Printer Friendly

The need to manage executive compensation: opportunity creates choices.

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)

[GRAPHIC OMITTED]

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 the goals of maximizing the potential rewards with managing the risk, in a way that is right for the individual. With good planning, you can build a portfolio that not only decreases your risk but also increases your potential for building and protecting wealth--possibly across generations.

Effective wealth planning with non-cash compensation plans requires multifaceted advisory expertise in stock and option valuation, tax laws and their potential changes, and (often) trusts and other estate planning vehicles. It requires clear articulation of your goals, income needs, and tolerance for risk. A healthy dash of psychology is also necessary, because most executives are invested emotionally, not just financially, in their companies.

Ranking the Choices

Compensation comes in three basic flavors: cash, restricted stock, and stock options. (Instruments such as phantom stock or stock appreciation rights are variations of restricted stock and options, but their operating premise remains the same.) Each has pros and cons, as shown in Display 3, and each has a distinctly different risk/reward profile. (See "Cash, Stock, or Options?" facing page.)

Given the choice of cash, restricted stock, or stock options, which is best? The answer always depends on your individual situation, but to compare the risk and reward potential of each, we used our Wealth Forecasting System to project 10-year probable outcomes.

We began by assuming an individual received one grant of cash, one grant of restricted stock, and one grant of stock options, each valued at $100,000 before taxes. (6) (We use this number because it is easily scaled: For example, to measure the growth of $1 million, simply add one zero to all the results. For $10,000, drop one zero.)
Display 3
Deferred Compensation Choices

 Pros Cons

Cash Tax deferral until vest --
 Investment flexibility
Restricted Tax deferral until vest Higher risk
Stock Potential dividends
Stock Tax deferral until Highest risk
Options exercise
 Higher upside (*) Can lose all value quickly
 (*) Expiration date No
 dividend income

(*) Due to leverage
Source: Alliance Benstein


For the cash grant, we assumed it was immediately invested in a diversified portfolio of global stocks. (7)The cash grant vested in equal portions over four years, as did the other grants, and a portion of the portfolio was sold to pay income tax as it vested. For the restricted stock grant, we assumed that shares were sold to pay taxes as it vested, but the remaining shares were held for the duration of the 10-year period. (8)And for the stock options, we assumed the entire grant was exercised after 10 years. (9) The ending values are all adjusted for inflation.

Display 4 shows the range of outcomes in a box-and-whiskers graphic, from dismal at the bottom to excellent at the top. The bigger the bar, the greater the range of possible outcomes, and, generally, the greater the risk. (See "A Closer Look at Our Modeling: The Wealth Forecasting System," page 8.)

The results are striking: For the highest median value, cash, invested in a diversified portfolio for 10 years, generates $87,000.10 That means, in typical market conditions, it is the safest of the choices. The potential downside (assuming very poor performance) also represents the best of all the choices: $50,000. However, its potential upside (assuming excellent performance) is not too exciting. Of all the choices, it is the lowest: just $155,000.

Restricted stock that is held for 10 years and then sold exhibits a wider array of returns. While its median result--$65,000--is lower, and its potential downside is also lower, its upside is much greater.

Finally, the rightmost bar vividly shows the appeal--and the risk--of stock options. The median result after 10 years is only $35,000. This may seem surprisingly low, but keep in mind that at the time of issue, options have no intrinsic value--the exercise price equals the current stock price. There is a significant risk that the options will expire worthless. However, if the stock performs very well, defined as the upper decile of performance in probable outcomes, it will be worth at least more than four times the starting amount: $450,000. And remember, that's after taxes and inflation.
Display 4

Quantifying the Pros and Cons


Probability 5%-10% 50% 90%-95%

Cash(Invested in Global Stocks) 155 87 50
Restricted Stock 198 65 24
Stock Option 450 35 0

All compensation is assumed to vest over four years- Cash is assumed
to he invested m global stocks (see footnote 7, below, tor global
stock assumptions) pre- and post-vest. Taxes due on vested
restricted stock are assumed to be paid in shares of stock. All
portfolios are liquidated and taxed at year 10. Options, are assumed
to expire at the end of year It). Amounts are net of embedded
capital gains and income taxes. Data do not represent past
performance and are not a promise of actual future results or a
range of future results. See Notes on Health Forecasting System,
page 44, for further details. Source: Alliance Bernstein

Note: Table made from bar graph.


The choices are many, and the stakes are high. The right choice depends entirely on your individual situation. In the next section, we will discuss a decision-making framework designed to help you make informed choices.

RELATED ARTICLE: Cash, Stock, or Options?

Generally, most people's first choice of pay is cold, hard cash. The gratification is instant: You can spend it, bank it, or invest it. Its value is clear; you don't need a calculator to figure out what it's worth. What's not to like?

Further, cash compensation can be deferred. And some companies allow it to be invested before you receive it, so you get the potential for investment growth while you wait for it, and you don't have to pay taxes until you actually receive it.

Nice Restrictions to Have

Restricted stock is stock that is granted to you, but it cannot be sold or transferred until certain conditions are met. Companies also offer restricted stock as an incentive to keep valued employees. The terms of the restrictions can vary widely, but usually restricted stock grants have a vesting period. For example, such grants may vest in four parts over four years. But should you leave the company during that time period, you lose the amount that has not vested. Some restricted stock has other conditions that determine if and when it vests, such as the company meeting certain financial goals.
Options Are a Leveraged Form of Stock Ownership

 Stock 100 In-the-Money Option 100

Stock Price ($) 100 100
Option Exercise Price -- 90
($)
Option Intrinsic 100 10
Value ($)
1% Change in Stock 101 101
Price ($)
Option Exercise Price -- 90
($)
Option Intrinsic 101 11
Value ($)
Change +1% +10%

* As with most stock-related compensation vehicles, the rules and
restrictions on option grants can vary widely from company to company.
[dagger] Intrinsic value is only part of the total value of an
option, but to illustrate this point We focus only on intrinsic
value. See "Understanding Time Value," page 19.
[double dagger] For a further discussion of option pricing, see
"Managing Stock Options to Meet Financial Goals," page 17.


The value of deferring income tax can be substantial, and grows over time (see "Weighing the Benefit of Non-Qualified Deferred Compensation," page 33). Further, some restricted stock plans allow you to accumulate the dividend payouts as well before the stock vests. One way of looking at restricted stock is that the government shares the single-stock volatility risk with you. If the stock price goes up, Uncle Sam takes part of the gain. If the stock price goes down, your tax bill will be lower than if you had received the stock immediately.

Turbocharging the Upside

A stock option gives its holder the right--but not an obligation--to buy common stock at a given price (the "exercise price") that is typically equal to the stock's current market price, at time of grant. Assuming the stock price rises, this option will gain value. The option expires at some point--often in five, seven, or 10 years. (*)

Stock options are the stuff of corporate legend because of their ability to create tremendous wealth through leverage. The display (facing page) shows how the leverage power of stock options works. In this example, we begin with an option that has an exercise price of $90 while the stock is selling at $100. The option's intrinsic value is, therefore, $10.[dagger] If the stock price moves to $101, the stock's value has increased by 1 %. But the option's intrinsic value has moved from $10 to $11--a 10% gain! When this leverage is applied to holdings of thousands or even millions of dollars, the exponential growth can be spectacular.

Of course, leverage is a two-edged sword. The option can lose value just as quickly as it gained it, and if the stock price drops below the option's exercise price, the option is "out of the money," meaning that for the time being, its intrinsic value has dropped to zero. Worse yet, if you hold the option to its expiration date and it's out of the money, it expires worthless.

Generally, when companies offer stock options to employees, they offer a greater quantity of them than if they had offered outright shares of stock or restricted stock. For example, if a company offers a choice of restricted stock or stock options, it might offer three or four options to every one share of restricted stock. This reflects the fact that companies value option grants based on option pricing models (usually the Black-Scholes model), and the value of a newly granted option is considerably less than the value of a share of stock.[double dagger]

RELATED ARTICLE: A Closer Look at Our Modeling: The Wealth Forecasting System

Bernstein's Wealth Forecasting System (WFS) is a proprietary planning tool uniquely suited to analyzing executive wealth. It projects the probable returns of portfolios holding virtually any mix of assets, including both current and expected future grants of single stock, restricted stock, and stock options--as well as traditional and alternative asset classes. Its projections integrate the effect of inflation, taxes, and spending. It also integrates multiple investment vehicles like taxable accounts, tax-exempt accounts, and charitable or wealth transfer trusts, modeling them simultaneously to show the effect of changes in one on the others and to forecast wealth across generations.

The WFS, like most sophisticated financial planning tools, uses a Monte Carlo-type model, which simulates 10,000 plausible paths of return for each holding or asset class, as well as inflation, and produces a probability distribution of outcomes. However, unlike many Monte Carlo models, it does not draw randomly from a set of historical returns or other broad measures to produce estimates for the future. Instead, it takes a "ground-up" approach to model single stocks and asset classes. The WFS projections:

* Are based on the building blocks of holdings or asset returns, such as inflation, yields, yield spreads, stock earnings, price multiples, and volatility

* Incorporate the linkages that exist among the returns of various asset classes

* Take into account current market conditions at the beginning of the analysis

* Factor in a reasonable degree of randomness and unpredictability

For example, when modeling the potential impact of inflation on a portfolio's spending power, the WFS has three unique attributes. First, it defines initial conditions, because they will affect future outcomes. In other words, potential outcomes will be very different if your starting point is 1980 (very high inflation), 2000 (lower inflation; high asset valuations), or 2010 (low inflation; modest valuations). Second, it recognizes that history has limited use as a guide. While many financial forecasting models use a random sample of history as their foundation, Bernstein's WFS creates plausible paths of investment outcomes to show how the financial markets may unfold, based on our understanding of economics and random shocks. This enables us to consider a wide range of potential scenarios. Third, in every path it ties together inflation's impact both on the value of future spending power and on stock and bond returns. Our model thus considers how inflation will affect spending and asset returns consistently, creating a more realistic set of projections on which to base planning.

[ILLUSTRATION OMITTED]

Outcomes from the WFS are shown as a probability distribution known as a box-and-whiskers chart. As the display (facing page) shows, the median outcome, or 50th percentile, is designated by the circle in the middle of the bar at the right. The 90th percentile--which represents very poor market performance--is at the bottom of the box, and the 10th percentile is at the top of the box. These outcomes have an equal one-in-10 chance of occurring. The "whiskers" extend the distributions to the 95th and 5th percentiles to graphically indicate that such extreme results, though highly unlikely, are possible.

Showing likely investment results in terms of probability is an excellent wealth planning tool. To gauge the midpoint of likely investment returns, we use the median result. But if we want to be conservative and plan for poor returns, we may use the 90th percentile, or even the 95th percentile, result. To illustrate, the 90th percentile reflects the fact that 9,000 of the 10,000 trials resulted in returns at this level or higher, giving us a 90% level of confidence that returns will be at this level or better. While this is no guarantee, statistically speaking, it provides a high level of confidence.

Using the WFS, we can model a simple illustration of the single-stock conundrum. The display (right) shows the range of probable annual returns for diversified portfolios with different asset allocations, from 0% stocks/100% bonds on the left to 100% stocks/0% bonds on the right--and the probable returns for a single stock of average volatility (*) It is a vivid demonstration of the risk and return of a single stock. The median return of the single stock--5.9%--is about one-third lower than that of a diversified portfolio of 100% stocks (9.0%). The downside risk (90th percentile) is considerable, with a one-in-10 chance that the single stock could drop 28.8%. Of course, the upside (10th percentile) is even more eye-popping: a one-in-10 chance the stock could rise 53.7%, which is precisely why single-stock ownership can be so rewarding. Using the WFS, we can model different strategies to seek the optimal balance of risk and return, depending on individual circumstances.
Compared with More Diversified Holdings, the Range of
Annual Returns for a Single Stock Can Be Extreme

Annual Returns (%) Over 20 Years.

Percentile 5th-10th Median% 90th-95th

0/100 9.7 3 -3.2
20/80 12.1 4.4 -2.5
40/60 16.9 5.5 -4
60/40 22.6 6.7 -6.3
80/20 28.5 7.8 -8.9
100/0 34.7 9 -11.7
Single Stock 53.7 5.9 -28.8

Based on Bernstein's estimates of the range for
returns for the applicable capital markets over the.
next 20 years. Data do not represent past performance
and are not a promise of actual future results or a
range of future results. Bonds are assumed to be
diversified intermediate-term municipal bonds, and
stocks are a global mix (see footnote. 7, page 10, for
global stock assumptions). See Notes on Wealth
Forecasting System, page 44, for further details.
Source: Alliance Bernstein

Note: Table made from bar graph.


(*) First-year volatility of the portfolios: 0/100 = 4.0%, 20/80 = 5.2%, 40/60 = 8.0%, 60/40 = 11.2%, 80/20 = 14.4%, 100/0 = 17.6%; Single Stock = 32.8%. Annual equivalent volatility of the portfolios over 20 years: 0/100 = 5.1%, 20/80 = 5.6%, 40/60 = 7.6%, 60/40 = 10.1%, 80/20 = 12.8%, 100/0 = 15.6%; Single Stock = 32.3%. Annual equivalent volatility differs from first-year volatility because the expectation and distribution of asset class returns change, over time. If the allocation targets change over time, this will also affect the annual equivalent volatility of the portfolio but will not be reflected in the first-year volatility.

(2) The National Center for Employee Ownership, 2009

(3) The 1.000 largest companies by market capitalization; reporting executives are those whose compensation is listed on SBC filings.

(4) Some employers may make the decision for you by restricting your ability to sell company stock.

(5) Not only are financial assets at stake, but a typical executive's career is also tied to his/her company, adding "career risk" to financial risk. If the company's stock suddenly plummets, chances are good that the company is under pressure, which may put the executive's primary income sources--salary and bonus--at risk as well.

(6) We base our assumptions on a federal income tax of 39.6%, a federal capital gains tax of 20%, and a state income/capital gains tax of 6%. All the choices are assumed to vest in equal portions over four years.

(7) Global stocks are composed of 35% US value, 35% US growth, 25% developed international, and 5% emerging markets.

(8) We assume the restricted stock is nixed as ordinary income when it vests: the ensuing growth at the end of 10 years is taxed as a capital gain. Some companies may offer the opportunity to defer receipt of restricted stock, but that is not the case in this example.

(9) The option grant assumes 2. 7 options per share of restricted stock. This number is based on pricing for a 10-year, at-the-money call option on a medium volatility stock (33% volatility: 1.5% dividend) and a risk-free rate of 2.8%) (i.e., the yield on US Treasury bonds). For more information, see Notes on Wealth Forecasting System, page 44. Other stock option exercise strategies are covered in "Managing Stock Options to Meet Financial Goals," page 17.

(10) It may seem disappointing that after 10 years a $100,000 award is worth only $87,000, but remember, all projected outcomes are after taxes and inflation.
COPYRIGHT 2011 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2011 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Publication:Directors & Boards
Date:Jun 22, 2011
Words:3748
Previous Article:Executive summary.
Next Article:The core and excess framework: an executive blueprint for building wealth.
Topics:

Terms of use | Privacy policy | Copyright © 2018 Farlex, Inc. | Feedback | For webmasters