Originally posted in the Baltimore Business Journal on September 20,2018
In 2017, the median pay of CEOs of the biggest U.S. companies in the S&P 500 reached $12.1 million 1, a post-recession high. While not all executive compensation will reach this level, the median salary for a Russell 3000 CEO was still over $3 million2 in 2017. With eye-popping figures like those, it makes you wonder what exactly executive compensation packages consist of.
The who, what, and why of executive compensation
Executive compensation refers to the financial compensation and non-monetary benefits paid to management employees, including the CEO, CFO, COO, president, vice president, or managing director of a given firm.
The most obvious component of executive compensation is salary, although it rarely consists simply of salary. Executives may be entitled to bonuses if they meet certain performance criteria. In fact, in 2017, annual incentives were almost equal to salary for Russell 3000 CEOs, making up 22% and 25% of total compensation3 , respectively.
Most executive pay packages consist primarily of equity, typically company stock or stock options. Equity accounted for 53%4 of reported CEO compensation for the Russell 3000 in 2017. Stock ownership attempts to align executives’ interests with the interests of stockholders, giving them a strong incentive to perform well. However, stock options could encourage executives to take unnecessary or short-sighted risks rather than focus on shareholders’ long-term interests.
Benefits like retirement packages including supplemental executive retirement plans (SERPs); health, dental, and life insurance; and paid vacation time are also common elements of executive compensation.
Executives may also have perks that aren’t available to all employees such as access to a private jet, travel reimbursements, company car, personal driver, etc. These perks recognize the value of the executive to the company but are usually only a modest component of their compensation.
Designing an effective compensation plan
Paramount to designing an effective executive compensation plan is linking pay to performance. Payment should be contingent on criteria such as achieving specific financial results or meeting strategic objectives. Failure to link pay to performance may invite shareholder scrutiny.
Companies should take a long-term view when designing their executive compensation plan with the aim of retaining top executives. Long-term incentive plans typically have a duration of 3–5 years with the executive not typically receiving the full benefit from the incentive plan until the end of the term.
Incorporating short-term incentives such as an annual bonus for achieving objectives like increasing market share or improving profit margins may also encourage executives to continually strive for results.
Financial planning considerations for executives
As executive compensation can include a wide variety of components, financial planning to minimize taxes and maximize rewards is critical.
With all the potential financial rewards on the table, there are going to be tax implications. One option available to executives is a non-qualified deferred compensation, which involves setting aside part of their salary or bonus to be paid at a later date, usually when the executive retires, to take advantage of potential tax benefits. Executives should seek financial advice before making decisions based on tax considerations.
Executives need to consider how secure their benefits are. In a marked difference to standard retirement plans (such as a 401k or 403b), SERPs are not protected by federal tax and pension rules, so if a company goes bankrupt, these retirement funds may be at risk.
Packages that include restricted stock will place constraints on planning; for example, executives may not be allowed to sell the stock until they reach a certain level of stock ownership, have remained employed by the company for a period of time, or during certain “blackout” periods.
Another perk may be access to a specific financial institution for financial planning and wealth management services or a stipend to put toward it. Taking advantage of the stipend will allow executives to choose who they work with.
As compensation fluctuates, we advise that executives meet with a financial advisor regularly to review and update their plan as circumstances change.
Let the Certified Financial Planner™ professionals at Williams Asset Management help with your wealth management needs. Whether you need comprehensive and holistic financial planning or investment management, we can help! We are fee-based, independent financial advisors located in Columbia, the heart of Howard County, Maryland. Schedule your complimentary consultation today by calling (410) 740-0220!
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