For many professionals, salary is just one part of the reward for work well done. The bulk of compensation may come in other forms: cash bonuses, stock options, restricted stock, phantom stock or stock appreciation rights, or a variety of deferred compensation plans.
These types of compensation offer the opportunity to amass much greater wealth than a traditional paycheck could provide. Surveys estimate that among companies that issue stock, about one-third of employees own shares--and the more senior the executive, the greater the holdings. (2) Our research found that among the 1,000 largest US public companies, top executives control an average of 8.6% of their companies' outstanding shares; their holdings are composed, on average, of two-thirds restricted stock/one-third stock options. (3)
Yet stock-based compensation brings challenges: Putting a fix on its future value can be tricky, which makes wealth planning difficult. Restricted stock, for example, fluctuates in value, and there's no way of knowing what it may be worth when it vests. Further, when it does vest, there's another decision to be made: to sell or hold. (4) Stock options present an even more difficult planning challenge: Because they are essentially leveraged instruments, they can soar in value--or expire worthless. And they have expiration dates, by which time you must "use 'em or lose 'em." Waiting may increase the options' eventual payoff, but it may do the opposite.
Similarly, some companies offer their employees choices on types of compensation--like receiving a portion of an annual bonus in stock options or restricted stock, or deferring pay in a non-qualified retirement plan. Unfortunately, most people have no frame of reference to help them make informed decisions. If you were given the chance to take any portion of your bonus in stock options, how much would you take? Anecdotal evidence suggests people tend to fall into three camps: The risk takers choose mostly stock options; those who are risk-averse take mostly cash; and the others split the choices evenly. But going on gut instinct or rough calculations is not the best way to negotiate this kind of choice. Your decision can have a huge impact on the ultimate value of the awards.
Presented with non-cash compensation, too many executives, especially those early in their career or pressed for time, make decisions without careful analysis: They simply accumulate whatever is offered and hang on to it for as long as possible. Unwittingly, they may be leaving money on the table--or adopting the highest-risk strategy.
In short, stock-based compensation and income deferral plans provide great opportunities to build wealth, but to make the most of them you need to make well-informed decisions. To maximize the value of these opportunities--and to manage their risks--you need to:
* Understand the risk/reward equations of each type of compensation award
* Have strategies for managing them
* Integrate them into your overall personal wealth planning
The Case for Active Management
A full accounting of your overall wealth may reveal that it is more dependent on your company and its success than you realized. As Display 2 illustrates, with an assemblage of directly held shares, stock options, company pension plans, and other deferred compensation plans, executives can easily have more than half their wealth tied up in the company. (5)
Large exposure to a single stock can increase the upside, should the company do well, but it also brings more risk than most people realize. Even the strongest companies can experience sudden stock plunges, sometimes for reasons that have nothing to do with the company's fundamental value. In the global credit crisis of 2008, many Fortune 500 stocks lost more than half their value. Many dividends were cut and stock options went "underwater." The stock price of some firms may have recovered (for some, it did not), but that was cold comfort to shareholders--especially if they were approaching or in retirement. In the worst case, the stock value of seemingly strong companies can suddenly plummet to zero--as was the case in 2008.
Yet it may not be easy to reduce this exposure. A thicket of securities regulations and company policies can stand in the way of selling stock. Employees of publicly held companies are prohibited from selling shares around the time of company earnings announcements, underwritings, or material events. Shares may be subject to vesting schedules or stock retention requirements. And sometimes a perfectly innocuous sale may incur regulatory scrutiny if a material event occurs shortly afterward. Some companies even forbid selling until you have left the firm.
The objective of wealth planning with non-cash compensation, therefore, is to balance...