More and more companies today are adopting pay for performance compensation plans for their executives. Such plans reward executives with shares of company stock if the business hits certain performance benchmarks, such as growth rate, sales levels or other measures of success.
As a result, many executives now receive a large portion of their compensation in the form of company stock. This can present both opportunities and challenges from a financial planning standpoint.
Financial Windfall … or Worthless Shares?
Receiving stock or stock options as compensation can result in a financial windfall if the shares appreciate in value. For example, think of early-stage employees at successful technology businesses like Amazon and Google who were paid in company stock. Many of these employees who held onto their shares and stayed with the companies have seen their shares multiply in value many times over.
But not every business enjoys the same level of success that Amazon and Google have, of course. If a portion of your compensation is paid in the stock of the company you work for, you are assuming some risk that the company will succeed only modestly — or maybe not even succeed at all.
In this instance, the value of your shares could end up being worth much less than what you’d have received if you’d simply been paid in cash. In a worst-case scenario, company stock could eventually wind up worthless if the company goes out of business.
Aside from uncertainty about the future value of company stock and stock options, another challenge with being compensated in this way is liquidity. This generally isn’t a concern if your employer is a publicly traded company. But if your employer is privately held, it can be difficult to convert shares of stock into actual cash. These shares may be illiquid until the business is sold or the owners launch an initial public offering (IPO).
Diversify Your Income and Holdings
Many financial planning experts recommend that executives who receive a portion of their compensation in the form of company stock or stock options take steps to diversify their income and holdings. This is especially true if stock or stock options form the bulk of your retirement nest egg.
For example, suppose your employer contributes company stock to your 401(k) account. If your account holdings consist solely of company stock and the company goes bankrupt, then you could lose not only your job, but all of your retirement savings as well. This is why you generally shouldn’t put all your retirement “eggs” in one basket of company stock.
One common rule of thumb is that company stock should comprise no more than 10 percent of a retirement portfolio. By following this guideline, you may be able to limit some of the downside risk involved in holding company stock in your retirement portfolio while still benefitting from appreciation if the company (and your shares) perform well.
Some 401(k) plans allow employees to exchange shares of company stock for other kinds of investments offered through the plan, such as mutual funds and exchange traded funds (ETFs). You might even be able to have these exchanges done automatically on a periodic basis so you don’t have to remember to do it yourself. Check with your HR department about your plan’s rules, as well as whether or not your shares need to be 100 percent vested before they can be exchanged.
Federal law requires employers to offer at least three 401(k) investment options other than company stock. Also, plan rules that govern the buying and selling of company stock can’t be any more restrictive than rules governing the buying and selling of other types of investments.
Please contact us if you have more questions about maximizing opportunities and minimizing the risks involved in being compensated with company stock.