Apr 12, 2021

The Financial & Psychological Considerations of Executive Compensation Plans

Apr 12, 2021
Tyler Scott – CFA CFP©
Wealth Architect
Tyler Scott CFA CFP©, one of our longest-serving Wealth Architects, has been helping Silicon Valley leaders navigate the ins and outs of their executive stock compensation plans for two decades. These plans can be sprawling and nuanced, so we asked Tyler to be part of this Q&A and share some insights he has gleaned from his work in this area, specifically regarding the financial and psychological factors at play when navigating concentrated financial wealth.

You’ve been advising Silicon Valley executives for 20 years. What do you find exciting about working with this type of clientele?

It’s invigorating to work with people who are often pioneers in their fields, building impactful companies, and driven to change the world for the better. There is a lot of complexity when it comes to executive compensation plans and my mission is to provide the clarity and information my clients need to make appropriate decisions to meet their overall goals.

There is no singular formula to follow here. Every client has a unique set of circumstances and costs/benefits to weigh, which keeps things interesting. I kind of nerd out on this stuff!

So, what are the most common kinds of executive stock compensation plans you see?

I see a lot of RSUs, ISOs, and NQOs and often a combination of all three. I’m including a high level breakdown of each type at the bottom of this article in case readers want to dive into the details.

What are the most common financial considerations your Silicon Valley executive clients need to take into account when receiving these forms of compensation?

Taxes are a big one. It’s possible to get upside-down with your tax bill in these scenarios. That’s something I frequently work with my clients and their CPAs to try to avoid.

Concentration risk and determining the appropriate strategy upon vesting are also key. I generally advise to sell or have a disciplined and systematic strategy to sell, as it locks in gains and helps diversify the portfolio. Some do choose to keep the stock concentrated in the company because they believe in the company and its growth in value over time, but most will continue to get additional compensation in the form of RSUs or options which only adds to concentration over time.

How do psychology and emotion play into these decisions?

I’ve seen clients choose to hold a larger position of company stock based on sentimentality. This can also happen due to perceived pressure from fellow executives to be a “team player” or someone who “believes in the company” by not selling.

Price targets can also be highly psychological, as it’s really a gamble. If you set a price target at which to sell your stock, it’s advisable to stick to it. Some might be tempted to keep pushing the bar every time the stock reaches a price target, but that mentality can create financial downside risk. Emotionally, it is often most difficult to diversify when a company is doing well or before it hits a period of bad performance which is very hard to predict.

Here’s another consideration: If you stick to your target, and sell your shares at a certain price, will you be upset if the price then goes much higher? I’ve observed varied reactions from clients in this situation, and I think it all comes down to mindset and appreciating the gains you were able to monetize, rather than grieving the ones you weren’t.

Stock decision-making can easily become entangled with anxiety, regret, and mind games. As a fiduciary, I enjoy guiding clients to make informed decisions and helping them feel confident in their choices, despite the uncertain outcomes, by framing them within the context of their larger life plan and goals.

Where do 10b5-1 plans come into all of this?

10b5-1 plans put stock selling on autopilot. They stipulate exactly how you would like to sell your stock over a time period within specific selling rules. A 10b5-1 may also permit selling outside of the open trading windows, time periods in which executives are expressly authorized to sell stock. Advanced planning through a 10b5-1 protects you against insider trading liability and saves you time, opening up the mental space to focus on other important things in life, like performing in your role, family and community, rather than tracking the performance of a stock and worrying when it’s the right time to sell.

A 10b5-1 plan can allow you to effectively “set it and forget it.” The goal is to set the selling parameters of the 10b5-1 to align with your overall life goals. Ideally, we have solved for, “How much is enough?” Creating a plan allows the proceeds of the stock to fuel your financial life goals and increase your well-being in other areas of your life.

So then, how much is enough?

There isn’t a simple quantity, of course, but I do run models for my clients designed to get as precise as possible. Most clients want to achieve a sense of balance and contentment that goes beyond financial stability into areas like career, family, community, legacy and more. “Enough” is when the proceeds from the stock sale support the financial piece of the overall plan for achieving this well-being and happiness.

For example, if a client wants to buy a house, I might figure out how much stock they should sell in the next open window in order to have enough cash for a downpayment. Then, we work together on a strategy for diversifying their portfolio without sacrificing their long-term goals, which may include things like starting a family, retiring early or establishing a philanthropic legacy. We typically don’t regret using our money to do things that are most important to us in life.

In your experience, what type of clients tend to be the happiest?

I think the happiest clients are the ones that aren’t reticent to cash out and not look back. It’s the ones that choose to spend a little less energy on the finances and a little more on things like family time, community involvement, pursuing personal passions and giving back.

My personal opinion is that fixating over the minutiae, the price targets, and the “should’ve, would’ve, could’ve” isn’t worth it and doesn’t do much to improve quality of life. I work with people who have had great financial success in their careers, any way you cut it. I encourage them not to agonize or overthink, but to be grateful for that good fortune, weave it into a broader life plan and go enjoy the experience of living a fulfilling life. This is what we mean here at Wealth Architects when we talk about building a wealthier life beyond financial stability.

RSUs (Restricted Stock Units): 

  • Typically at large, public companies.
  • RSU grants usually vest over four years. As an example, one quarter of the grant may vest after the first year, with the vesting cadence usually converting to monthly, quarterly or annually thereafter. 
  • On the date of the vest, the gross portion of the vested RSUs is taxable income to you and a portion of the vested RSUs are automatically sold to cover tax withholdings on this income. The result is your net after-tax RSUs are deposited directly into your stock plan account and may be sold immediately with little to no tax consequence. 
  • THE RISK: A common issue is the tax withholdings on RSU income is sometimes under-withheld. Therefore it’s wise to run tax projections to see if you may need to set aside additional withholding or make estimated tax payments. Some companies do allow you to adjust the tax withholding and it is important to understand if this option is available
  • THE BENEFIT:  This is a more certain form of compensation, rather than options which may fluctuate above and below their strike price, making their value potentially worthless. 

ISOs (Incentive Stock Options):

  • Typically at smaller, private companies, like startups.
  • Unlike with RSUs, when selling ISOs there are no automatic withholdings. It is up to you and/or your CPA to factor in the tax.
  • ISOs stipulate a grant price per share–the price at which you can exercise your options once vested. If the stock price surpasses the grant price, you can net the difference.
  • THE RISK: If you exercise and hold, there could be an Alternative Minimum Tax (AMT) on the spread, which the IRS considers income even though you haven’t sold it yet. If the stock goes down before you liquidate, you may not be able to pay off the AMT.
  • THE BENEFIT: By exercising and meeting specific holding criteria, you can potentially convert a holding into a long-term gain at more favorable tax rates versus a short-term gain with a straight exercise and sell.

NQOs (Non-Qualified Stock Options):

  • Typically issued at companies where they have exhausted their ISO allocation.
  • As with ISOs, once you exercise a NQO, the difference between the grant and stock prices is taxable income to you.
  • Unlike ISOs, exercising NQOs requires a partial sell to cover withholding for taxes. (As with RSUs, sometimes this partial sell does not cover the total withholding requirement.) The net exercised shares are then deposited directly into your account and can be sold with little to no tax consequence, similar to RSUs.
  • THE RISK: The question with NQOs is whether you would rather have cash or own the stock. Since the cost basis is on the date of the exercise , as with ISOs, I often encourage clients to exercise and sell right away, rather than hold onto stock that could go down.
  • THE BENEFIT: NQOs (and ISOs) offer flexibility relative to RSUs on when to realize the income, given income from ISOs and NQOs is realized upon exercising the option, not when the option vests. RSU income, on the other hand, is realized immediately on the vesting and there is no flexibility around that taxable event.