Executive Compensation: Stock Options, Restricted Stock, and Deferred Compensation Plans.
- Erik James Roberts, Founder & Chief Investment Officer | Infinitus Wealth Management
- Apr 18, 2022
- 6 min read
Updated: 17 hours ago
Employee compensation plans, if implemented correctly, have the potential to help you build wealth and reach your financial goals.
Numerous public companies use equity compensation and non-qualified retirement plans to pull in and retain top executives. Nevertheless, the complexity of these plans can often lead to confusion on how they work and how best to manage them.
Suppose your company offers these types of compensation plans. In that case, it is essential to know as much as you can about them to build a retirement savings strategic plan that makes sense for you.
Ahead, I will go over three types of compensation plans that I often come across when working with clients:
Non-qualified deferred compensation (NQDC) plans
Non-qualified stock options (NSO)
Restricted stock units (RSU).
I will also share tips on working with a personal financial advisor to get the utmost out of your executive compensation plans.
Non-qualified deferred compensation plans
Non-qualified deferred compensation is an example of a tax-deferred retirement plan extended by some employers to help encourage employee retention.
Now, let us break that definition down. These retirement plans are "non-qualified" because they are not subject to regulation following the Employee Retirement Income Security Act of 1974 - more frequently known as "ERISA," a federal law that sets guidelines for specific retirement plans.
Non-qualified deferred compensation plans enable you to defer a part of your earned compensation (and any taxes owed on that compensation) later. In other words, you can set apart a predetermined percentage of your income and elect to receive it in the future.
The distribution or payment schedule for your deferred compensation will depend on the plan agreement you have with your employer. Furthermore, plan options will vary for various companies. For instance, some non-qualified deferred compensation plans might enable you to schedule your distributions over the course of your employment. In contrast, others may require you to defer until a particular date, such as your retirement.
Companies ordinarily offer non-qualified deferred compensation plans as an executive retirement benefit. In addition, it provides an added opportunity for high earners to save for retirement – outside of 401(k) plans and IRAs. In addition, non-qualified deferred compensation could provide possible tax-deferred benefits, and these non-qualified plans can be complex and come with potential risks.
For instance, the compensation you have put away into a non-qualified deferred compensation plan is subject to possible loss if the company runs into financial instability. The money you have deferred into a non-qualified deferred compensation plan is kept in an account (or a trust) maintained by your employer, part of the firm's general assets.
The funds are unsecured, and there is no guarantee that your company will be able to pay you the balance you have deferred. So, for example, if your company were to file for bankruptcy or experienced additional financial challenges or setbacks, those funds would be subject to creditor claims.
If you consider a non-qualified deferred compensation plan, it is good to speak to a financial advisor first. They can help you understand your plan's details and potential risks and develop the proper deferral strategy that's right for you.
Equity compensation plans
Some companies elect to incentivize employees with noncash, stock-based compensation, also known as "equity compensation."
Equity compensation allows employees a stake in the firm – an opportunity to share in potential gains if the business does well. The idea is that this will incentivize employees to stick with the corporation and work toward its benefit.
The two common types of equity compensation are non-qualified stock options and restricted stock units.
Non-qualified stock options
When a corporation offers you non-qualified stock options as compensation, you have the right to buy a certain number of the corporation's stock at a predetermined price and time. If your company does post good results over the next couple of years and your company's stock price increases, you could make a profit when you exercise your options.
With non-qualified stock options, your potential gains must be calculated between the grant price and the price you exercise the options. "Potential" is the keyword here because while gains are possible, there is also a risk for loss. For instance, if the corporation's stock price drops, you may lose a portion of your compensation.
Keep in mind that you cannot exercise your options until you are vested. The vesting requirements will differ from company to company. Non-qualified stock options also come with an expiration date. You must exercise your options within a specific timeframe or risk losing them.
With non-qualified stock options, you must pay income tax when you exercise your options. The "non-qualified" wording means that these stock options (unlike incentive stock options) don't receive special tax treatment from the IRS. However, non-qualified stock options can come with complex tax considerations, so consult a tax professional to understand your potential obligations.
Restricted stock units
Restricted stock units are another way your company may elect to grant you shares of its stock. They're a common alternative to providing stock options.
The stock units are often "restricted" because the shares are dependent on a vesting schedule. The vesting schedule varies for each company and potentially can be based on years of employment or certain performance goals. Restricted stock units will also be subject to income tax when receiving the shares after your vesting date.
A quick word on concentration risk
Both restricted stock units and non-qualified stock options carry a concentration risk. This happens when you hold a considerable amount of a single stock in your investment portfolio. Overexposure to any single stock can boost the overall risk in your investment portfolio. However, if your company underperforms and its stock price falls, the value of your portfolio will also be impacted.
If you're receiving equity compensation from your employer, contemplate working with a financial advisor who can help you evaluate your exposure and discuss potential diversification strategies.
Making the most of your compensation plans
Non-qualified deferred compensation plans, non-qualified stock options, and restricted stock units can be an essential part of an executive compensation package. And if you are assessing these plans from your employer, here are some general points I'd like to share:
Understand your plan. Consider the type of plan you have and know the actual dates and deadlines. For instance, what kind of equity grants are being presented? With non-qualified deferred compensation plans, consider the deferral and distribution options. Each company will have varying plan rules – you will want to review those details carefully.
Diversify Holdings. Heavy exposure to any one stock is a potential risk, and as with any investment plan, diversification is essential. You don't want to rely on one company's stock for your retirement savings. Whatever compensation plan you choose, you want to make sure it aligns with your risk tolerance and time horizon.
Optimize Distributions. With non-qualified deferred compensation plans, look over ways to optimize your deferred compensation payout with a well-thought-out distribution strategy. Speak with a financial advisor about tax strategies that anticipate your cash flow needs. In my experience, mapping out your expected income in retirement is an excellent first step.
Consult a Tax Professional. Compensation plans for executives come with many complex tax considerations. Understanding what activities (distributions, exercising your options, etc.) can trigger a tax event is vital. In addition to working with a trusted financial advisor, consult a tax advisor for any specific questions about your current tax situation.
We all require a little guidance in understanding how much your compensation plan is possibly worth and considering its fit into your comprehensive financial plan. I hope my tips will help guide your next visit with your financial advisor. Realizing the most out of your compensation plans takes expertise and financial planning. Working in conjunction with a financial advisor and tax professional can help you put together a strategy to optimize your retirement savings.
At Infinitus Wealth Management, we offer a complimentary, no-obligation portfolio review for investors who want an independent fiduciary second opinion on how their capital is actually being managed.This is a conversation, not a sales process. If your portfolio is already well constructed, we will say so directly. If we identify avoidable costs, unnecessary concentration, tax inefficiencies, or portfolio structure that may be working against you, we will show you specifically where those issues exist. From there, you decide what to do with the information.
Important Disclosures
Infinitus Wealth Management is a registered investment advisory firm. This article is provided for educational and informational purposes only and does not constitute investment, tax, legal, or accounting advice. It is not an offer or solicitation to buy or sell any security or to enter into any advisory relationship. Any references to specific strategies, withdrawal rates, tax provisions, or historical figures are general in nature and may not be appropriate for any individual investor.
Past performance is not indicative of future results. All investing involves risk, including the possible loss of principal. Tax laws are complex, change frequently, and have unique application to individual circumstances; please consult a qualified tax professional regarding your specific situation. Social Security rules, Medicare rules, and retirement account regulations are subject to legislative and regulatory change.
The information in this article was believed to be accurate at the time of writing but is not guaranteed. Readers should consult with their own qualified advisors before making any financial decisions specific to their situation.
