants in recent decades have often been related to managers’ ability to extract rents (Bebchuk and Fried 2004). However, the long-run trends in pay seem inconsistent with this theory because both external and internal corporate governance mechanisms were most likely weaker earlier in the century (Jensen 1993, Holmstrom 2005). Among the firms in our sample, the median fraction of the board of directors occupied by officers of the firm fell from 0.42 in 1950 to 0.18 in 1990.20 More generally, proxy fights and takeovers were rare prior to the 1980s (Holmstrom and Kaplan 2001), boards of directors have become smaller and more independent since mid-century (Lehn, Patro, and Zaho 2003), and both the ownership of institutional shareholders and shareholder activism have increased since the 1950s (Khurana 2002, Gillian and Starks 2007). These aspects of corporate governance are not comprehensive, nor do they rule out a positive effect of poor corporate governance on compensation, but nevertheless they suggest that the ability of executives to set their own pay may have diminished over time.21 On the other hand, improvements in board diligence over time may actually have contributed to the upward trend in executive pay (Hermalin 2005).
A second proposed explanation for recent increases in executive pay is related to managerial talent and the labor market for executives. Theories of the span of control (Lucas 1978, Rosen 1982, Rosen 1992), superstars (Rosen 1981), and competitive assignment of CEOs to heterogeneous firms (Tervio 2007, Gabaix and Landier 2007) predict a positive correlation in the cross-section between firm size and compensation. In fact, a vast number of studies have documented that CEO pay tends to be 0.3 percent higher in firms that are 1 percent larger (Rosen Board membership was constructed by matching the names of the executives in our data to a list of the board directors from Moody’s Manual of Investments. Thus, the fraction of insiders in the board is probably underestimated since we lack information on grey directors.
For example, Bertrand and Mullainathan (2001) find that executives in corporations with weak corporate governance are remunerated for lucky outcomes.
1992). Moreover, extensions of these models propose that the variation in compensation over time is related to aggregate firm size (Gabaix and Landier 2007). This framework seems promising because recent decades have experienced large increases in both the level of pay and the value of publicly-traded firms (Hall and Murphy 2003, Bebchuk and Grinstein 2005, Gabaix and Landier 2007). However, the long-run trends are inconsistent with this hypothesis, as the relationship between compensation and the market value of firms has not always been as strong as it was in the past 25 years. Aggregate market capitalization (measured by the S&P 500 index) increased considerably during the 1950s and 1960s, but the level of pay experienced little change (see Figure 5).22 In Section 4 we present further evidence on the link between executive compensation and firm size in order to better assess the role that this connection may have in explaining the long-run evolution of managerial pay.
A third proposal relates the upward trend in compensation to the rising use of incentive pay since the 1980s, as higher remuneration may be necessary to compensate executives for a riskier stream of income. Among other problems, this hypothesis has been difficult to assess because consistent estimates of the correlation between pay and performance are only available since to the 1980s, a period of simultaneous increases in the level of pay and in pay-toperformance. We return to this issue in Section 5 by calculating consistent measures of pay-toperformance that span the past 70 years.
4. The relationship between the level of executive pay and firm size
4.1 Decomposition of the correlation between total compensation and firm size Prior studies of executive pay relied on the gains from exercising options to value options prior to 1980, but these values are mechanically correlated with the market value of firms. Because we calculate the value of stock options granted using the Black-Scholes formula for the entire sample, our measures of total pay are not subject to this concern.
To better understand the relationship between firm size and the level of pay, Table 4 fully
(reflecting the size of a typical firm in the market), average size of each firm across all years (reflecting firm-specific factors), and the difference of firm size in each year from these yearspecific and firm-specific averages (reflecting transitory changes in firm size that are unrelated to market fluctuations). We estimate the correlation between each of these factors and the
compensation of each executive in our sample from the following OLS regression:
where Sjt is firm j’s size in year t, St is the average size across all firms in our sample in year t, and S j is the average size of firm j across all years. We measure firm size using the firm’s market value and break the sample into two periods in order to examine how these correlations have changed over time.23 Firm-specific and idiosyncratic components of firm size had a positive and significant effect on compensation over the entire sample period (the coefficients were both around 0.2 to 0.3, and did not vary noticeably across periods). However, the role of aggregate market value has changed markedly over time. During the second half of our sample, the relationship between executive pay and the average market value of firms was roughly 1-for-1 (col. 3).24 However, we estimate a much smaller coefficient of 0.1 in the first 40 years of our sample (col. 1). This We use the average across firms to represent aggregate market size because it fits easily into a variance decomposition framework. However, our results are robust to using other proxies for aggregate market size including the median market value in our sample, average and median market value in the largest 500 publiclytraded firms, and the S&P index.
These results are in line with the effects reported by Gabaix and Landier (2007), who use a much larger sample of firms from ExecuComp from 1992 to 2004.
result cannot be explained by unusual factors related to the Depression or World War II, as we find a similarly small coefficient for the period 1946 to 1975 (col. 2).25 The bracketed values in Table 4 report the fraction of the variance in compensation that can be accounted for by each of the independent variables.26 The firm-specific component of size explains between 13 and 17 percent of this variation in both periods, while idiosyncratic shocks to firm size account for another three to four percent. By contrast, the importance of aggregate firm size has changed substantially over time: it explains between 25 to 30 percent of the variation in pay from 1976 to 2005, but only two percent in the first half of our sample. The second panel of the table replaces the average size of each firm with a firm fixed effect, providing a more flexible way to control for firm-specific factors. The estimated coefficients on the other two variables are unchanged. Thus, the cross-sectional relationship between firm size and executive pay has remained relatively stable over the past 70 years, while upward and downward shifts in the distribution of firm size have only affected the level of compensation more recently.27