Saturday, December 27, 2008

Backloaded Contracts

I don't like this piece at all; it defies the normal good quality of content over at Statistically Speaking.

The article asks a simple question--why are contracts backloaded?--and proposes several arguments that have little real-world application:

- Jones wants to be paid more than Smith because he's a better player right now than Smith, who has declined significantly since signing his free agent contract years ago. Some dumb team accepts this reasoning and incorrectly pays Jones a higher average annual salary than Smith's.

This offseason, A.J. Burnett and Ryan Dempster have signed long-term deals for less per year than Barry Zito is getting, and I'm sure no one would argue Zito is the better pitcher right now. Mark Teixeira and C.C. Sabathia will each make less in 2009 than Jason Giambi did in 2008. I don't think this hypothesis is correct in practice.

- Players refuse to believe they will grow old, so they demand an escalating salary to prove that they will improve with age.

If I believe I'm going to improve or stay at this level as I age, why am I signing a five-year deal worth $65 million when I can take $17 million for one year and re-enter the market in a stronger position next offseason? Surely the risk of a career-ending injury next year is not that great, and if you buy the idea that salary is most important as a status symbol, $17 million fares a lot better in a measuring contest than $13 million.

A marquee free agent seeks a long-term deal for the exact opposite reason: he (or his agent) knows this is likely his last big payday, so it's time to make the most of it.

- It's more difficult for a team to manage an "albatross" contract than to consistently overpay him from year-to-year.

I would argue that if anything, albatrosses get traded more often than other players. There always seems to be some team that believes a change of scenery will help the player, who must have been good at some point to earn such a large contract. (Well, not always.) Of course, you'll often have to eat some cash to swing such a trade, but the ability to equalize a trade with money proves that a large salary is not a barrier to a trade in and of itself.

Teams have also shown a willingness to release players who are worth nothing to the club, even if they have plenty of money left on their contract. Russ Ortiz was released with $22 million still due him. Frank Thomas and Richie Sexson were cut last year in the middle of earning $8MM and $14MM respectively for 2008.

- Baseball players are financially illiterate and want to guarantee themselves a high income in the future.

Most baseball players are well aware that they are financially illiterate, which is why they hire an agent to negotiate their contract for them.

How often do you hear about a player voluntarily asking for his salary to be deferred for 20 years, to ensure a solid income well into retirement? Even a baseball player knows that a dollar today is better than a dollar in 2030.

The article does contain hints at the right answer. Player salaries are something of a measuring contest, as there is an element of pride in having a higher salary than a comparable player. And because players aren't finance majors, they're likely comparing average annual salaries rather than the net present values of their contracts. A team, on the other hand, concerns itself with things like time value of money, so it is in their interest to pay the player as late as possible.

How can a team give a player a higher average annual salary while holding constant the total value of the contract? By backloading it. As any FIN 101 student could tell you, a contract structure like Sexson's (05:$4.5M, 06:$11.5M, 07:$14M, 08:$14M) is considerably less costly to the team than simply giving him $11M every year--and much better than frontloading a $44M deal.

I doubt anyone making $5M in 2005 tried to win a measuring contest with Sexson. Through the magic of backloading, everyone was happy*.

*Well, except the Mariners when Sexson sucked.

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