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«Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Executive ...»

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Although incentives were never inconsequential, we do find significant fluctuations in pay-to-performance over time, as this correlation was much stronger in recent decades.54 This result is not inconsistent with the theory that higher levels of pay have been needed to compensate executives for optimal increases in the strength of incentives. However, this explanation seems unlikely to fit the long-run trends in the level of pay because we find meaningful increases in pay-to-performance in periods that experienced little change in compensation.

We cast our findings in terms of managerial incentives, but we want to stress that we simply document changes in the correlation between executive wealth and the market value of firms. This correlation may motivate executives to improve firm value, but it does not reveal the intentions of shareholders. Although the evolution of pay-to-performance may reflect changes in One explanation for this regime shift in pay-performance sensitivities could be an increase in the aggregate demand for top executives (Himmelberg and Hubbard 2000).

the optimal contract between managers and shareholders, it also may be an unintentional byproduct of other factors that have altered the structure of executive pay.55

6. Conclusion In this paper, we document important changes in the level and the structure of executive pay from 1936 to 2005. The real value of total compensation followed a J-shaped pattern over our sample period. After a sharp decline during World War II, the level of pay increased at a modest rate from the mid-1940s to the mid-1970s, and then rose at an increasing rate from the 1970s to the present. The composition of executive compensation also changed considerably since the 1950s, as both stock options and other forms of incentive pay became larger shares of total compensation over time.

The relative stagnation of compensation during the 1950s and 1960s is surprising because the level of executive pay did not keep pace with the growing size of firms during this period.

By contrast, pay and firm size have been more strongly correlated in recent decades.

Decomposing the relationship between compensation and firm size into its cross-sectional and time series components, we find that the cross-sectional relationship has remained relatively stable over the past 70 years. On the other hand, while the level of pay moved almost one-to-one with the average market value of firms over the past 30 years, this correlation was one-tenth to one-third as large in the 1946-1975 period. Moreover, the strong correlation that we find in the later period may be biased upward by spurious correlation in the market value of firms and the level of pay.

Examples of these other possible factors include changes in the corporate governance of firms (Bebchuk and Fried 2004, Bertrand and Mullainathan 2001), tax advantages of certain instruments of pay (Hall and Liebman 2000), regulation (Rose and Wolfram 2000), and product market competition (Cuñat and Guadalupe 2006).

The transformation in the structure of compensation over the past fifty years has important implications for managerial incentives because incentive pay ties an executive’s wealth to the performance of the firm. Using a broad measure of executive compensation that includes salaries, bonuses, stock option grants, and revaluations of stock and stock option wealth, we find that the pay-performance sensitivities were considerable in most decades except the 1940s and the 1970s. Thus, compensation arrangements have served to tie the wealth of managers to firm performance — and perhaps to align managerial incentives with shareholders’ interests — for most of the twentieth century.

The long-run trends in executive compensation allow us to reassess several common explanations for changes in the level and structure of pay over the past several decades. The data prior to the 1970s are inconsistent with theories of managerial rent-seeking, a competitive labor market for executives, and increases in managerial incentives. These explanations may still help to explain the recent surge in compensation, but only if the determinants of executive pay were different in the past. Plausible reasons for such a shift may involve changes in the nature of the tasks carried out by top executives (Murphy and Zábojník 2004, Frydman 2005), or in social norms that may have constrained inequality in earlier decades (Piketty and Saez 2003).

Alternatively, changes in managerial pay over time may have been driven by other factors, such as the development of alternative job opportunities for executives (Kaplan and Rauh 2006), improvements in board diligence (Hermalin 2005), and the rise in peer group benchmarking (Murphy 1999). By providing a contrast to recent data, the long-run trends in managerial pay present a challenge that we hope will further our understanding of the determinants of executive compensation.

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