Strategic Compensation: Maximizing the Value of Your Corporate Benefits
ISOs, NSOs, RSUs, strike price, option period, vesting schedule… For the uninformed, executive compensation can sound like a combination of “alphabet soup” and legalese. But for those in positions of corporate leadership and other high-performing executives, understanding the outlines of your executive compensation package is vital to building a sound investment strategy.
But corporate leaders can get so involved in the business of the company that they may be neglecting important matters of their own personal finances. This makes it imperative for all corporate leaders and other key executives to understand the basic outlines of their executive compensation packages, since these benefits will typically form a large portion of their ability to create and maintain the wealth necessary to provide for a secure retirement and achieve major financial goals. In other words, the nuances of executive compensation require careful attention to some specific elements and potential issues, especially for corporate leaders who are engaged in purpose-driven financial planning. Let’s talk about some of the basics of executive compensation, how they might fit into your long-term financial strategy, and some particular matters that deserve specific focus.
What Are the Basics of Executive Compensation?
Executive compensation may take one or more of several forms:
- Base salary and cash bonuses: These are unlikely to provide the bulk of your wealth-building opportunities, but your cash flow strategy, including budgeting, saving, and spending habits, form an important basis for making the most of other opportunities.
- Incentive stock options (ISOs): These can come in both qualified (tax-advantaged) and non-qualified (NSO) form. Qualified ISOs typically incur no tax when they are granted, vested, or exercised (though you should consult with your tax expert about possible alternative minimum tax—AMT—implications). When the options are exercised and the stock is sold (assuming the appropriate holding period), gains are taxed at the long-term capital gains rate, which is typically less than the ordinary income rate. With an NSO, you pay ordinary income tax on the difference between the grant price and the price at which you exercise the option.
- Restricted stock awards (RSAs): These grant the employee immediate ownership of stock, but they must meet certain conditions before they can sell or transfer them (completion of a required period of employment or meeting certain incentive-based goals). A key decision that comes with RSAs is whether or not an IRS Section 83(b) election should be made. This election permits the holder of the RSA to pay taxes on the stock at its present value rather than the value at the time of actual receipt. If the recipient believes the value of the stock is likely to be higher at the time the RSA is received, it could be advantageous to pay the taxes now, at a lower rate.
- Restricted stock units (RSUs): These differ slightly from RSAs in a variety of ways. Notably, employees don’t receive the shares until the vesting conditions are met.
Here are important terms related to executive compensation that you should understand:
- Strike price: Also known as a “grant price” or “exercise price,” this is the fixed cost that you’ll pay per share in order to exercise your stock options and take ownership of the shares.
- Option period: This is the period of time—usually about ten years—during which you may exercise your option to purchase the stock to which your options entitle you.
- Vesting schedule: This may be either a minimum period of continuous employment or certain performance incentives required for you to take full ownership of your options.
What Are the Liabilities Involved in Executive Compensation?
While executive compensation is certainly a powerful wealth-building tool and a key element of financial wellness for high-performing executives, it is not without some challenges that require careful management.
- Concentrated positions. This situation occurs when a large proportion of your wealth consists of a single asset—such as the company stock represented by the stock options and actual shares available to you as part of your stock option package. At a certain point, financial planning best practices may make it advisable for you to begin selling a portion of your stock so that you can diversify your holdings, rather than having too much exposure to the market value of a single asset. Often, experts recommend limiting your exposure to a single asset to 10% of your portfolio. You may want to design a plan based on your anticipated retirement date. Or you may develop another strategy to unwind the position over a period of time. You will need to take care, however, to observe any requirements of your plan with regard to minimum shares required for retention (and also, as a practical matter, to demonstrate appropriate confidence in the company’s prospects). A financial planning professional can help you determine which restricted stock or options you should consider selling first.
- Capital gains tax implications. Closely related to the risk implied by concentrated positions, the potential tax liability incurred by selling appreciated company stock or options must be factored into your strategy. You should coordinate closely with your tax advisor, since taxation on capital gains may need to be factored into the timing of your selling and purchasing activity. Particularly when some portion of your executive compensation package consists of restricted stock units (RSUs), you should discuss with your tax and financial advisors whether or not an IRS Section 83(b) election should be made. This election permits the holder of the RSA to pay taxes on the stock at its present value rather than the value at the time of actual receipt. If the recipient believes the value of the stock is likely to be higher at the time the RSA is received, it could be advantageous to pay the taxes now, at a lower rate. For those with high income, advance budgeting for the anticipated taxes due in a given year may be important.
- Holding period requirements. Securities laws impose certain requirements on senior executives for the amount of time they are required to hold company stock and options; this requirement can pose additional implications for your planning around executive compensation. Your company’s plan documents will provide you with this information. You should be familiar with any restrictions on the timing and amount of shares you can sell.
At GEM Asset Management, we understand the needs of corporate leaders and key executives. Our fiduciary duty of care obliges us to provide guidance and recommendations that keep our clients’ needs foremost at all times. That’s why we work with clients to develop financial plans designed around their unique goals, resources, and values. If you have questions about your options for your executive compensation or any other aspect of your financial planning, we want to help.