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WARNING: Moral hazard ahead

Do you ever scratch your head in confusion when you see the contract amounts of some professional athletes? Don't get me wrong, I am all for athletes making as much money as they can. For one, the economic value provided to an organization and city oftentimes makes "large" contracts seem small in comparison. But, perhaps most importantly, it's not my money. As long as my team is getting better today, why would I care how an owner spends their money, even if it might create a more difficult financial situation for a team in the future by carrying this large contract? General managers and team executives likely have similar thoughts, showcasing an insight into an interesting phenomenon at play in many baseball front offices known as a "moral hazard."

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Let's put ourselves in the shoes of a general manager (GM) of a sports team. The goal of a GM, simply put, is to make a team as competitive as it can be within the confines of how the team operates financially, which is dictated by the team's owner. Some GMs never really have the opportunity to spend much money compared to other teams. Perhaps the team's owner is not willing to spend past a certain amount, or perhaps the team operates in a smaller market with fewer opportunities to capture the revenue needed for increased operating budgets and player salaries. However, some teams do have an opportunity to spend lavishly on player salaries to achieve the GM's goal of creating a competitive on-field product (in 2022, the average MLB payroll was $150.3 million, with14 of the 30 teams above the league average amount). This is a great position for a GM to be in because they often have very short windows of being able to compete for a championship. In a study conducted by The Athletic, the median tenure of a MLB organization’s GM is just 5.5 years. 5.5 years! With this time pressure lurking, how are GMs supposed to think about how to be competitive not just in the moment, but also in future years? Well, that's the thing. They often can't be focused on both, which leads to consequences for someone else to deal with down the road.


Take for example, my favorite baseball team, the St. Louis Cardinals. Albert Pujols, one of the greatest players in the history of the organization, was a free agent during the 2011-2012 offseason, meaning he could sign with any team at that time. The Cardinals made Pujols an offer that they considered fair for his age, expected production, and anticipated financial value to the organization. However, Pujols ultimately signed a 10 year, $240 million contract with the Los Angeles Angels.


This contract, while enticing enough to bring Pujols to the Angels, drew skepticism from the baseball community, with many believing that this deal would prove unwise for the Angels down the road; Pujols may have been worth $24 million a year at the time of the signing, but he would likely see decreased production as he aged into his late 30s and early 40s, making his value to the team significantly less at that time than someone making that much money, or maybe even several players making that much money combined. But, for the Angels GM at the time, Jerry Dipoto, this was likely not a huge concern because of a potential moral hazard at play. Again, with the average tenure of GMs only being 5.5 years, Dipoto was unlikely to see the potentially negative effects of this contract in its final years. Dipoto knew that if Pujols played well with the Angels in his first few seasons that he would look like a genius for securing the contact needed to bring him to Los Angels as they competed for a championship. However, Dipoto also knew that if Pujols did not live up to his contact value (he did not) and produce the results the team was hoping for, either now or in the future, Dipoto would likely be fired or resign, making it someone else's problem to sort out the negative effects of signing an aging player to such a large contact (Dipoto ultimately resigned in 2015, less than four years after being hired).

A moral hazard represents a risky action that someone takes due to the lack of consequences that would be incurred in the future because of that action. Why would Jerry Dipoto care that he is giving a potentially risky contact to Albert Pujols? If the contact loses its value (which it very quickly did), then the consequences of that contact will be incurred by some future GM, while Dipoto can move on to a new job with a new team (he has served as an executive in the Seattle Mariners organization since 2015).

As we'll see, moral hazards don't just exist in baseball. They exist in workplaces and in our daily lives. By better understanding the structures, mindsets, and situations that allow for moral hazards to influence our actions and the actions of those around us, we can work to create more sustainable and ethical decision making.


If you found the Albert Pujols story interesting, consider further exploring moral hazards in baseball through Keith Law's book that I referenced in my last post.


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So where exactly do we see moral hazards in our own lives? Let's start with our cell phones. The latest iPhone could cost us $1,000, making it potentially difficult to stomach the cost of insurance on top of the price of the phone.

You are probably thinking, "I am very careful with my phone and other valuable electronics, so why would I need insurance?" But, just for the sake of this exercise, imagine that you did buy the insurance. The phone companies and Apple would like to think that you'll take the same careful actions with your phone as though you don't have insurance so that you don't need a new phone to replace your broken one, and they can receive the financial benefits of this transaction. But, that doesn't make sense, does it? Why would you be just as careful with your phone when there is insurance that could replace it for you? Just as a baseball GM doesn't care about the risky actions taken today that could be potentially disruptive for someone else in the future, you may not be as careful with your phone today with insurance because it will be someone else's problem if it breaks.


Moral hazards, however, can be seen on much larger scales with more significant consequences than your favorite professional sports team or your technology decisions. It has often been argued that the financial crisis of 2007-2008 was driven in part by moral hazards. Asset managers, originators, and banks took on oversized risks in the short-term because of the upside that those risks carried, all while being able to be bailed out by the government and the public, who ultimately paid the price. Perhaps moral hazards were not entirely in play here due to losses still occurring for these parties and because maybe they did not assume they would be bailed out, but we can quickly see how short-term benefits from actions today can carry significant risks to be incurred by someone else in the future, creating potentially disastrous consequences.


What if we are seeing these same actions in our own workplaces? How do we incentivize individuals to take actions that are beneficial for them in the short-term, and also beneficial for a larger group, team, or even themselves in the long-term?


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In business school we are often taught that the way to entice executives to take actions for the long-term betterment of stakeholders, as opposed to short-term, is by directly aligning executives’ incentives to long-term goals. Instead of solely rewarding executives with bonuses for meeting a quarterly financial target, organizations can also reward executives with bonuses for meeting emissions targets, improving supplier diversity, and achieving safety goals over longer periods of time. Additionally, organizations can make the bulk of an executive's pay based on these metrics so that they carry sufficient weight in a decision-making process. Therefore, an executive can be incentivized to think about how to improve the company's future outlook and those directly affected by the company, not just focus on slashing costs, making unwise acquisitions to boost short-term revenue, and ignoring ESG concerns to improve a financial position today.


These incentives that encourage long-term thinking and decision making are not just beneficial for large Fortune 100 companies; they can be beneficial on smaller, more direct scales in our own lives. Yes, maybe the insurance on your new iPhone would provide some assurance in the event that you happen to break it, which causes you to act more carelessly. But, what if phone companies assessed the value of your old phone before you purchased a new one so that you could receive a cash-back offer in the future if you handled your phone with care (oh wait, AT&T is actually doing that now)? What if GMs were honestly evaluated based on their previous signings when interviewing for new positions, not just their grand visions for the future with a new owner's money (something explored on The Hardball Times by attempting to rank GMs, in part, by their expected wins compared to their teams' payrolls)? What if we rewarded the employee who created a fantastic new onboarding process that they may never even see utilized by granting spot bonuses or a reward system for going above and beyond (explored by Harvard Business Review)?


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What can we do as leaders to help our teams to win today and in the future? We can start by creating the structures, systems, and incentives that reward the actions we want to see.

  1. Develop policies and guidelines that expressly prohibit certain behaviors. If we are aware of the specific risky actions that may produce short-term wins, with potentially disastrous long-term outcomes, note these actions in the policies that team members need to avoid. Be explicit about what actions should and should not be taken without giving an opportunity for a moral hazard to be at play.

  2. Create incentive structures that reward the behaviors you want to see. So many positions we see in our careers provide high fixed salaries with smaller, variable bonuses. What if this was changed? In addition to the specific ways mentioned above on how organizations can change the incentive structures for top executives, those same organizations can significantly change the amount of salary that is tied to bonuses so that executives actually want to achieve these goals. According to Harvard Business Review, in North America, 75% of total CEO compensation comes from long-term incentives. It's certainly difficult to make decisions that could negatively affect the future when your salary is tied to being with the organization and succeeding in the long term.

  3. Provide benefits that make your employees want to stay. If you are worried that team members might be taking actions influenced by them not being around to see the potential risks realized, create reasons for them to want to stay because of fantastic benefits that they would not find anywhere else. This allows them to view their decision-making processes with their own futures in mind.

Like many biases, we often just need some awareness that they are present. However, awareness without action is useless. If we want to avoid our teams falling prey to moral hazards, we need to examine the systems, structures, and incentives that can better align to and reward the actions we want to see for sustainable success.

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