Key Features of Executive Compensation Packages

Whether evaluating competing offers for a new position or placement, or desiring to broaden understanding of a current package, looking at the key components of executive compensation packages can be a valuable exercise. Doing so can help ensure fair and equitable earnings are being offered and can help an executive avoid common mistakes and pitfalls that can prove quite costly. It’s important for an executive to approach their compensation in the same way they might tackle work: by putting an equal focus on both details and the big picture.

Early in a career, a compensation package could consist of a simple base salary + bonus(es).

But as job complexity grows, so can compensation. Soon an executive could find that base salary and bonus structure being supplemented by stock award options and deferred comp.

Each of these aspects contain variables to be maximized, especially as they relate to tax, retirement, and financial planning goals, and each require highly specialized best practices and education as well.

During prime income earning years, it is vital to maximize where possible with things such as tax efficiency. It is equally important to skirt easily avoidable mistakes. With compensation complexity comes variables, and key decisions become less binary. No longer is the formula a basic “if X, then Y.” Suddenly “if X, then Y” is only true if “A > B and C = D” as more and more constraints get tacked on.

Because of this, it becomes increasingly important to have perspective on individual components of your compensation package, and also a broad perspective of how the whole picture affects your tax situation and investment objectives.

Let’s start by talking about the foundational feature of compensation — base salary.

Base Salary

Base in simplest terms is an executive’s actual annual salary. A base salary should meet all of an executive’s budgeting and cash flow needs month to month. Because it is the only guaranteed, liquid income an executive receives in a year, base salary should be sufficient to support the lifestyle that an executive needs and expects. In this way, it should be looked at no differently than a salary was looked at fresh out of college. Of course, as experience and responsibility grows, so should an executive’s base salary. All other components of compensation are either variable, contingent on uncertain outcomes, or don’t get paid out on a regular basis.

Base salaries can vary largely across a single industry, with some total compensation offers leaning more heavily on stock and performance-contingent bonuses. In these scenarios, your “annual compensation” is actually more “potential annual compensation” based on myriad scenarios and variables that may or may not be within the executive’s control. The potential for larger payouts exists, but so does the possibility of smaller. Whether that’s preferable lies solely in the eyes of the beholder. Factors like age, risk tolerance, monthly income needs, and intermediate financial goals all play a role in determining the percentage of your salary you want in base versus equity, options, bonuses, etc.

Risk-reward analysis for an executive’s compensation should be based in a deep knowledge of taxes, risk management, long-term planning, and dozens of other factors. There’s no right or wrong answer, but a fiduciary advisor who has navigated other executives through these decisions can be a key ally for most executives as a result.

Restricted Stock Units

Up next is a common form of equity-based compensation that has grown ever more popular. Unlike stock options, which only give the right to buy a stock at some point in the future, Restricted Stock Units (RSUs) are actual shares of stock, guaranteed to be issued at a future date. So long as the company’s shares don’t trade for $0 on that future date, the RSU award will have guaranteed value.

The exact number of shares to be received is known upfront — how much those shares will be worth when they become vested in the future is an unknown, however, since their value will be determined by the prevailing market price at the time the shares are actually deposited into your account.

A common vesting schedule is the anniversary date of employment, although some RSUs are performance driven and vest when a pre-established company performance target is met.

Keep in mind that the value on the day of vesting will be reported via the executive’s W-2. A company may withhold appropriate taxes to cover this additional income, or the earner may be able to surrender an equivalent value of shares to cover their tax liability. Either way, this additional income has to be taken into account when planning for that year’s finances.

Any or all shares of restricted stock can be sold as soon as the shares vest. If the shares are held for over a year, any gains in the stock price would be taxed at a (lower) long-term capital gains rate. Conversely, if the shares were to fall in price, it would create a tax deduction for the amount of value lost.

For a broad demographic of executive positions, RSUs are the largest component of salary outside of base (excluding 401(k) and health/wellness benefits). They can be a stable source of investment or retirement assets, but can become an increasing risk over time without balancing since they can create a lack of diversification in the owner’s portfolio. Betting on the fate of one company is almost always a risk.

Employee Stock Purchase Plan

Though Employee Stock Purchase Plans (ESPPs) are not directly compensation, they deserve mentioning. When evaluating competing offers, an ESPP should be factored in. ESPPs work through payroll deductions, so a certain amount of base salary is set aside each pay period toward the purchase of company shares during a window of time called the Purchase Date. The prevailing market rate for shares at that time will be paid, but at a predetermined discount (generally 10–20% off market price).

A plan like this can be useful if more accelerated access to company stock is a desired part of a compensation package. Like with many of these factors, the benefits of control (the amount of fully-owned stock with no restrictions once purchased to buy) have to be weighed against the tradeoff of smaller base salary/cash available each pay period.

Stock Options

Stock options are contracts which give an employee the option to buy specific numbers of shares of their company at a specific time in the future. They are sometimes considered the lightning rod of compensation since they have very high upside potential, but are also highly volatile, and potentially very risky.

In the best case scenario, a stock options award lets an executive buy company shares at a price drastically lower than the current market price — 30%, 50%, or even more. Because of this, they also have the potential of being a powerful wealth generator. However, things can also rapidly turn south if the company does not perform or grow as hoped and expected.

Either way, the scenario will likely play out with uncertainty since it is not uncommon to wait years for stock options to become vested.

Options, once vested, need to be decided on rather quickly, typically in six months or less. And once those options are converted into real shares of stock, other decisions need to be made about how much to sell, and when.

Younger executives with 15 years or more until retirement are often considered the ideal demographic to seek out generous stock options packages as a portion of their overall compensation packages. Because of their age and remaining time in the workforce, these younger executives have more capacity to absorb uncertainty and risk, more years to patiently wait out trends, and extra time to de-risk from a concentrated stock portfolio.

Deferred Compensation

At its core, the idea of deferred compensation is very simple — defer some, or even the bulk, of negotiated compensation to be paid after retirement or leaving the company, as opposed to being paid now.

Some might wonder why delaying gratification is looked at as a positive. The general goal is to aid retirement planning by having predictable streams of income in later years. The structure could theoretically also create tax savings since income taxes on deferred comp would be paid while the recipient is in a lower tax bracket than their current. Keep in mind, though, that taxes trend upward over time, so this latter argument could be negated. It is also important to note that many deferred comp plans have prepayment penalties for monies received prior to age 59½ should access to these funds need to be earlier than was anticipated.

Deferred compensation plans can either be qualified or non-qualified.

Qualified plans must be broadly made available to all, and they must have percentage limits of how much income can be set aside each year. But they have fantastic tax advantages; pre-tax income is set aside for contributions, and annual gains in the account grow tax free until the money is taken out in retirement. A 401(k) plan is an example of qualified deferred compensation often available to most employees of a company.

Non-qualified plans are more often reserved for C-suite level executives. These plans allow a much higher percentage of income to be set aside. In the event of company bankruptcy, however, non-qualified deferred comp can be at risk of being wiped out.

All deferred compensation plans allow the assets set aside to grow tax free until the money is paid out. This creates an opportunity for strong wealth creation, but also increases variability. As you get nearer to retirement, deferred compensation plans need active management and dynamic steps to mitigate the risk of concentrated positions in stock.

High-Level View of Executive Compensation

Base salaries are inherently tied to a company, but over time many compensation package elements can lead to a bulk of an executive’s investment holdings becoming intertwined with the company as well. Higher executive compensation can mean increased stock exposure in the employer company. While this can be a wonderful motivator for high-level employees to drive company growth and success, it can easily create blind spots in those executives’ own financial scenarios. This is all well and good if the company is successful, but it can also be an executive’s downfall if the company experiences a dip in profits at the wrong time.

The smartest executives have dedicated teams watching over important calendar dates, regularly monitoring company health and macroeconomic conditions, and poring over the latest tax and investment news from around the world. A good financial advisor looks well past goals for the year and strategizes goals that stretch out decades into the future. Gaining efficiency around taxes, optimizing retirement income, and creating adaptive wealth management plans can amount to millions of dollars over an executive’s lifetime.