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Understanding the Machine Against Which We Rage

The stratospheric compensation of modern big-business CEOs has been in the news again recently, and it’s become a discussion point amongst some of my friends. How can one person possibly be worth that much? is a common, and completely understandable, refrain.

My reply? “Aren’t you on like a 2% mortgage rate right now?”

What do those two things possible have in common?

In any economy, all things involving money are connected. Understanding those connections is what lets you navigate the system more proficiently, and at least better grasp the rules of the game in which you play. At the very least, simply understanding can help quiet the rage at what seems like a senseless, unsupportable situation.

Here’s how it works.

People need their money to make money. Whether you’re a mega-rich investor or, more commonly, the owner of a modest IRA or 401(k) account, you need your money to make money. That is, you need your money to grow. But wait—perhaps you’re on a fully paid pension plan, or you live in a country that takes care of your retirement for you. In that case, you don’t need your money to grow, right? Wrong. You still need money to grow. Even government retirement systems, who take their input in the form of tax dollars, need their money to grow.

Okay, so how do you get your money to grow?

Well, one simple way would be to stash your money in an interest-bearing bank account, right? That’s not a huge way to grow money, but it’s still growth. Except that interest-bearing bank accounts are all but extinct. You see, banks used to use the money in your savings account to back loans—primarily home mortgages. If the home buyer was paying a 6% rate, then the bank would keep around 4% and pay you the other 2% (very roughly). That was the situation in the US through most of the 1990s (source). But with mortgage rates now at rock-bottom, banks barely make any money themselves—they’re certainly not going to pay you anything. In fact, banks no longer use savings accounts to back loans. Instead, they bundle loans together and get investors to provide the cash—those are the “mortgage-backed securities” you hear about in the news sometimes. So the money in your savings account basically just sits there, doing nothing.

“Nothing” isn’t growth.

So let’s instead look at government bonds, particularly the US Treasury (other countries have very similar securities, but the 10-year US Treasury note is the world standard for safe, reliable investment). Unfortunately, Treasury notes are returning super-pathetic numbers. Like, super-pathetic. With so many people looking to grow so much money, and with the Treasury being such a safe bet (meaning there’s almost zero chance of you losing your investment), the government doesn’t have to pay much to borrow your cash from you. Back in 2000 you could earn almost 7%, which is pretty respectable. Today? You’re lucky to get 2% (source). 2% isn’t “growth.”

Savings accounts and Treasury notes have historically been the two safest, lowest-risk ways of growing your money. Both are essentially off the table.

Welcome to the stock market. A place of wildly varying risk that is almost impossible to mitigate. Returns can run from negative numbers to huge positive ones—my own 401(k) claims to have returned almost 30% in the past year!

And therein lies the jabberwocky. Most of the money in the stock market wasn’t put there by super-wealthy individuals. Most of the money in the stock market was put there by small, individual investors, by means of investment firms. The huge “institutional investors” like CalPers, Vanguard, Fidelity, and so on, all of whom are trying to get other people’s money to grow.

If I gave you a thousand bucks, and you promised to make that money grow and make sure I wouldn’t lose any of it, I’d be putting a lot of pressure on you to deliver. Vanguard doesn’t manage a thousand bucks; they manage trillions of bucks ($6.2 trillion, to be exact). So there’s a lot of pressure on their fund managers to Be Awesome.

Yet the fund managers actually have no control over the things they’ve invested in. It’s like if I was to try and hold you accountable for the amount of traffic on the highway during rush hour. You can certainly decide whether you want to be on the road at that time, but you can’t control everyone else. It’s insane.

And so fund managers make bets on companies. Because world stock markets have evolved away from paying dividends, and evolved toward growth, that means fund managers can’t just make a “safe bet” investment and rely on the company to drive a solid profit margin, resulting in a regular and predictable dividend payment. Nope. Instead, fund managers mostly have to bet that the companies they invest in will grow. Endlessly. Apple sold a zillion iPhones last year? They need to sell a zillion-plus this year. Growth is what drives the stock price up, and rising stock prices is what makes your moneygrow too.

What fund managers are largely betting on are the CEOs of the companies they invest in. They’re betting on those CEOs to somehow drive growth—betting on Tim Cook to make a crapload of money on subscription services, now that every human who actually wants an iPhone already has one. Betting on Satya Nadella to drive Azure subscriptions now that Windows licenses are no longer bringing in megabucks.

If you were a fund manager, and your job was on the line, and you’d put a billion dollars into Apple, how much would you pay Tim Cook to turn that billion into two billion?

You might well pay him a couple of hundred million. No, Tim isn’t the one actually making it all happen, but as a fund manager—as an investor—all you can do is try to throw money at the problem. Like, you look at the companies you’re investing it, you look at the markets they play in, you look at what they’ve been doing, and you try to make a smart decision. But in order to mitigate the horrific amount of risk still involved, you try to find The Chosen One who can make the company perform. And if you find that Chosen One, you pay out the wazoo.

Which is what the boards of these big companies do. It’s not that Tim is worth $15 million in cash every year (which is actually a shockingly low package given Apple’s revenues and growth; only $3MM of that is base cash—plenty of big-tech CEOs make tons more). It’s just that $15MM is a drop in the bucket to the returns Tim is expected to make for Apple’s investors.

Satya Nadella is at $44MM. Bob Iger at Disney was at more than $47MM. Elon Musk apparently made around $11 billion. (Those are all 2019 or 2020 numbers, by the way.) Oracle paid over $400MM to their top four executives in 2018.

It’s not because those people are inherently worth that amount. It’s that the investment community, whose will is expressed through the companies’ Boards of Directors, was simply willing to pay that much to create a better return on their investment. And investors are okay with those ridonkulous compensation packages because there’s literally nothing else they can do to mitigate their investment risk.

Right now, our economy (and I mean world economy here, not US alone) is massively over-tilted toward stock markets. Bonds return so little right now that they’re an almost meaningless way to hedge your bets and balance your portfolio. So when you’re all-in on the world’s riskiest way to make money, you start to look at stupidiotic executive salaries as a kind of insurance policy—a way of making your crazy-risky bets a bit less risky.

What would change it?

Raising prime lending rates. This has the effect of boosting what bonds, especially the all-important US Treasury, return. It also boosts savings account returns. Both of those become a bit more attractive to people looking to make money grow, which means they’ll pull some money out of the stock market. That’ll settle the market down, which will gradually settle executive compensation as well.

But mortgage rates will go up. If we’re not extracting huge sums from the stock market, then we’ll need to extract some more money from mortgage borrowers, right? The money—the growth—has to come from someplace.

Pricing for products and services will go up, too, because businesses will be paying more to borrow money for capital investments. Remember, businesses pass along 100% of their expenses to you, the consumer. They can’t often just “eat” higher expenses by lowering their profit margins, because their investors want those profit margins to remain high, so that the company looks attractive, so that the company’s stock price goes up, so that your invested money can continue to grow.

These are just the facts of how modern economies work, and it’s been heading in that direction largely since the 1930s. This isn’t new. What’s new is that we’ve had a lot more government participation, where they use things like prime lending rates—in many countries, the central financial authorities’ only lever—to try and manipulate the economy. Lower the prime rate, more people can afford a mortgage, more people buy a home. Home sales are a prime mover in any economy, and they help create solid tax bases for local governments, which helps keep the roads paved and the schools open.

So: you can rage against the machine of insane executive salaries, but know that it’s all part of a complex balancing act. Everyone wishes that our economy was less fragile, but that would mean relying less on the stock markets, which will mean raising interest rates, which nobody wants. The machine is what it is, and we all play our part in how it operates.

At a broader level, particularly from a career-growth perspective, this tale underscores the importance of knowing how the system works. Whatever systems you’re a part of, that is. You have to look past the surface of what you perceive as a problem, and dig into the why. Dig into the multitude of reasons why you’re seeing what you’re seeing. Many times, you’ll find that the “problem”—abusrdly high executive compensation, in this case—is actually a symptom.

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