How to Minimize Disability Risk for High-Income Earners

Seventy-seven percent of workers think that missing work for at least three months because of injury or illness would cause a financial hardship, while half think it would cause a “great hardship.”

Nearly all households, ninety percent, say that they would suffer financial hardship if they were disabled and unable to work for a year.* For this reason, disability insurance remains a long-standing core employee benefit.

Most companies provide their employees with a group long-term disability plan (LTD) that typically covers a percentage of their salary, typically 60 percent. Income Replacement Benefits are paid in the event of a sickness or injury resulting in a disability while employed.

For low to middle-income employees who derive most their compensation from a base salary, LTD can be an effective tool to ensure they can meet their financial obligations in the event of a disability.

By contrast, high-income earners, such as corporate executives, professionals and business owners, often have more sophisticated compensation packages that can include benefits like bonuses, partnership distributions, retirement contributions and restricted stock units. For these individuals, suffering a disability could lead to significant income shortfalls.

Four Types of Non-Salary Compensation

Different forms of non-salary compensation for high-income earners are:

Annual Bonuses

According to human resources consulting firm Aon Hewitt, the percentage of total payroll dedicated to performance-based annual bonuses has increased since the economic downturn of 2008.

Aon Hewitt concludes that companies have become more comfortable with pay-for- performance, as well as limiting their exposure to fixed salary expense in the event of another recession.

This compensation trend presents two challenges to high-income earners regards most LTD programs: 1) often, the base salary of these employees exceeds the maximum coverage amount; 2) bonuses, commission and other incentive payments are not covered.

As an example, ABC Company offers a group LTD plan that covers 60 percent of salary up to a benefit of $15,000 a month. If John Smith of ABC earns an annual salary of $300,000 and an annual bonus of $180,000 (total compensation of $40,000 per month), he is limited to 37.5 percent coverage ($15,000/$40,000), as opposed to 60 percent for lower-earning employees.

Partnership Distributions

Law firms commonly use partnership structures. Equity partners of a law firm are entitled to a share of the company profits, in addition to earning a salary and other employee benefits.

While some law firms adjust their LTD plan to include higher monthly benefit caps to accommodate high-earning partners, exposure still exists in the event of a disability.

To illustrate this problem, let’s examine a mid-size, California-based law firm with 20 partners and total earnings (salary plus partnership distributions) between $500,000 and $800,000 annually. The firm maintains an LTD plan that provides a 60 percent benefit up to a maximum $20,000 monthly benefit; that is, partners earning up to $400,000 realize full coverage. However, LTD plan will only cover between 30-48 percent of the total compensation of the 20 high-earning partners.

Retirement Plan Contributions

A recent Retirement Plan Survey conducted by Aon Hewitt shows nearly 70 percent of employers report that 401(k) plans are the primary retirement vehicle they offer to their employees.

This study confirms the trend of the last 30 years─namely; employees must fund most of their retirement. Highly compensated employees face the additional burden of limitations to how much they can save in 401(k) plans, as well as the amount of benefit they will receive at retirement from Social Security.

In the event of a disability, an employee not only misses the opportunity to defer his income into a 401(k) plan, he also does not receive any match offered by the employer. Depending on the beginning age and length of the disability, this limitation could have a significant impact on future retirement plans for high-income earners.

Restricted Stock Units (RSUs)

RSUs involve a promise by the employer to grant restricted stock at a specified point in the future. RSUs became a prevalent form of compensation in the early 2000s when changes in accounting rules lessened the advantages of offering stock options to employees.

A review of publicly traded company proxy statements reveals that the amount of RSUs paid out to executives can often be three to five times annual compensation. This pay out creates a substantial challenge for highly compensated employees in the event of a disability. To understand the potential magnitude of the problem, let’s review the details of the compensation plan of Mary Miller of XYZ Company.

  • Annual Salary of $750,000 with an annual bonus of $250,000;
  • RSUs of $2,000,000 with 50% vesting at three years and the remainder vesting after four years;
  • Total compensation is $3,000,000; after-tax income (35% rate) is $1,950,000.

Mary’s monthly income, in the event of a disability, would be $30,000 ($20,000 from LTD and $10,000 from individual coverage) meaning she would receive only slightly less than 20 percent of her current after-tax income.

Supplemental Solutions to Consider

As evidenced above, the different forms and magnitude of compensation earned by successful individuals can present a serious gap problem in the event of a long-term disability.

When looking to solve the potential income shortfall, a highly-compensated individual should consult an insurance professional with a thorough understanding of supplemental coverage.

Supplemental coverage options can range from individual disability insurance policies, which can address the needs of those with bonus and other forms of incentive compensation to specialty products that cover those with significant partnership distributions, as well as restricted stock units.

*Source: Consumer Federation of America and Unum, “Employee Knowledge and Attitudes About Employer-provided Disability Insurance,” Opinion Research Corporation Survey, April 2012.

If you would like more information on how to address the disability risk of high-income earners, you may contact Don Curristan, Managing Director at EBS. Voice: 760.788.1321 Cell: 619.318.6620 or e-mail to

Improve the Value of Your Restricted Stock Units: Minimize Taxes and Diversify Investment Risk

Restricted stock and restricted stock units continue as an important part of an executive’s pay package, with 89 percent of executives and 85 percent of middle management receiving such grants in publicly traded companies.

Restricted stock and restricted stock units (RSUs) are different. Units, which are used in a variety of executive compensation instruments, represent a measurement of contractual rights to a company’s stock. Often, the measurement is 1:1, meaning that each unit exchanges for one share of stock upon the “settlement” of the units.

In the case of RSUs, the amount of units earned by the employee vests similar to the common provisions of restricted stock. Employees earn units under the vesting conditions of the agreement and are contractually entitled to exchange the units for stock or cash or some combination of the two depending upon the terms of the agreement.

On the other hand, restricted stock is a grant of stock that holds certain vesting conditions, usually related to the passage of time or performance. The holder has legal title to the stock, which is subject to the company’s contractual right to repurchase if the vesting conditions are not met, as in the case of termination or departure from the company.

The use of these vehicles is fairly straight forward. The company issues common stock or units to employees and puts some restriction on the stock or unit. The restriction typically includes a vesting schedule and some limits on how the stock can be sold once it is vested. The vesting schedule for restricted stock is typically the same vesting schedule as the company would use for stock options.

Main Advantage

A significant advantage of restricted stock or RSUs is the executive is typically granted the stock or units without any required investment on his part. In addidition, he would be eligible for favorable long-term capital gains if he holds the restricted stock for at least one year past the vesting period.

Since most companies issue more RSUs than restricted shares, the balance of this post will focus on RSUs.

Downside Risk

The one downside to RSUs is the executive must pay tax at ordinary income tax rates on the fair market value of the units at the time of vesting.

Example from the restricted stock section of Executive is granted 4,000 shares at a current price of $20 (see the chart below). The company has a four-year vesting schedule (25% per year). Assuming the stock grows from $20 ($20, $25, $30, $33), the executive would have $108,000 of taxable income as he vests over the four years. In a 40% tax bracket (combined federal and state), he would have an out of pocket cost of $43,200.

In our experience, the executive would normally sell enough shares to cover his taxes upon vesting. In this example, he would have to sell 400 shares per year. Instead of selling 4,000 shares two years after full vesting at a value of $200,000, and paying capital gains tax on $92,000, he would only have 2,400 shares left and a capital gain of $55,200 (2,400 net remaining shares at $50 per share minus the basis for those remaining shares $64,800).

Assuming a combined state and federal income tax rate of 20 percent, the out-of-pocket tax cost would be $11,040, and the executive would net $108,960 ($120,000 minus $11,040). This result is a significant benefit, as the executive didn’t have to pay for the shares, only the related tax liability.

An option exists for an executive to make a Section 83(b) election with respect to Restricted Stock at the time of grant (but not for RSUs) and pay tax on the value of the award at that time, even though the shares are not vested. The advantage of this approach is the appreciation in the value of the shares from that point forward would be subject to tax at favorable capital gain rates. However, we have found most executives don’t do this as they don’t want to pay tax on something they may never receive.

However, there is another option.

Deferral of RSUs

One of the ways to maximize the benefits of RSUs is to defer them. Many companies allow their executives the opportunity to defer the units rather than be taxed when the RSUs vest. So the executive would defer paying the tax on the $108,000 of taxable compensation in our example above until he receives a distribution from the deferred compensation plan. This way, he doesn’t have to sell shares and would receive the benefits from the growth of 100% of the RSUs granted (rather than just the residual amount after sale of shares to pay taxes upon vesting). Furthermore, if the Company credits dividend equivalents to the RSUs deferred, he would receive such dividend equivalents on 100% of the RSUs (again, rather than the net amount of shares remaining after sales to pay taxes upon vesting).

To take advantage of this deferral feature, the executive must hold the shares (units) in the deferred compensation plan, and the company must pay the executive with shares at distribution. The details of this deferral feature may be found in our brochure, Restricted Stock Units in a Nonqualified Deferred Compensation Plan – An Effective Tax Planning Tool for Future Financial Needs, and downloadable here.

By deferring, as discussed in the white paper, the executive could elect to spread out the distribution and be taxed, accordingly. Going back to our example above, when the executive vests in the first four years, he is not paying income taxes. Therefore, at the end of four years, he holds the 4,000 shares with a value of $132,000 ($33 per share). If he takes a distribution two years following full vesting, the RSUs are projected to be worth $200,000 ($50 per share).

To compare the results:

Pay Tax when Vested and Sell Defer Shares
$120,000 (1) Value of Shares at Sale / Distribution $ 200,000
43,200 (1) Ordinary Income Tax Paid 80,000
11,040 Capital Gains Tax Paid 0
$108,960 Net Cash to Executive $ 120,000

Assumes ordinary income tax @ 40% and capital gains at 20%

(1) Assume executive sold 400 shares each year to pay tax; therefore, at the time of the sale in year 6, he was holding 2,400 net shares.

While there is some benefit of deferral in the above example, a much greater advantage would be realized by spreading the payments over an extended period of time. In fact, if the payments were spread over ten years or longer, and the executive took up residency in a state with a lower or no income tax, he could potentially avoid paying state income tax in the state in which the RSUs were granted.

As an example, an executive living in California who retires to Nevada, Texas, Florida, Tennessee, New Hampshire, Washington, Wyoming or South Dakota, could potentially save up to 13 percent in state income taxes.

Historically, the primary concern regarding the deferral of RSUs is the investment risk of holding a single company stock for a long period. Most financial planners would recommend diversification; however, the conventional thinking is that such diversification triggers unfavorable “variable” accounting treatment for the Company.

The ability to defer stock awards AND diversify is the real advantage.

Defer RSUs and Diversify Investments

As you can see from the example above, there are major advantages to tax deferral, especially if the deferral is for an extended period of time. In our example, if the stock continued to grow at 6%, the executive could take the $200,000 value over 15 years and produce $20,593 of annual income for a total of $308,895. Of course, where he retires could determine how much after-tax income he receives.

If the executive elects to defer the taxation of the RSUs, he could (subject to certain conditions) diversify his deferred compensation account among a wide rage of notional investment funds. And, the notional fund line-up could include a “collared index” option to allow allocation to the equity markets, with downside protection – a very attractive feature based on the volatility in the stock market today.

Similar to his 401(k) or nonqualified deferred compensation plan, he would have 24/7 access to re-allocate within the tax-deferred plan. He also can select when he wants distributions.

The critical piece for the company is the accounting treatment. EBS has mastered this treatment, establishing and vetting it with accounting and tax firms. If you want to minimize taxes and diversify investment risk, sit down with an EBS consultant to work through the structure. We invite you to a no-obligation, educational conversation at your earliest convenience.

Diversification, Tax and Index Disclosures and S&P definition:

  • Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
  • Executive Benefit Solutions does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
  • Indices are unmanaged and investors cannot invest directly in an index.
  • The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Bill MacDonald 760-340-4277
Chris Wyrtzen 617.904.9444 ext. 1
Managing Directors

To learn more about the potential financial benefits of deferring and RSUs, download our RSU case study here.

Prefer to watch and learn?  EBS created an informative video discussing RSUs.  You can access it by clicking here: Watch the EBS RSU Deferral and Diversification Video