By Craig Lemoine, Ph.D., CFP®, Director of Consumer Investment Research
At their most basic level, executive compensation plans are designed to attract, retain and motivate top talent and leadership. But truly successful plans are designed to be much more than providing a high salary to a key employee – they support the business’s philosophies, values, and mission.
During times of change, these plans can help establish smooth transitions and provide a scaffolding of reliability. They can reinforce corporate dedication to transparency and strong economic, social and corporate pillars for employees and organizational stakeholders to follow.
The four elements of effective executive compensation plans
Executive compensation plans require knitting together four quadrants to form a total compensation and benefit strategy: direct compensation and benefits, short-term (annual) bonuses and incentives, longer-term bonuses and incentives, and special retirement plans.
Organizational structure, size, fundamental economic cycles and industry norms dictate the magnitude and offering of each quadrant.
Direct Compensation & Benefits
Short-Term (Quarterly/Annual) Bonuses and Incentives
Longer-Term Bonuses and Incentives
Nonqualified Defined Contribution and Split Dollar Life Insurance Plans
Let’s take a closer look at each of these quadrants.
Direct Compensation and Benefits
These generally start with a strong salary and benefits. Salaries are typically determined by an executive compensation committee and take into consideration industry salary comparisons, annual revenue and sales growth. In addition to a base salary executives receive benefits that go far and above those offered to non-key employees. Employee benefits, such as health insurance or group life insurance, generally provide tax deductions to the employer. Executive benefits are designed to differentiate between classes of employees and lose some of their tax deductibility and shine.
Executive benefits can include company-provided vehicles, housing stipends, extensive moving expenses, access to a corporate jet, country club memberships, sporting-event seating, executive dining, and supplemental disability, life, healthcare and wellness plans. These benefits can be critical in stakeholder management and building financial success.
Short-Term (Quarterly/Annual) Bonuses and Incentives
These incentives can help align executive behavior with organizational goals and performance. Short-term cash bonuses can be tied to shareholder goals – such as share price, revenue or profit metrics – and/or organizational values. Cash compensation is also tied to ESG measures, employee retention, community involvement or other mission-driven metrics. Attractive short-term incentives can nudge behavior and help an executive drive more than financial performance.
Longer-Term Bonuses and Incentives
Often given in the form of stock bonus plans, these incentives prioritize retention while aligning behavior with long-term organizational and shareholder objectives. These plans are generally stock based with vesting restrictions rewarding organizational financial health and time spent with an organization. Two popular long-term stock bonus strategies are incentive stock options (ISOs) and restricted stock units (RSUs).
ISOs are frequently offered to executives of public or soon-to-go-public private companies. An ISO allows the executive to purchase stock at the granted option price. ISOs are statutory and must be exercised within ten years of the grant date. ISOs offer a favorable tax effect to executives who hold the ISO for at least one year before exercising, then hold the underlying shares an additional twelve-months. ISOs frequently have three-year vesting schedules, meaning if an executive leaves an organization before ISOs vest, they lose the options. Similar to some other forms of executive compensation, the employer may not receive a tax deduction on ISOs. ISOs may vest upon death or disability.
Assume Camille is the CFO at Zippy Drone Company. She was hired January 1, 2020 and granted 1,000 Incentive Stock Options at $10 per share. The options have a three-year cliff-vesting period, meaning Camille will be able to exercise these and buy 1,000 shares of Zippy at $10 per share on or after January 1, 2023.
If on January 2, 2023 Zippy Drone Company shares are priced at $100 a share, Camille can exercise the ISOs and purchase the shares for $10,000. As long as Camille holds this $100,000 position for one year, she can then sell the entire position as a long-term capital gain and take advantage of more favorable tax rates. If Camille leaves prior to the option vesting date she forfeits this portion of her compensation. Exercising the ISO may trigger an Alternative Minimum Tax event.
ISOs have become less popular in the last decade, as companies must book them as expenses the year they are issued. As an alternative, many businesses have started offering RSUs instead.
RSUs grant an executive shares of stock, with either a cliff- or a grated-vesting schedule. With a cliff-vesting schedule RSUs are available to sell after they are vested. Executives do not receive dividends or voting rights on RSU shares until they vest, and RSUs are forfeited if the executive leaves an organization prior to being vested. RSUs may vest on death or disability.
Assume Bianca is the CEO of Zippy Drone Company. She was hired January 1st of 2020 and granted 1,000 RSUs at $10 per share. These RSUs have a four-year grated vesting schedule, with 25% of RSUs vesting each year. Bianca will receive 250 shares every year. She must include the market value of these shares as income as they are delivered to her. Once delivered she is free to hold or sell the shares.
Organizations make additional grants of ISOs and RSUs. In our earlier example Camille may receive an additional 1,000 ISO grants annually, Bianca annual RSU awards. Additional grants and awards keep executives targeting long-term performance goals and encourage retention.
Nonqualified Defined Contribution Plans and Split Dollar Life Insurance
These provide the ability to thoughtfully prepare for an executive’s eventual retirement or departure from the company. Deferred compensation plans can benefit both the employer and highly paid employee by deferring income into future years.
Some traditional qualified retirement plans, such as 401(k) Plans and SIMPLE IRAs, allow employees to defer wages into tax favored accounts. These accounts work well for most employees, but all have limitations that might make them fall short for highly paid executives. In 2022 the most an employee can defer into a 401(k) plan is $20,500 ($27,000 if an employee is 50 or older). A SIMPLE plan allows a $14,000 deferral ($17,000 if an employee is 50 or older). But when an executive earns close to a million dollars annually, setting $20,500 aside annually falls short.
Nonqualified Deferred Compensation Plans (NQDCP) are formal agreements allowing an executive to defer a much larger portion of their salary to a future date. An NQDCP can defer salary and cash bonuses giving an executive great flexibility in retirement savings. An NQDCP must be in writing, specifying the amount paid, payment schedule and triggering events (such as a retirement age) that will distribute plan assets. Nonqualified compensation plans offer similar savings vehicles to 401k plans (employer stock, mutual fund options, stock and bond options and fixed accounts). Distributions are taxable to the employee, much like a 401(k) plan. However these plans do carry some additional risks.
Plan assets are considered general assets of the employer and are subject to creditor risk. Accounting requirements can be onerous and funds cannot be used for non-triggering events. Additionally, the employer can customize the plan and limit the plan offering to specific classes of employees rather than all employees.
Assume Nellie is the CMO of Zippy Drone Company. Her base pay is $600,000 annually. Nellie defers $20,000 into the Zippy 401(k) plan but is worried about her future retirement. Assuming Zippy has a Nonqualified Deferred Compensation Plan Nellie could Contribute another $200,000 into that plan. Both plans can have similar retirement funding options. Zippy Drone Company benefits
Lastly, executive compensation plans may include split-dollar life insurance. Split-dollar life insurance is a way for an executive to receive life insurance coverage leveraging employer dollars and premium payments. Employers are able to offer up to $50,000 of group life insurance to all employees and deduct the premiums. Executives looking for additional cash-value insurance protection and growth can benefit from split dollar plans. Split dollar life insurance takes two forms:
- Economic Benefit Arrangement. With an economic benefit arrangement the employer owns the policy, pays the premium but allows the executive to appoint a beneficiary who would receive a death benefit if the executive died prematurely. The executive will have an income tax liability to the extent of the death benefit, and may be able to borrow against the cash value of the policy based on the nature of the agreement.
- Loan Agreement. In a loan agreement split dollar plan the employee owns the policy and employer pays the premiums in the form of loans to the employee. The employee provides a collateralized interest back to the employer to recover loan proceeds. In the event of death or retirement the employee owns the policy and employer is reimbursed.
Alexis is the CCO of Zippy Drone Company. She has entered into a loan agreement split dollar life insurance policy with Zippy Drone. Zippy Drone pays $50,000 in annual whole life insurance premiums to BIG insurance company on a $1,000,000 death benefit policy. After ten years of working at Zippy, assume the cash value of the life insurance policy has grown to $600,000. Alexis departs Zippy and pays back the loan ($500,000), plus any accrued interest, using a loan against the insurance policy. This arrangement allows Alexis to depart with a million-dollar life insurance policy with some cash value.
Get Professional Advice on Executive Compensation Plans
Taken together, these financial tools allow organizations to build executive compensation plans that can attract, retain and reward high value employees. Compensation can be tied to performance, values and deferred to encourage retention.
Have questions? Your financial advisor is here to help – whether you are the employer or the employee. Talk to your advisor today, or contact us if you are looking for a professional advisor in your area.
The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product [and/or service].
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty.