Avoid Common Planning Mistakes with Executive Compensation
Whether you work for a budding start-up or a well-established Fortune 500 company, it’s imperative to have a firm understanding of the components of your executive compensation plan—along with the inherent risks and rewards. Creating and maintaining a thoughtful strategy to integrate your executive benefits into your overall financial plan can help you maximize your wealth and achieve your goals in a tax-efficient manner.
Still, even the most accomplished and organized executives can fall into some very common traps when incorporating complex aspects of their compensation into an overall plan. Here, we outline common mistakes we see and key considerations for executives when factoring executive compensation into their long-term financial plans.
Don’t neglect risk management
With executive compensation comes the need for an acute focus on risk management. The receipt of stock options, restricted stock, or performance shares leaves many executives with a far greater risk exposure than their perceived risk profile due to concentrated reliance on the company’s performance or profitability. With economic and other changes, companies once viewed as powerhouses can suddenly lose millions or cease to exist (remember Enron?).
It’s essential to recognize and acknowledge this risk; you could be even more concentrated than you think. Broaden your view to encompass your full wealth – your annual and future cash flow may mostly come from your company through different vehicles: salary/benefits, 401k, deferred compensation, or a pension. This means that your current and future wealth are both tied to your company’s performance. But for many with an equity stake in a company, emotional ties may cause them to hesitate to trim a position or diversify into other investment asset classes.
To ensure you’re adequately protected against the risk of concentrated stock positions, consider several strategies, all of which have their advantages and disadvantages, including:
- Outright sale of the stock in stages: A simple solution to reduce concentration risk, outright sales of stock can add liquidity to align with cash flow needs. Keep in mind that stock sales are taxable transactions and mean you will forgo possible future gains. Staged selling can make sense if executed thoughtfully under the guidance of a tax advisor.
- Protective put: This is an equilibrium strategy to buy the same number of put options at a set price to cover the shares you own. It is essentially “buying insurance” on the stock, as it provides a floor value for an investment while allowing for further upside potential. Protective puts defer capital gains but are subject to counterparty and other risks.
- Selling out-of-the-money calls: This strategy allows you to enhance the yield on your stock position by selling covered calls at a price set above the stock’s current price. With out-of-the-money calls, you receive some income upfront and possibly won’t pay taxes until the stock is sold. You will be required to post the stock as collateral.
- Selling deep-in-the-money calls: In this scenario you sell call options at a price significantly below the current price, in order to monetize the position. This way, you lock in the gain and are hedged against downward stock prices. The biggest advantages of this options strategy are protection and generating predictable returns.
For a full breakdown of strategies to hedge risk, consult your financial planner. Your advisor can also help you proactively create and follow a plan to remove the behavioral and emotional elements that can complicate managing risk.
Don’t forgo savings priorities
While those with executive compensation benefits that include retirement savings through deferred compensation or stock awards may feel financially secure, it’s important to remember basic savings principles. This means taking steps such as augmenting an emergency fund with 6 to 12 months’ worth of living expenses. Your company stock should not count toward this reserve; you don’t want to have to sell the stock when it is down to meet an emergency need. Your emergency fund should be easily accessible in the form of cash or cash equivalents and not invested in illiquid or volatile investments such as stocks. Further, working with an experienced tax advisor to ensure that you have sufficient withholdings for your executive compensation awards may result in increased efficiency and savings.
Prioritize other important financial goals such as establishing 529 plans for children, maximizing 401k deferrals, and ensuring spousal contributions to retirement accounts. Make sure to diversify other savings by allocating dollars to more traditional investments.
Don’t mistake unrealized future assets as present-day cash flow unless you have a comprehensive plan in place
Most executive compensation represents future cash flow and is often intended for retirement. It is important not to treat this future asset as current cash flow. You should manage current spending in terms of your current cash flow constraints, without banking on intangible future assets. For example, it isn’t a good idea to borrow more than you can afford on your current cash flow anticipating future gains from executive compensation.
In unusual circumstances, there can be a thoughtful way of translating executive compensation into current cash flow should you absolutely need to. If you’re up against the wall and don’t have an emergency cash fund, one way to tap into executive comp is by leveraging margin accounts. However, keep in mind that this may increase risk. See our article on margin lending.
Be aware of limitations
Executive compensation programs often come with limitations. And for certain executives at publicly held companies, trading restrictions and black out periods are common. For those wanting to sell stock, many are required to implement a 10b5-1 plan whereby executives set pre-determined parameters (such as number of shares, stock price, date) to trigger a sale in order to avoid violating the SEC’s insider trading rules. Consult a compliance professional prior to any sale.
Consider other planning strategies
There are several other planning strategies to consider, such as using appreciated stock to fund a Donor Advised Fund (DAF), which allow donors to take tax deductions on contributions to the fund in the same year they’re made but distribute the funds to charity with donor discretion over time. For more information on DAFs, see the post, “Optimize your Charitable Giving with Donor Advised Funds.” Investing in designated Qualified Opportunity Zones is another tax-preferred investment opportunity whereby gains from the sale of incentive stock options or company stock can be reinvested in a way designed to reinvigorate economically-depressed communities while providing tax incentives to investors.
Many types of executive compensation are subject to complex regulatory rules and tax considerations; some are subject to blackout periods or other restrictions. Your advisor should work in tandem with a tax advisor to ensure you leverage your executive compensation in the most tax-effective way possible. If properly managed, executive compensation has the potential to provide executives with opportunities to build wealth for the future.