2012-08-11 – What do CEOs and firefighters have in common?

If you said they both take big risks, you’d be wrong. Firefighters do take big risks, but CEOs don’t, for the most part. Firefighters’ risks are obvious. Regularly entering burning buildings does not make firefighters preferred life insurance customers. But you may think CEOs are risk takers. After all, they deal with uncertainty every day.

The question is: whose risk do they deal with. When a firefighter goes to a fire, it’s his or her skin that is on the line. When a CEO makes a “tough” decision, though, he rarely has much skin in the game. A bad decision could lose jobs for employees or lose value for shareholders, but the CEO’s personal exposure is minimal. What’s he risking? Okay, his own stock value may be impaired, but cash compensation and golden parachute payments that come his way when he flees the sinking ship are pretty decent insulation from the fortunes of the corporation he leads.

So, what do CEOs and firefighters have in common?

They both enjoy benefits that their employers think they don’t have to pay for.

In the case of firefighters, it’s the unfunded pension plan. (Yes, I’m sure not all firefighters have unfunded pension plans across the country, but many do.) The beauty of an unfunded pension plan is that municipal employers (mayors and city councils) can give public employees a “raise” without spending any cash, if they give it in the form of a promise of future retirement benefits. It’s called an unfunded pension plan.

Federal law requires most companies to fund their pension plans according to a payment schedule that forces the company to fully fund their plans in a relatively short period of time. This law does not apply to public employers or to certain collectively bargained pension plans. The mandatory funding law is obviously a good idea. Before the law was enacted, private pensions regularly went belly up. Now the pensions that get into trouble are exactly those plans that are exempt from the funding law.

Unfunded pension plans are beautiful when the promise is made. But they turn ugly when the promise has to be kept. In other words, they predictably become ugly when the time comes for the employee to collect the pension.  The first few years may be okay, but sooner or later such funding as there is becomes inadequate.

CEOs also enjoy a “free” benefit. When you hear that a CEO is getting $100 million in pay, typically only the first million, or even less, is in cash. The rest comes in the form of a variety of stock rights.

You may say that this undercuts my argument about risk that I made at the top of this post. By having $99 million in some form of stock, you could say that 99 percent of the CEO’s pay is at risk. You could say that, and we’ll get to that in a minute, but first I want to talk about how this form of pay is viewed as a cost-free benefit, in the same way as municipal employers view the unfunded pension plan.

In both cases, the employer is able to make big promises to the employee (CEO or firefighter) without spending a dollar in cash. What could be better?

But now, we come to a difference between the firefighter and the CEO.

The firefighter takes the promise and keeps running into burning buildings for 20 or 30 years, counting on the pension being there when he retires. If it’s not, he’s out of luck.

The CEO takes the promise, but normally doesn’t have to wait to begin converting the promise into cash. In most cases, he will almost immediately begin a program of gradually converting his stock or stock rights into bankable cash. He may not be able to access all the money today, but he doesn’t have to wait long. So, if you say the CEO is taking a big risk by accepting part of his compensation in stock options, the risk isn’t as big as it seems. The CEO can usually get a sizable amount of money out before any troubles occur.

That’s not true for a firefighter. For 20 or 30 years, his skin is at risk. And his pension is, too.