Executives help make crucial strategic decisions and are expected to coordinate and reach those strategic goals with their team. Losing one of your top executives can wreak havoc on those goals and on the company’s bottom line. Implementing an individualized and comprehensive executive compensation package is crucial to capturing, motivating, and retaining superior executives in a competitive market.
Taking the time to create an organized and ideal executive compensation plan can protect and benefit both the executive and the organization. To get started, the business needs to consider the following when creating this plan:
- Mission, values, and objectives
- Size and revenue
- Number of key executives
- Tax structure (ex. C-Corp vs S-Corp)
- Available cash flow and projected future growth
- Business continuation and succession plan
- Once the above questions have been answered, the business can begin to create a plan that is unique to them and the needs of its key executive(s).
The main elements in most executive compensation plans include:
- BASE SALARY
The base salary is straightforward and simplistic as annual salaries are paid in cash. It is imperative that it be competitive in your industry and region. This piece of the compensation plan is agreed upon when an employee is hired. It is also the easiest component to increase in any given year.
- SHORT TERM INCENTIVES
Short term incentives are typically cash bonuses and paid out during the year in which they are earned. These bonuses are designed to motivate executives to meet more immediate individual and corporate goals. They are free and clear of any conditions from the employer. The employer has complete discretion over who receives these bonuses. Like the base salary, providing a short-term incentive is a straightforward way to offer more cash to an executive when considering compensation planning opportunities.
- INSURANCE AND FRINGE BENEFITS
These benefits are often as important as annual wages. Comprehensive health insurance, as well as life, disability and possibly long-term care insurance can be a vital part of the package. For example, offering your key executives enhanced life or disability insurance is an attractive benefit for them and their family. Another example would be to offer a key employee continued employer paid health benefits for a period of time if the executive retires under agreed upon conditions or if the business is subject to a change of control.
Typical fringe benefits can include additional vacation time, country club or gym memberships, paid parking, transportation benefits which could include a corporate car, tax, and financial advice.
- RETIREMENT BENEFITS AND LONG-TERM COMPENSATION
These benefits are what really sets an executive’s compensation apart from other employees. Retirement plans, or deferred compensation, could include both qualified and non-qualified plans to maximize tax savings for executives. Most companies have a qualified retirement plan, such as a 401(k), in place for all employees. With qualified plans, both the employee and employer can contribute to the retirement plan. Qualified plans must conform to Employee Requirement Income Security Act (“ERISA”) rules and must be offered to all employees. These plans are for the sole benefit of the employee. Creditors cannot access the funds if the company goes bankrupt, and there are limits on plan contribution amounts.
A company can also add a non-qualified deferred compensation (NQDC) retirement plan. These plans can help attract and retain key employees by providing additional incentives for performance and length of service. NQDC plans are exempt from most ERISA requirements and reporting. This means there are no limitations on the deferral amount, and it can be offered to select employees. A NQDC plan is an agreement between the employee and employer. In this agreement the employer promises to distribute money, plus any earnings to that employee at a future date. To defer taxation, federal and state laws require the plan to be a legal document specifying the amount to be paid, the payment schedule and the triggering event that will result in payments in the future. A triggering event could be a fixed future date, separation from service, death, disability or change of ownership or company control.
There are two main types of NQDC plans: elective and non-elective. In an elective non-qualified deferred compensation plan, an employee chooses to defer a portion of their current salary and bonus compensation until a future tax year. With a non-elective plan, the employer funds the entire benefit and the employee’s current year compensation is not affected. NQDC plans can carry risk for the employees because the future payments are unsecured, not guaranteed and face creditor risk if the business faces bankruptcy. There are ways to mitigate some of this risk by establishing appropriate plan designs and implement the use of trusts to hold plan assets. Therefore, it is extremely important to understand the plan structure and utilize a financial advisor to guide you to the correct decision.
Long term incentive plans, or equity compensation, are earned in the present but structured to pay out over time, usually ranging from three to five years. Like non-qualified deferred compensation plans, their purpose is to increase longevity and loyalty within the company. As stated above, losing a top executive is more costly since they are typically in charge of coordinating priority projects that can take years to implement. When it comes to equity compensation, it is not as straightforward as the other benefits previously mentioned. A typical form of equity-based incentives is Employee Stock Options (ESO’s). They give an employee the right to purchase a certain number of the company’s shares at a certain price for a given period. The two types of ESO’s are:
a. Incentive stock options (ISOs) – These benefits are only available to employees. They give employees the right to buy shares of company stock at a discounted price with the added benefit of tax breaks on the profit. Profit on qualified ISOs is taxed at the capital gains rate, not the higher rate for ordinary income.1
b. Non-qualified stock options (NSOs) – are available to employees, as well as outside service providers, such as advisors, board directors or consultants. Non-qualified stock options give employees the right, within a certain timeframe, to buy a set number of shares of the company’s stock at a preset price. They do not qualify for special capital gains treatment like ISOs, instead, they are taxed as ordinary income.2
Employee stock options used to be the predominant form of equity-based compensation. However, because they are more difficult to administer, companies are veering away from them. Also, executives now view other types of equity compensation as more enticing. These other types of long-term incentives explained below have become more common.
a. Restricted stock units (RSUs) – RSUs award stock shares to an employee that are tied to performance goals or length of time you have been employed. They have a vesting schedule and do not have value until vested. Once they are vested, they are no longer restricted and are assigned the current fair market value of the stock. Ordinary income tax is due at the time of vesting. Typically, part of the proceeds are withheld to pay the taxes. The employee receives the remaining shares. They can then sell them anytime they like, and function like any other sale of stock.3
b. Stock appreciation rights (SAR) – SARs are an award based on the company stock value not actual stock. SARs are tied to stock performance during a preset period and are profitable when the stock price rises. Profit to key employees can be paid with cash or stock. Stock appreciation rights are enticing to companies who want to offer employees compensation without diluting share prices by issuing extra shares.4
As you can see, executive compensation is a multifaceted and complicated topic. Whether you are the employer providing these benefits or key executive receiving them, it is imperative that you take the time to evaluate all aspects of the plan. Utilizing advisors to understand your options versus trying to figure it out on your own is critical. For employers, key executives’ compensation can directly impact a company’s success. Not only does it motivate top executives within the firm to accomplish their goals, but it also helps attract the types of executives your organization desires. For executives, these benefits can be large sums of money. It important to evaluate how each of the benefits affect your financial plan, especially your cash flow and tax ramifications currently and in future projections. Our financial advisors at Fragasso Financial are equipped to discuss these plans and help guide you to the ideal solution for your individual situation.
1. Kagan, Julia (2021 March4) https://www.investopedia.com/terms/i/iso.asp
2. Chen, James (2020 June 30) https://www.investopedia.com/terms/n/nso.asp
3. Fernando, Jason (2022 September 1) https://www.investopedia.com/terms/r/restricted-stock-unit.asp
4. Hayes, Adam (202 June 27) https://www.investopedia.com/terms/s/sar.asp