One goal for employers is to hire and then incentivize the brightest talent available to remain with the employer and grow the business over time. So, what are the components of a compelling compensation package that keeps the prized executive employee with the company?
The most recognizable component of the executive’s employment compensation is the salary. The salary must be competitive for the industry and skillset the executive brings to the organization. But the salary is just one component. Often the executive has other interests the employer can address.
One common tool to incentivize the employee to stay is to offer the employee ownership (stock for corporations or ownership units for limited liability companies) in the organization. This gives the executive a real stake in the success of the company. And, the ownership can be paired with work longevity requirements. When a company uses regular equity stock to incentivize employees, it usually does so through direct stock compensation or through stock options. The “stock option plan” (also known as the Incentive Stock Option or Qualified Stock Option or Restricted Stock Option) is where the employer allows the employee to purchase stock at a value that is the current fair market value, but it remains locked in for later purchase at the original option price. The hope is that the stock appreciates and the employee then gets to purchase at the discounted locked-in price previously established. The granting of this option is generally not taxable but the tax is assessed when the employee sells the stock for which he previously exercised the option to purchase. At exercise, the employee needs cash to buy in to own the stock. Importantly, with the stock option, the company gets no tax deduction for the stock options offered.
Similarly, the employer may not offer “real” ownership in the form of stock, but might instead offer some of the benefits of stock ownership through “Phantom stock.” It is not real stock ownership. Instead it is simply the contractual relationship between employer and employee that gives the employee stock-like rights when it comes to income and even to the proceeds upon the potential sale of the business without incurring income tax to the employee upon receipt of the Phantom Stock. For example, an executive might be given the right to 5% of the employer’s net income (as if he owned 5% of the company). Phantom Stock doesn’t provide the employee with actual stock ownership rights which can simplify organizational requirements (one less stockholder to be concerned about).
Benefits can be tailored for specific key executives
An employer might choose to use a new or existing 401(k) or other qualified retirement product to incentivize the executive. Of course, these plans must meet nondiscrimination rules that are designed to not favor highly compensated employees. Still, there are some lawful tweaks that a plan can make. For example, perhaps the employer has a short vesting schedule for it’s qualified plan (say, 6 months of employment). The employer might revise its plan to a 5-year vesting schedule (with 20% vesting each year) to further incentivize longevity with the employer. And, if the employer includes a profit-sharing component to its qualified plan, it can pass more qualified funds to the key executive subject to the same vesting rules.
Non-Qualified Retirement/ Deferred Compensation
Sometimes the executive is especially concerned with retirement income. A typical qualified plan may not be able to infuse enough cash for the executive to accommodate his or her lifestyle at retirement. Because qualified retirement plans have the built-in limitations of non-discrimination, it becomes necessary to use non-qualified (regular ol’ taxable income) to solve for the executive’s retirement needs. This kind of deferred compensation is called a Supplemental Executive Retirement Plan (SERP).
The SERP offers a solution to the executive’s concern about retirement. It is a planning strategy that provides for additional retirement compensation for the executive. It is usually structured as a non-qualified payment stream to the executive at retirement. As such, it neither qualifies for any special tax treatment (as true IRAs or 401ks can), but neither is it constrained by the limitations imposed on qualified plans (as traditional retirement plans are).
The payment is only a promise. That means that the employer is promising to pay a certain amount of money on an agreed basis for an agreed amount of time. But, if the employer faces hardship (think bankruptcy), the executive might find that the employer’s promise to pay takes a backseat to creditor claims. The bottom line is it is not a guaranteed payment. But, really what is guaranteed these days anyway?
By utilizing one or more of the tools considered here (sometimes individualized for the executive), the employer can present a compelling package to entice the executive to stay and grow with the company.
* Licensed, not practicing.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.