Many public companies use equity compensation and nonqualified retirement plans to attract and retain top executive talent. But the complexity of these plans can often lead to confusion on how they work, how best to manage them and a lack of understanding and appreciation for the financial opportunity that the company is providing.
If your company offers these types of compensation plans, it’s important to know as much as you can about them, so that you can build a retirement savings strategy that makes sense for you and your overall financial plan. Employee compensation plans, if managed correctly, have the potential to help you build wealth and reach your financial goals. This article examines three types of common executive compensation plans and offers ideas to maximize the financial opportunity they create:
- Non-qualified deferred compensation (NQDC) plans
- Non-qualified stock options (NSO)
- Restricted stock units (RSU)
Non-qualified deferred compensation plans
Nonqualified deferred compensation is a type of tax-deferred retirement plan offered by some employers to help encourage employee retention.
Now, let’s break that definition down.
These retirement plans are “nonqualified” because they’re not subject to regulation under the Employee Retirement Income Security Act of 1974—more commonly known as “ERISA”—a federal law that sets guidelines for certain retirement plans.
NQDC plans allow you to defer a portion of the compensation you’ve earned (and any taxes owed on that compensation) to a later date. In other words, you can set aside a predetermined portion of your income and choose to receive it later in the future.
The payment or distribution schedule for your deferred compensation will depend on the plan agreement you have with your employer. And plan options vary from company to company. For instance, some NQDC plans might allow you to schedule your distributions over the course of your employment, while others might require you to defer until a specific date, such as your retirement.
Companies usually offer NQDC plans as an executive retirement benefit. It provides an additional opportunity for high earners to save for retirement—outside of 401(k) plans and IRAs. And while NQDC could provide potential tax-deferred benefits, these nonqualified plans can be complex and come with potential risks.
For instance, the compensation you’ve put away into a NQDC plan is subject to potential loss if the company runs into financial trouble down the road. That’s because the money you’ve deferred into a NQDC plan is kept in an account (or a trust) maintained by your employer (as part of the company’s general assets). In other words, the funds are unsecured and there’s no guarantee that your company will be able to pay the balance you’ve deferred. If your company were to file for bankruptcy or faced other financial challenges, those funds would be subject to creditor claims.
If you’re considering a NQDC plan, it’s a good idea to speak with your financial advisor first. They can help you understand the details and potential risks of your plan and come up with the appropriate deferral strategy that fits your goals.
Equity compensation plans
Some companies choose to incentivize employees with noncash, stock-based compensation (also known as “equity compensation”). Equity compensation gives employees a stake in the company, providing an opportunity to share in potential profits if the business does well. The idea is that this will motivate executives to stick with the company and work toward its success.
The two common types of equity compensation we see today are nonqualified stock options (NSO) and restricted stock units (RSU).
Non-qualified stock options
When a company offers you nonqualified stock options as compensation, it means you have the right to buy a certain number of shares of the company’s stock at a predetermined price and time. If your company does well over the next few years and the stock price goes up, ideally you’ll make a profit when you exercise the options.
With NSOs, your potential gains are calculated by taking the difference between the grant price and the stock price at which you exercise the options. “Potential” is the key word here because while gains are possible, there’s also a risk for loss. For instance, if the company’s stock price drops, you may lose a portion of your compensation.
Keep in mind, you can’t exercise your options until you’re vested, and the vesting requirements will vary from company to company. NSOs also come with an expiration date, which means you have to exercise your options within a certain time frame or risk losing them.
When it comes to taxes, with NSOs, you’re required to pay income tax when you exercise your options. That’s because the “nonqualified” part means that these stock options (unlike incentive stock options) do not receive special tax treatment from the IRS. NSOs 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 that your company may choose to grant you shares of its stock. They are a common alternative to offering stock options. The stock units are “restricted” because the shares are subject to a vesting schedule. With RSUs, your company promises to deliver the shares to you once specific criteria or conditions have been met.
Again, the vesting schedule is different for each company and can be based on specific performance goals or years of employment. RSUs are also subject to income tax when you actually receive the shares after your vesting date.
A quick word on concentration risk
Both NSOs and RSUs carry a concentration risk. This happens when you hold a large amount of a single stock (like your company’s stock) in your portfolio. Overexposure to any single stock can increase the overall risk in your investment portfolio. If your company underperforms and its stock price falls, the value of your portfolio will also be impacted.
If you’re receiving any form of equity compensation from your employer, consider working with a financial advisor who can help you assess your exposure and discuss potential diversification strategies.
Tips for assessing your compensation plan
NQDCs, NSOs and RSUs can be an important part of an executive compensation package. And if you’re evaluating these plans from your employer, here are some general tips to help maximize your financial opportunity:
- Understand your plan. Determine the type of plan you have and know the important dates and deadlines. For example, what kind of equity grants are being offered? With NQDC plans, what are the deferral and distribution options? Each company will have different plan rules—you’ll want to review those details carefully.
- Remember to diversify. Review your exposure to your company’s stock. Overexposure to any one stock is a potential risk. And as with any investment plan, diversification is essential. You don’t want to rely completely on the stock of one company for your retirement savings. The bottom line is: Whatever compensation plan you sign up for, you want to make sure it’s aligned with your risk tolerance.
- Optimize distributions. With NQDC plans, review ways to optimize your deferred compensation payout with a solid distribution strategy. Talk to a financial advisor about balancing tax strategies and your cash flow needs. Mapping out your anticipated income in retirement is often a good first step.
- Consult a tax professional. Compensation plans come with many complex tax considerations. It’s important to understand what kind of activities (distributions, exercising your options, etc.) can trigger a tax event. In addition to working with a financial advisor, you may also want to consult a tax advisor if you have any specific questions about your tax situation. Here’s a guide to executive taxation that you might find helpful.
We all need a little help when it comes to understanding how much our compensation plan is potentially worth and how it fits into our overall financial plan. This is particularly true for executive compensation plans that have a lot of interconnected moving parts. Remember, getting the most from an executive compensation plans takes financial planning and expertise. Working with an Ayco advisor can help you put together a strategy to optimize your retirement savings, grow your wealth and maximize the financial opportunities your employer provides.
At Goldman Sachs Ayco Personal Financial Management, our advisors receive training in the specifics of their clients’ employer benefit and compensation plan. We act as an extension of our corporate partners’ human resources and benefits teams to help their employees understand and make the most of their company-sponsored benefits.
