We live in a society where we parcel out almost everything we do, from mowing the lawn to selling our home. In ivory-tower terms, we use agency theory every day.
Editor's note: This article originally ran on Five Cent Nickel. It has been reprinted here with permission.
We live in a complex world where many things happen around us that we’re at a loss to understand or explain. High CEO compensation, soaring health care costs, a biased media and politicians being bribed are but a few of the things we see wrong with the world. Those (and other) problems have their root in a single trait of human nature. The study of that trait is called agency theory.
In a nutshell, agency theory states that when a principal hires an agent, the agent is supposed to act in the best interests of the principal. However, despite being compensated in accordance with the principal’s interests, agents will pursue their own best interests, even at the expense of the principal compensating them. That may sound abstract and ivory-tower irrelevant to your daily life, but it isn’t. It affects your pocketbook, directly and often.
Take health insurance. The insurer collects premiums from millions of people and becomes the gatekeeper for your medical expenses. Doctors, pharmacies and hospitals all have to submit their claims to the insurance companies for payment. You would think those insurance companies’ interests would be aligned with yours and the other policyholders: The less they pay out in claims, the more money they keep. You would think that they contest claims and negotiate them down to the lowest possible number to save everybody money.
You would be wrong. Their incentives work in exactly the opposite way. It didn’t start out like that, though. In the beginning, it worked as planned: Insurance companies predicted what claims would be and set their premiums a little above that (let’s say 30 percent) in order to cover their expenses and leave them a little profit.
It took only one bad year for insurers to discover something nobody thought of. Claims, despite their best efforts, happened to be higher one year than expected. That, as you can imagine, ate into the allowance they had set up to cover their costs. The outcome? No profits, no bonuses, no raises, no budget to hire help to process extra claims.
So, the following year, they told their employer clients, “Look, guys, we lost our shirts last year. We have no choice but to increase our rates across the board. You’ll see everyone’s doing the same.” Employers looked around and, sure enough, all insurers were upping their rates.
The insurance companies’ “30 percent” increased the following year on the backs of the higher premiums. Then there was enough in the budget for help, raises and bonuses, especially at the top level. However, halfway through the year, the brass discovered claims were dropping again. They faced a tough choice.
- Lower their premiums the following year (They couldn’t very well go back to their clients and say, “Hey, guys, claims were down, but we’re going to keep raising your premiums.”)
- With much shoulder-shrugging and crimped mouth corners, explain that claims went up yet again, necessitating another round of premium increases. But, of course, claims would need to actually have gone up for them to do that. Hmmm what to do?
If they followed the first course of action, their 30 percent would go down. That would mean no raises or bonuses. However, if they were forced to show the clients an increase in claims, then their 30 percent would grow the following year. Saving cost (by laying off part of their workforce) and raising next year’s 30 percent — Can you spell “no-brainer”?
It’s no surprise that, after a decade or two of following this system, America has one of the highest-cost health care systems, with one of the worst in terms of outcomes. It’s also no surprise that their combined lobbies pushed for Obamacare, which simply takes that system, offering the same policies as before, but forcing everyone to buy.
But wait, there’s more
Speaking of CEOs and their skyrocketing compensation packages, that’s another face of agency theory in action. Boards are supposed to represent stockholders and keep compensation to CEOs to the minimum needed to get the job done. However, CEOs stock the board with other CEOs and together they embark on a strategy of back-scratching: “I’ll approve a raise for you if you do the same for me.” Again, the agents look out for themselves first, at the expense of the people they’re supposed to represent.
Well, this is interesting and fine for a good after-dinner rant or two, but how does it affect you (other than paying more for your health care)? In a general way, it’s a warning to beware of assuming others will do well by you just because you pay them to protect your interests.
Take real estate agents, for example. When you sell your house, your Realtor will tell you that your interests are aligned: He gets more money if he pushes for the maximum price for your house. That’s good theory, but it doesn’t necessarily work in practice.
Here’s the math:
Let’s say you want $400,000 for your house. Normal Realtor commission is 6 percent, split between two agents. If your agent works for an agency, they will usually take half, more or less. That means your agent makes 1.5 percent, about $6,000 on the sale of your house. Another $10,000 for your home would only put $150 more in his pocket, but it would take a lot of extra work to get that $10,000 for you. Which do you think he’ll push for: a quick sale so he can move on to the next $6,000, or the heavy pursuit of another $10,000 for you for $150?
You may do better if you:
- Stick to your guns on your price, especially in the seller’s market we seem to have today.
- Pick an agent who’s a one-person show and, therefore, gets to make $300 extra for that extra $10,000.
Another example comes from the world of financial planners. Nothing against them as individuals or as a group, but their best interests are not always directly aligned with yours. It is tempting to hand your money to someone else and expect them to get the greatest possible return for you, or at least more than you could earn yourself. You have to know that, although they may indeed pursue good returns for you, their first priority will be their own well-being not yours.
Abdicating responsibility for your money can be very expensive, without your even realizing it.
As stated in the opening, we live in a society where we parcel out almost everything we do, from mowing the lawn to selling our home. In ivory-tower terms, we use agency theory every day.
If you understand agency theory, you may be surprised at how many ways you can make or save money. (Oh, and by the way, it is always better to invest than to complain. After the passing of the ACA, I shifted some of my investments into health care stocks. They’ve outperformed everything else in my portfolio.)
You have the option of involving yourself to a greater or lesser degree in all areas affecting your wealth. The point of this post is understanding that your cost for subbing out a service may be more than the cash you pay for the service.
In general, the more you involve yourself in anything, the bigger the payoff. That time and effort can put cash in your pocket.