Why aren’t free agent contracts front-loaded?

‘Tis the season.  No, not that season.  It’s free agent season, when teams take a look at would-be employees and sign them to ridiculous-sounding contracts.  For a moment, I can leave aside the thought that no person should make $20 million dollars for playing baseball, and even put aside the sour taste in my mouth from the most recent Yankee spending spree.  There’s something else that confuses me in free agent signings.  Why is it that the contracts are all backloaded?

Recently, players have been signing contracts for multiple years which gently increase in value over the term of the deal.  (i.e., Smith makes $10 million this year, $11 million next year, $12 million the year after that).  At the very least, the contract simply pays the same flat salary over the course of the contract.  Why do teams and players sign these contracts with one another when it would make more sense for both to have the contract front-loaded?

Let’s get a few things out of the way.  Because of the way that the labor contract is set up, most players on the free agent market are in their late 20s at the youngest, and some of them are well into their 30s.  Statistically, we know that players start to decline at this point.  They may be descending slowly from great heights, but in terms of on-the-field performance, it’s all downhill from here.  Why pay more for a depreciating asset?  The following strategies wouldn’t really apply to signing a young player on the upside of the growth curve.  So, let’s assume the player in question is a player at his peak or even past his prime.

Some of the answer of why salaries are back-loaded probably has to do with the escalating salaries that the market will bear.  I chuckle to think that in 1997-1998, there was talk of the Indians trading for/signing Pedro Martinez, then of the then-Expos, but they balked at the thought that Martinez would command a 6 year deal at $12M per year.  (If only…)  That same deal will now get you Carlos Silva and a utility infielder.  This year’s player worth 9 million might command 10 million next year or in two years.  So maybe the teams are just building in cost-of-living adjustments, but is the COLA based on the player’s current talent level or his projected actual value adjusted for inflation.  Either way, the inflation of the market is something that can be built into a projected value system.  I’m not an economist, but it can’t be that hard.

So why would it make sense to front-load a contract?  From the player’s perspective, it’s simple.  Suppose a team is willing to pay me 10, then 11, then 12 million dollars over three years.  When would I rather have the 12 million dollar payday?  If I’m a wise player with a good financial advisor, I’d say give it to me now.  Better that the money be sitting in my account gathering interest than in the club owner’s!  I come out ahead if I make the money as 12-11-10 instead of 10-11-12.

Why would it make sense for the team to front-load the contract?  The case is less clear-cut here, but I think there are a few strategic advantages to be had.  In last week’s roundtable, Eric asked a question that contained a rather astute observation on the status of the market.  Teams often seem to value players by thinking “What is he worth now?” and signing him for that much over the course of 4-5 years, not even taking deteriorating skills into account.  Let’s leave aside how flawed the thinking in how to value players often is.  They have a formula (HR + RBI + SB) that they use and it spits out a number.  We’ll go with it.

I have to wonder if this failure to recognize diminishing skills is partially responsible for the salary “explosion” in recent years… consider the following for a moment.  Smith is a free agent third baseman in 2006 and signs a 5 year deal worth 10 million per year.  At the time, he really was worth 10 million a year, but on the false assumption that he would stay young and pretty forever, he gets 10 million in each of the next 5 years.  After 2008, his skills have dulled a little bit, but he’s still getting paid 10M, even though he’s really only putting up about 7 million in results.  Jones (not Chipper) is a free agent third baseman after the 2008 season, and has been an up-and-comer.  He points out that he had a better year in 2008 than did Smith, maybe something around the neighborhood of $8 million worth of value.  But, Jones says that since he had a better year than Smith, he deserves more than Smith is being paid ($10M) and asks for $11 million, if not more.  In three years, the cycle will repeat itself.

But other than controlling salaries, there’s another advantage to front-loading the contract.  Consider how many teams have “albatross” guys on their rosters.  They are guys who aren’t useless and should have a roster spot, but are in the later years of long-term deals and due to those diminishing skills, are now scheduled to make an amount of money well beyond what they will be worth.  They’re hard to move in a trade because of the big salary, but the contract eats up a lot of this year’s payroll, so his team can’t go out and sign someone else to bolster the roster.  In a front-loaded contract, his salary is now much lower and either he’s easier to move if he needs to be traded or his salary number doesn’t look so out-of-line with his production.

With this in mind, why contracts continue to be back-loaded?  On the player’s side, I often hear about players wanting to guarantee themselves a good income later in the future.  Considering that we have a country where the savings rate is negative 3% (Americans spend 3% more than they earn, on average), it’s not shocking that there’s a lot of financially illiteracy out there.  Take the money up front and find a nice investment manager who will grow the money.  You’ll actually make more in the long run.  Plus, in that last or next-to-last year, you’re more attractive to a contending team at the trading deadline.  If the team you originally sign with is floundering, you’ll have made your money and maybe you have a better chance at going to a contender.   The logic makes sense to me. 

But I think that from the player’s perspective, back-loading has more to do with the fact that in America, no one wants to be told that they will grow old.  In America, growing old is apparently the worst thing that could ever happen, even though all of us will.  Rationally, we know that players’ skills will regress as they get older, and I’m sure that the players probably understand that too.  Except that people are very good at assuming that the laws of physics apply to other people and not themselves.  Oh sure, Jones and Smith will fade out, but I won’t.  And teams don’t have the guts to tell players that they will grow old.  Who would want to play for a team that thought he would depreciate, when in his own mind, he (falsely) believes that he is an exception to that particular rule?

Then there’s the (how to keep this PG?) “I have a larger nose than you do” (in the 18th century sense of the word) factor.  I want my salary to keep going up because I know that next year, someone will sign a slightly bigger contract and I want to continue to be the highest paid (shortstop/guy from Pennsylvania/third starter) in the game.  We’re dealing with a bunch of guys.  When have you not known guys to try to one-up each other?

On the team’s side, there is something of a justification for back-loading a contract.  Suppose that a team needed “one more piece.”  They know that in the long run, they’re signing a bad contract, but in the short run, it maximizes their chances for this year.  Baseball executives live from year to year and have very little incentive to think about the distant future (primarily because they will be fired in the meantime).  So, the system is set up to reward bad, long-term contracts, which push up salaries, which breed things like the New York Yankees.  All because people can’t think rationally.

There’s one other problem.  My plan wouldn’t work in isolation.  It would require… well, collusion.  Suppose that one team made an organizational decision to use front-loaded contracts.  For the above reasons, free agents would simply go to other teams… and someone has to play for your team.  A good number of teams would have to wise up (on their own, as collusion is illegal), and that would take years.  Game theory at its finest!  The reward of simply sticking with the status quo is a chance at short-term success, even if it has all the unfortunate side effects of higher salaries and lessened roster flexibility.  The price of trying to buck the system is probably getting fired before it caught on, if ever at all.

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8 Responses to Why aren’t free agent contracts front-loaded?

  1. Paul Singman says:

    I’ve often wondered the same thing, usually when playing franchise mode in Madden.

  2. themarksmith says:

    I wonder if a few free-agents wouldn’t like that type of deal. I have wondered as well why teams don’t do this, and I think you make an excellent argument. However, just like I like green and you like red (or some other color), wouldn’t a free-agent have different feelings towards the type of contract? I think it has more to do with, as you said, the philosophy of “I need one more piece”. I’m not so sure that a free-agent would be opposed. It may be that they never get the option. Then again, I’ve never been in a front office before.

  3. themarksmith says:

    Oh, and Paul, hilarious. Then again, I never get past the first season or two to worry about it, just like real-life GMs, except for a different reason.

  4. Mark says:

    Player contracts are backloaded because of Net Present Value. It is a finance concept. That is the number 1 reason.

  5. Nathaniel Dawson says:

    One other reason that also has to do with a players ego. He is likely to get a larger total value on the contract if he backloads than if he frontloads.
    6 years, $80 MM sounds a lot better than 6 years, $72 MM.

  6. @ Mark:
    For sure, it’s Net Present Value—probably nothing more. The NPV of $12 million in three years, is significantly less than the PV of $10 million right now.
    Of course, the caveat to the NPV argument, which I think is undoubtedly the rationale in play, is that we’re facing a series of significant deflationary pressures. Even if the Fed were to finally release some of the burgeoning monetary base, interest rates are likely to remain low and could make front loading a rational choice.

  7. MattS says:

    It has to do with who has a higher rate of return. The teams have higher rates of return than the players– look at the average annual growth rates in baseball teams’ values and compare them to the stock market. Baseball teams increase more in value per year than the average portfolio that individual players have. Therefore, there is an incentive for teams to offer the player the same present value (from his perspective) with more money coming towards the end of the deal, since this will be a smaller present value from the team’s perspective (i.e. based on their interest rate).

  8. jw says:

    Nice post. I’ve been toying with a similar train of thought recently.
    The psychology of it is probably the biggest reason. No player wants to see his salary decrease as he plays. In conventional business most people gain value through experience and therefore should increase salary as they accrue said experience. In physical sports the opposite happens, but everyone involved is mostly stuck in the other mindset.
    One thing to keep track of is the increasing risk of a player. As they age even if they keep performing at the same level as they initially signed they’ll be more likely to get injured. When working out contracts GMs need to consider a risk premium in addition to the monetary cost for the player. Vernon Wells will be paid 22 million near the end of his contract and he will be less healthy and thus his total cost will be higher even if he was paid a flat rate throughout the length of his contract.
    On the other hand, with the rate of escalating contract values, the opportunity cost of capital will decline sharply over the length of the contract. Basically, the opportunity cost is the value of the next best alternative for your money. So the opportunity cost of AJ Burnett at the beginning of his contract with the Jays was something like the value of Kevin Milwood. During the 2008 season, the opportunity cost of AJ was the value of Carlos Silva. Milwood might not have been the greatest example, but clearly the opportunity cost for Burnett declined over the years of his contract.
    Total (real) cost is equal to monetary cost plus the risk premium plus the opportunity cost. Compare that to the value of the player for each year of the contract.

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