Key Takeaways
- Many corporate executives with complex compensation end up with a highly concentrated and illiquid portfolio, which can lead to several challenges.
- These challenges are compounded when both your income and your investments are highly concentrated in a single company.
- A qualified financial advisor can help you navigate the challenges of executive compensation in order to help optimize your long-term wealth-building potential.
If a significant portion of your earnings is in the form of company stock, bonuses or deferred pay, it is important to have a plan in place to turn that compensation into long-term wealth. That is because stock awards and complex compensation packages can result in concentrated holdings, inconsistent payouts, blackout windows and illiquidity.
Here, we examine the challenges of executive compensation and offer strategies to help turn your pay package into long-term wealth.
The Challenges of Executive Compensation
Many corporate executives with complex pay packages end up with a highly concentrated and illiquid portfolio, which can lead to several challenges.
Concentration risk
When both your compensation and your investments are concentrated in a single company, you could face significant risk should an unexpected event impact your company. That is because you are depending on the success of your employer for both your salary and your investment performance.
Perhaps the most infamous example of this risk occurred in 2001 when Enron went bankrupt. Due to highly concentrated stock positions, many Enron employees simultaneously lost both their jobs and their life savings.
Tax exposure
Not only can having a concentrated stock position put you at risk of market volatility and bankruptcy but it can also expose you to significant tax liabilities should you decide to sell your appreciated shares at some point in the future. When you sell, you will likely need to pay capital gains taxes on any appreciation, which can be substantial if your shares have significantly appreciated in value. And certain forms of equity compensation, such as restricted stock units (RSUs), are taxed as ordinary income on the full value of shares, which can bump you into a higher tax bracket.
Timing challenges
RSUs are taxed when they vest, while options are taxed at the time of exercise or sale. Incentive stock options may be subject to long-term capital gains taxes if you hold them for two years from the grant date and one year from the exercise date, but the spread can trigger the alternative minimum tax. Employee stock purchase plan (ESPP) purchases can create ordinary income if you sell too soon, while deferred compensation is taxed when it is paid, not when you earn it.
The different timing of each compensation type can greatly impact your financial planning strategies because those dates decide when income appears, what type of tax you pay and when you can access cash. These factors all result in a loss of control that can keep you from optimizing your long-term financial outcomes.
Illiquidity
Executive compensation is often subject to blackout windows, Form 4 filings, lockups and complex distribution rules, including Rule 144 and Section 409A. These restrictions can block a sale at a time when you need access to cash, resulting in liquidity challenges.
Strategies for Managing Executive Compensation
The following strategies can help you manage the challenges of your complex executive compensation package and provide an opportunity to optimize your long-term wealth-building potential.
Understand what you own
Start by listing every award type you are eligible to receive, including your salary, bonuses, RSUs and performance stock units (PSUs), incentive stock options (ISOs) and non-qualified stock options, ESPPs, deferred compensation, etc. If there are any benefits you do not fully understand, schedule a meeting with your HR representative to go over details. The most successful executives do not simply accumulate company stock. They develop a disciplined plan for converting concentrated compensation into diversified, long-term wealth aligned with their personal goals and values.
Track key dates
Track all relevant dates and key data related to these awards on a calendar. Include vesting dates, strike prices, expirations, election windows and tax withholdings. Use this calendar to identify timing challenges and material tax events. Then work with your financial advisor to implement proactive financial and tax planning strategies to help mitigate the impact and tax exposure of these events.
Set a personal cap on company stock
Your job already ties your income to your employer, and maintaining a large allocation to company stock could expose you to additional risk. Work with your financial advisor to set a limit on how much vested, sellable company stock you will keep. For example, you may decide to limit company stock investments to 10% of your net worth.
Once you have established a limit, make a plan to regularly sell shares as they vest in order to balance out your portfolio allocation.
Consider charitable giving
Highly appreciated company stock may be an efficient asset for charitable giving. Depending on your situation, strategies such as donating appreciated securities or utilizing a donor-advised fund may help reduce concentration risk while potentially enhancing tax efficiency.
Diversify
The easiest way to diversify a concentrated stock holding is by simply selling some of the stock and using the proceeds to invest in a diversified mix of investments. However, there can be significant tax implications from doing so, including short- and long-term capital gains tax, income tax and alternative minimum tax (AMT).
Your financial advisor can help you determine whether it makes sense to diversify using other strategies, such as:
- Direct indexing
- Margin
- Options strategies
- A prepaid variable forward (PVF)
- An exchange fund
Could you use some help managing the complexities of your executive compensation package? We would love to have a conversation. Please schedule a call with a member of the United Capital Financial Advisors team.
