Trends in Retirement Plans

Option 5: Employee Equity Compensation Plans

Stock Options

Stock options as a component of compensation started with a general acceptance of the concept that an equity stake in a company is necessary to "align the interests of the executive with those of the shareholders." A comparable view that an equity stake in the company increases the productivity and loyalty of lower–level employees has also contributed to the adoption of equity incentives by many companies and employees may regard their stock options as part of their retirement plan (stock option plans should not be confused with employee stock ownership plans (ESOPs) mentioned earlier in the course).

A stock option is a right given by a company to its employees to buy a specific number of shares of company stock at a set amount within a certain time frame.

Reliance on stock options increased during the technology boom of the late 2Oth century when start–up dotcoms with little cash for salaries began using large stock option grants to attract workers. Stock options are still popular with high growth startups.

The effectiveness of stock options as an incentive for rank–and–file employees has been questioned much more than the effectiveness of stock options for executives due to doubts that lower-level employees can affect company performance and, as a result, the price of the stock.

How Employee Stock Options Work

The basic idea behind stock options is to provide employees with a right to buy company stock at a discount, which they can then sell at the market price.

How employees realize compensation from stock options generally proceeds via two or three basic steps:

1. Shares of Stock or Stock Options Are Granted - The process of providing stock options usually begins by granting shares of stock to employees. The employer issues an agreement giving employees the option to purchase either a specific number or a dollar amount of shares according to a set schedule or other conditions set forth in the plan. The option to buy the stock becomes active on a specific date known as the grant date.
2. Stock Options Are Exercised - If the option to buy company stock is granted, the stock can then be purchased according to the plan rules, and the period during which this is permissible often lasts for several years until the opportunity expires. Most option plans allow the employee to buy the stock either at a specific predetermined price, or at the price it was trading at on the grant date. This means that the employee will be able to buy the stock at a discount if the price has risen by the time the option is exercised.
3. Shares of Company Stock Are Sold - This is when the employee sells the share(s) of stock they acquired through the plan. They may do this immediately upon exercising the option or they may hold the stock until a more opportune time to sell.

Restricted Stock and Restricted Stock Units

Stock options have fallen out of favor in recent years because they are no longer given advantageous tax treatment and employees have found them to be risky and oftentimes gain no benefit from them.

Instead, companies that want to reward and incentivize employees with ownership of company stock are turning to restricted stock and restricted stock units (RSUs). Both are a grant of the company’s stock. Restricted stock is distributed at the time of grant and may be sold at some specified time in the future, usually after vesting requirements have been met. These stock grants are normally given to executives. RSUs may be granted to all levels of employees after certain vesting requirements have been met. Once received, these stock grants may be sold at any time.

Restricted stock and RSUs almost always have value, unlike stock options that can end up under water. While the upside to grants of restricted stock and RSUs is not as great as for stock options, many employees prefer them because they are low risk.

Taxation of Equity Compensation

The rules for taxation of equity compensation vary with each type of plan. The rules for some plans are much more complex than others. For a more in-depth treatment of taxes, see ERI Distance Learning Center Course 20: The Basics of Equity Compensation

Advantages of Equity Compensation

Equity plan advantages include all of the following:

• acknowledge employee performance
• promote and acknowledge employee ownership
• boost employee motivation
• offer flexibility
• save money and offer employees a part of future success (particularly for small, growing companies)
• cost of plan can be compensated for by increased employee productivity and retention

If the business succeeds, an employee's stock gains in value. But things don't always go smoothly. If a company's stock drops substantially, depending on the kind of equity plan being used, the employee's potential retirement savings may take a dive as well, unless the company makes adjustments.

For more information on how equity compensation plans work, see Distance Learning Center Course 20: The Basics of Equity Compensation and Distance Learning Center Course 22: Black-Scholes Valuations.