One of my clients was recently offered restricted stock units as part of his executive compensation package. He and his wife always had aspirations of international travel. All of their children would be out of the house in a few years, so they would finally have the time and energy to do it. The vesting schedule of his restricted stock units aligned with his wife’s retirement, which made his decision to accept them an easy one.
This form of executive compensation was perfect for my client and his family at this point in his life. However, some executives don’t always consider how and if a certain type of compensation fits into their unique financial situation before they opt into a new compensation package or take a new job.
If you are a top-level executive, one of the best things you can do is to work with an experienced executive financial advisor to weigh the pros and cons of any form of executive compensation before you accept it. This is true whether you make $1 million or $30 million a year in salary, stock options, restricted stock units, or anything else.
Below, let’s discuss the advantages and disadvantages of executive compensation and compare the different types of incentives, so you can consider how each might fit into your overall financial plan.
Comparing the Advantages and Disadvantages of Executive Compensation Types
There are several ways companies are compensating and incentivizing top-level employees these days. Here’s a closer look at the most common types of executive compensation.
Cash compensation: This type of compensation is exactly as it sounds. Cash offered to executives as part of their compensation package is traditionally in the form of a salary. This is typically the base on which all of the other types of executive compensation are built. For example, you could be offered a base salary plus employee stock options or a base salary plus a long-term incentive plan.
- Advantages: You have immediate access to the funds, and they can be used for virtually anything you want or need. You can pay your home mortgage or buy a new car, there are no limitations put on cash compensation.
- Disadvantages: Cash compensation is taxed as income, which is typically one of the highest, if not the highest, tax brackets for top-level executives. This is a major reason why it is usually beneficial to receive additional forms of compensation on top of your salary.
Employee stock options: These are options granted to corporate employees (typically executives) to purchase a certain amount of corporate stock at a specific price (called a strike price) during a given period of time. The employee then has the option to hold onto the shares or sell them for additional income. There are two common forms of employee stock options typically offered:
- Incentive stock options: These are stock options that can only be granted to employees of that specific company.
– Advantages: One of the biggest benefits of incentive stock options is that they will be taxed at a long-term capital gains rate when they are sold, which is lower than the normal income tax rate.
– Disadvantages: Incentive stock options usually involve a vesting schedule and sometimes other rules in regards to when they can be exercised and sold. Also, on a corporate level, incentive stock options are more difficult to administer and less favorable for companies, making them less commonly offered to executives.
- Non-qualified stock options: These are stock options that can be granted to both corporate employees and non-employees, such as contractors or consultants (although this is a rare occurrence).
– Advantages: Non-qualified stock options can be exercised at any time. They also bring tremendous upside if your company continues to perform well and the stock price continues to rise.
– Disadvantages: Non-qualified stock options are taxed at the ordinary income rate in the year in which they are exercised. This makes them less tax favorable in many cases to incentive stock options.
No matter what type of employee stock options you have, it is important to work with an experienced executive financial advisor to exercise and sell your stock options at the right time for the market and for your personal situation.
Restricted stock units: These are similar to employee stock options. The restricted stock units are given a predetermined vesting schedule. Once they are fully vested, they are paid as income to the employee at fair market value. A portion of the shares is withheld to pay the income tax owed. You then receive remaining shares, and you can sell them at any time. Again, working with a wealth manager can help ensure you sell at an optimal time.
- Advantages: You don’t have to worry about paying taxes out of pocket or being hit with a surprise tax bill the following year when you file because the income tax is automatically withheld.
- Disadvantages: When restricted stock units are vested, they are taxed as ordinary income.
Deferred compensation: This is a plan between the employer and employee to delay (defer) a portion of his or her income until a later date, after the income was earned. This also defers the taxation on the income. It is typically deferred until retirement or a later predetermined date.
- Advantages: You have the ability to defer your taxable income to a later date. This is helpful for executives that plan to retire completely one day and will be in a lower tax bracket later in life.
- Disadvantages: Because your compensation is deferred, you don’t have access to the funds until you receive them, at which time you will pay taxes on the income. There are some other aspects of these plans to consider as well, including that they can’t be rolled over into an IRA like a 401(k) or 403(b).
Long-term incentive plan: This is a plan to incentivize long-term performance and growth of an employee, with benefits not necessarily tied to the company stock price. Long-term incentive plans can be paid out in cash, stock options, restricted stock units, and other forms of compensation. One example of this could be incentivizing an employee based on their tenure and future company adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA).
- Advantages: You are typically compensated for your work beyond what the company stock price reflects, which is not true if you were only compensated in stock options.
- Disadvantages: If your company performs very well, but you are only compensated with cash incentives, for example, you could miss out on a huge potential for stock appreciation. Also, compensation paid through a long-term incentive plan will be taxed. The taxation depends on how the compensation is funded, but it is typically taxed as regular income.
As a top-level executive, your income is likely made up of more than just your salary. When you are being offered a new job or compensation package, it’s important to consider your own financial situation and understand the advantages and disadvantages of the executive compensation you are being offered. An experienced executive financial advisor can help you navigate the pros and cons of different offerings and help you develop a financial strategy to maximize your earnings, so you can reap the rewards of your hard work and dedication for years to come.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for integrated asset allocation and equity compensation management. For more information on how Wade and the Carpenter Team can advise you on the advantages and disadvantages of executive compensation and help you develop a strategy around it, reach out today for a complimentary consultation.
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