In a previous article, we discussed the basics of two popular forms of executive compensation: restricted stock units (RSUs) and incentive stock options (ISOs). As we mentioned, for many rising executives, these and other forms of equity compensation, in addition to aligning the executive’s interests with those of the company, also can form a significant cornerstone of wealth-building for successful company leaders.
But, while equity compensation is often a significant source of wealth, it can also be a source of risk. This problem becomes especially acute when the value of the company stock or stock options forms a significant percentage of the executive’s net worth. When this happens, managing the related risks becomes a crucial part of equity compensation planning and the executive’s overall financial strategy.
What is concentration risk?
As mentioned, when compensation, equity awards, and career income are all tied to a single company, a large portion of net worth becomes dependent on the success of the company and the attendant value of the company stock. While that concentration can certainly drive wealth creation, it also increases downside risk, particularly as the executive moves through the career cycle toward retirement and financial independence from the company becomes more of a priority.
To deal with concentration risk, it is typically necessary to develop a measured plan for unwinding the concentrated position by selling portions of company equity over time and repositioning the proceeds in a broadly diversified portfolio designed to manage market volatility, allow for future growth and income, and decouple the investor’s financial security from the performance of a single asset. Such an approach requires careful consideration of liquidity and tax implications, since the sale of appreciated stock will generate capital gains tax liability.
What is equity compensation planning?
A thoughtful strategy for managing the concentration risk attendant to equity compensation typically includes:
- Establishing a disciplined approach to equity sales over time;
- Coordinating transactions with tax planning to manage realized gains;
- Maintaining sufficient liquidity for near-term needs, including taxes and lifestyle expenses;
- Reinvesting proceeds into a diversified portfolio aligned with long-term goals.
In some cases, equity compensation planning may also involve charitable planning strategies using appreciated shares, which can help reduce both concentration risk and tax exposure. For some individuals, it may even make sense to establish a charitable remainder trust to accept the shares. With the help of a qualified estate planning professional, the trust could be structured to provide income during the donor’s lifetime, alleviating the necessity of paying taxes on the sale proceeds and pass on the remaining assets to a charity.
In cases where company stock is held inside a 401(k), one might consider a net unrealized appreciation (NUA) approach. This allows the owner to roll over the shares to a taxable account, at which time they recognize and pay taxes on the owner’s cost basis (calculated on the strike price). If they hold the shares in the account for at least a year before selling them, they would be responsible only for the gain between the time of the rollover and the time of the sale. Further, this gain would qualify for more favorable long-term capital gains treatment. For some individuals, dealing with the tax implications of their stock holding in this way could be more advantageous than simply rolling the shares into a traditional IRA, which would require paying taxes (at ordinary income rates) on the entire amount of appreciation all at once, when shares are liquidated to meet RMD rules.
In all these considerations, timing matters. Deferral elections, option exercises, and stock sales all occur within specific windows, and decisions made in isolation can have unintended consequences.
For this reason, a coordinated approach to executive compensation planning brings together:
- Current and projected income;
- Tax brackets and potential changes over time;
- Portfolio construction and risk exposure;
- Retirement and distribution planning.
This allows each decision to support the broader plan rather than working against it.
What are the non-financial considerations of executive compensation planning?
For those nearing retirement with large holdings of company stock and options, it is vital to consider the issue of diversification. However, this can be complicated by the emotions that sometimes accompany the ending of a long, successful association with a company. Selling company stock can feel like disloyalty to the enterprise or even like a denial of personal identity. It’s important to remember, however, that the reason you have the holding is because of your years of loyalty and effort on behalf of the company. It may help to think of unwinding the position as the company’s way of thanking you for all you’ve done.
Getting the right assistance is vital.
For effective executive compensation planning, getting the right kind of advice is crucial. At JFS Wealth Advisors, our fiduciary duty obligates us to consider each client’s circumstances as a whole before we make any recommendation. This is the only way we can help our clients develop individualized plans that support their most important goals and values. If you have questions about how you can better integrate your executive compensation package into your overall financial plan, please let us help you find the answers you need.
