Executive compensation: equity compensation continuum
Retaining and recruiting top talent has been a challenge for employers over the last few years, with companies struggling with how to best hold onto and reward employees. Even as we have started to see some layoffs, many employees are finding new positions quickly and negotiating their compensation and benefits. Employers are realizing they have to be creative and reconsider the types and amounts of compensation they are offering if they want to make themselves more attractive to new and legacy employees.
It’s not always that easy, however, and the different types of equity compensation have pros and cons. Baker Tilly has created an equity compensation continuum that can help companies weigh their options to determine what will work best for their circumstances.
The continuum starts with the basics (e.g., base pay, spot bonuses, 401(k) match), moves to intermediate (e.g., elective deferred comp and supplemental executive retirement plans) and then on to advanced (e.g., stock options, stock appreciation rights, etc.). This is not a comprehensive list, but it covers the more common compensation types.
Basics
When comparing an employee’s compensation to market data, the most important comparison is total direct compensation consisting of base pay, short-term compensation such as annual bonuses, and long-term compensation such as deferred compensation programs and equity compensation.
It is generally accepted that an incumbent’s compensation is competitive or “at market” if the compensation is within 20% of market median (50th percentile). However, most employers are having difficulty retaining their employees, in part because the average raise of 4% is not keeping pace with inflation at 8%. As a result, employees are willing to change jobs for higher base pay and sign-on bonuses.
Some companies choose to reward employees with spot bonuses, which are typically one-time awards of cash compensation, ranging from $50 to $5,000. Spot bonuses differ from other types of bonuses because they are an immediate reward and usually acknowledge something specific in terms of the employee’s performance.
There are a few benefits of spot bonuses: They show appreciation for someone going above and beyond; they can be motivating; and they can quickly boost morale. This type of bonus can have a big impact without having to be that costly to the company.
Beyond spot bonuses are what are traditionally thought of as traditional bonuses. There are several different types, including short-term deferred bonuses, insurance bonus plans and split-dollar arrangement, which are discussed below.
Short-term deferred bonuses: Historically, these are currently one of the more attractive arrangements for employees. As the employee hits annual milestones, the employer grants an award to the employee to be paid after a short period of time, such as two, three or four years. If the employee is still employed by the employer at the end of that period, the award vests and the employee is paid. Short-term deferred bonuses can also be designed to rise and fall in value on the performance of either the employer, the employee or both. This type of compensation has changed over the years with more companies accelerating the vesting schedule to three to five years from what was typically more than 10 years.
Insurance bonus plans: The employer agrees to pay the premiums on a life insurance policy owned by the employee. Because the premium payments are considered income to the employee, the employer can deduct the amount of the premium. With most bonus plans, the employee is free to exercise any rights with regard to the policy, including surrender, taking policy loans, changing the beneficiary designation, etc. However, it is possible to place a restriction on the policy for a period of time that will limit the employee’s rights to the policy, including accessing cash value and taking policy loans.
Key person insurance and split-dollar: Key person insurance is life insurance purchased by an employer on the life of an employee. The employer is the owner, premium payer and beneficiary of the policy, and in the event of the employee’s death, the employer collects the income-tax-free death benefit and uses it to offset the loss of the employee. Should the employer decide to pay some or all of the death benefit to the surviving spouse of the employee (or otherwise to family) — commonly known as a “death benefit only” arrangement — the amount paid will be taxable income to the surviving spouse and deductible by the employer.
Additionally, it’s a common option for the employer to agree to “rent” the death benefit to the employee, a financing arrangement known as split-dollar. Essentially, the employee will pay rent — a cost based on standard term life insurance costs — for the right to name a beneficiary. In this case, the death benefit paid to the surviving spouse will be free of income tax.
Another standard compensation tool is the 401(k) company match. According to a study by SHRM, 57% of employees would rather receive a higher employer match contribution than more paid time off. Furthermore, a Betterment survey found that 65% of employees would leave their current employer for a higher quality plan. Companies should be aware of the risk of not staying competitive with their 401(k) plans.
Finally, a more recent addition to the compensation conversation is student loan assistance. Currently, there are two proposals in Congress — the House-passed Securing a Strong Retirement Act of 2022 (aka SECURE 2.0) and the Senate-passed Enhancing American Retirement Now (EARN) Act — that would permit an employer to make matching contributions under an employer-sponsored retirement plan for employees who make “qualified student loan payments” as if the payments were salary-reduction contributions.
The purpose is to assist employees who may not be able to save for retirement because they are overwhelmed with student debt and missing out on available matching contributions. By making student loan payments, employees’ retirement plan accounts would be credited with matching contributions.
A qualified student loan payment is broadly defined as any indebtedness incurred by the employee solely to pay qualified higher education expenses of the employee. The employee certifies to the employer that the employee actually made the student loan payment, and the employer is entitled to rely on the employee’s certification and doesn’t need to investigate further.
Intermediate
More traditional compensation matters are elective deferred compensation and supplemental executive retirement plans (SERPs). The major difference between the two is the financial source: The money for an elective deferred comp comes from the employee’s paycheck while the money for a SERP comes from the employer. It may seem that one has an edge over the other, but when it comes to retaining employees, both are solid options.
With elective deferred compensation, the employer allows certain employees to opt to defer some or all of their current income, to be paid in the future. For example, an employee with a base salary of $250,000 who is eligible to participate may opt to defer $50,000 of their current income. In this case, $200,000 will be current income to the employee and they will not be income taxed on the additional $50,000 until it is paid out under the terms of the agreement. However, since the employee is vested in this amount, it is subject to payroll taxes upon vesting. Future payments are either designed as lump sum payments or are paid over a period of years.
A SERP allows for the employer to make a promise to the employee to pay them a certain additional amount of money at some point in the future. As opposed to elective deferred compensation, this is the employer’s money and is over and above the employee’s current salary and bonuses. For example, with an employee who makes $250,000, the employer may agree to pay the employee $100,000 if the employee is still employed seven years from the time of the agreement. The employee’s $250,000 salary continues to be taxable income and deductible by the employer, with no tax on the $100,000 until it is paid out. The employer is under no obligation to set aside the money or otherwise “fund” the promise, although equities, life insurance or other assets are commonly used. The risk to the employee is that these funds, even if set aside, are subject to creditor risk. The employee is only an unsecured creditor of the employer. The same is true with an elective deferred compensation plan. In either case, the funds are at risk.
Keep in mind, with both of these intermediate plans, they are subject to IRC section 409A, which is a punitive section of the Code that dictates how this type of compensation is set up, when it is paid and how it is paid. Most importantly, once written, a plan is pretty much set in stone. Still, these structures are helpful for executives looking to set money aside for retirement, while reducing their current income tax burden. Notably, there is no limit on how much can be deferred.
Advanced
Long-term incentive compensation can take many forms and usually includes a form of equity arrangement. The overall purpose is to incentivize, reward, attract and retain key employees. It also promotes long-term thinking, helps grow the business, aligns the employee’s interests with the company’s objectives and builds shareholder value.
There are two major types of equity arrangements: direct and synthetic. Direct equity is where the employee owns stock in the company, such as through stock options or restricted stock, and synthetic equity comes in such forms as stock appreciation rights and phantom stock, which mirrors stock ownership but does not result in actual ownership.
Given that there are many types of equity or synthetic equity, how does an employer decide what to use to incentivize its key employees? The short answer is, it depends. A useful starting point is with the company’s compensation philosophy which explains the approach to how compensation is determined and provides a framework for consistency. Factors that influence a compensation philosophy include the company’s culture and structure, business goals and what the key employees want.
Stock options: Stock options are available for public and private companies. A stock option is the employee’s right to buy or exercise a set number of shares at a set price. It can be a win-win for a company in that the employee feels they have a vested interest in the company. If the business does well, stock prices increase and they are rewarded. It’s a common way for startups to reward employees when they don’t have other types of compensation to give.
The two types of stock options are nonqualified stock options (NSOs) and incentive stock options (ISOs). NSOs can be awarded to anyone, including employees and independent contractors. ISOs are limited to employees only. If the employee has vested but unexercised ISOs and leaves the company, the employee must exercise the ISOs in a designated time period or they may expire. If the arrangement allows the former employee to exercise the ISOs after the designated time period, the ISOs become NSOs.
Restricted stock and restricted stock units: Restricted stock is an outright grant of equity subject to time- or performance-based restrictions that create a “substantial risk of forfeiture” (i.e., the shares are unvested). The employee acquires a share of restricted stock, which can come with voting and dividend rights, and is treated as if the employee owns the shares outright as of Day One. It is also possible the employee could lose the shares in the event the substantial risk of forfeiture never lapses (aka they never vest). With restricted stock, the employee has discretion to make an election to be currently taxed on the value of the restricted stock over the purchase price, if any. The advantage to making this election is to start the long-term capital gain holding period. On the other hand, a disadvantage to the employee is if the stock declines in value, the employee has already paid tax on the higher value with no adjustment permitted.
Restricted stock and restricted stock units are not the same but are commonly mistaken as such.
Restricted stock units are not a transfer of property but represent a contractual right to receive shares in the future. They are similar in that the employee can transfer shares at no cost and they are subject to vesting schedules, but they differ when the transfer occurs. With restricted stock, it’s Day One. With restricted stock units, transfer doesn’t occur until they vest.
Restricted stock units are subject to section 409A and the documentation must be drafted in a manner compliant with 409A, which greatly restricts their flexibility.
Stock appreciation rights: A stock appreciation right gives an employee the right to receive an increase in value of a specified number of shares of the employer’s stock. It is granted with an exercise price that equals the fair market value of the stock on the date of grant. The employee has complete discretion when to exercise. SARs are typically settled in cash but can also be settled in stock, equal to the stock’s appreciation.
Beware: Just because it’s called a stock appreciation right doesn’t mean it is one. If the stock appreciation right specifies the payment event, it is not a SAR since the employee does not have discretion to exercise. It would actually be considered a phantom stock appreciation only plan, which is subject to 409A. Stock appreciation rights are not subject to 409A, so long as their exercise price equals or exceeds the stock price on the date of grant.
Phantom stock: A phantom stock plan grants a contractual right to receive the value of a share of stock, called a full value plan, or the appreciation of a share of stock, i.e., an appreciation only plan. To prevent dilution of the company, payment is almost always in cash but technically could be made in stock. It is best for closely held companies that do not want to give actual equity.
Phantom stock plans are also subject to 409A and are required to comply with its restrictive provisions and the valuation requirements. The arrangement has to be in writing, specifying not only the amount or formula that is objectively determinable but also the form of payment (lump sum or periodic) and the time of payment (limited to one or more of six permissible payment events).
Unlike with stock appreciation rights where the employee decides when to exercise, an employee who has phantom stock does not have discretion as to when to exercise and, instead, must adhere to the timing in the plan document.
Employee stock purchase plans: Employee stock purchase plans are payroll deduction opportunities for employees to purchase stock at a discount, typically 5% to 15% of fair market value. Traditionally, it is used by public companies and there is a vesting period associated with it. These can be beneficial for employees as it allows them to build financial wealth, but they are not as popular as they once were.
Conclusion
Employers have a broad range of compensation vehicles available to them, but not every one of them will be right for their needs. Regardless, they should be revisiting their compensation plans to ensure they are staying competitive in order to recruit, retain and reward desirable employees.
To learn more on equity compensation, connect with our team.
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