The Deferral and Diversification of Restricted Stock Units
In the first blog in this series, we discussed how the design of long-term equity compensation plans has evolved from a primary emphasis on stock options to the portfolio approach commonly used today. And within the portfolio of equity compensation awards, Restricted Stock Units, both time-vested and performance-vested, have become the vehicles of choice for many companies because of the flexibility of plan design, potential tax advantages and simplified stock plan administration.
In the second blog, we provided a hypothetical analysis illustrating the potential advantage of the deferral of taxation upon vesting and discussed the issues associated with participation in a non-qualified deferred compensation plan including; the timing of deferral elections in general, and the opportunity for a “look back” election with respect to prior year grants. In addition, we reviewed the potential benefit of the active management of distributions.
In this third blog in the series, we address the issue of diversification; that is, the ability of a participant in a non-qualified deferred compensation to reallocate some or all of the RSUs deferred to other notional fund choices offered under the plan (such as a notional S&P 500 fund).
Deferral and Diversification
There can be significant advantages to permit the deferral of taxation on RSUs upon vesting through a non-qualified deferred compensation plan. Federal income taxes can be deferred and, in some cases, state income taxes can be reduced or eliminated entirely. In addition, distributions can be managed in a manner consistent with the executive’s overall financial and tax plans.
As a result, a number of publicly traded companies permit the deferral of RSUs; however, few permit diversification. This creates a unfair disadvantage of deferral as it precludes the opportunity to diversify company stockholdings as an executive might do if he/she accepted delivery of the shares upon vesting, paid the related income taxes and then diversified the remaining shareholdings to avoid a concentration of net worth linked to company stock.
The reason most cited by plan sponsors for not offering diversification of RSUs deferred is that permitting the reallocation of the RSUs to other notional investment choices in the deferred compensation plan and the payment of benefits in cash at the end of the deferral period, would trigger accounting issues.
That is not necessarily the case. If the conditions on which diversification is permitted are properly structured, “liability” accounting treatment would not be required until such time as an executive chooses to reallocate the RSUs deferred to other notional fund choices in the deferred compensation plan. The conditions for diversification might be a specified holding period for the RSUs deferred, a specified age, retirement, or upon a change in control.
The net P&L impact of permitting the deferral and diversification of RSUs through a properly designed non-qualified deferred compensation plan would be comparable to that for RSUs that are distributed as shares at the time of vesting; that is:
- The date of grant value would be recognized as compensation expense over the vesting period,
- Any appreciation in value of RSUs deferred from the date of grant to the date of diversification would not impact the P&L,
- If and when an executive choses to diversify the RSUs deferred through reallocation to other notional funds offered in the deferred compensation plan, “liability” accounting would kick-in and the value of the participant’s deferred compensation account would be marked to market through the P&L from that point forward.
- However, that expense would be offset by the investment income from the rabbi trust assets purchased to hedge the deferred compensation plan liability (e.g., an S&P 500 Index Fund).
It may be possible to significantly enhance the value of the total rewards package for senior executives by permitting the voluntary deferral and (subject to specific requirements) diversification of RSUs deferred without triggering accounting issues.
RSU Blog #4: Final Blog in the Series
In the next and final blog in the series, we will recap the benefits of permitting the deferral and diversification of RSUs including the opportunity for a “look back” deferral election for prior year grants. In addition, we will discuss the implementation steps and administration issues associated with permitting deferral and diversification.