Advanced Executive Compensation Strategies With Derek Jess (EP.139)

0:27We all need to make smart decisions with our money. Senior Wealth Manager and Shareholder at PlanCorp. Last week, Derek shared his extensive experience and knowledge in helping individuals make the most of their equity and executive compensation plans. This week, Derek will guide us through a more intricate exploration of deferred compensation plans, advanced strategies for exercising stock options, and the importance of setting up a 10B51 plan. As always, you can find detailed show notes at thelongterminvestor.com, and I will also include a link to schedule a call with Derek if you're interested in learning more about working with him.

1:06And now, without further ado, here is my conversation with Derek Jess.

1:14Derek Jess, welcome back to the show. I feel like it's not been that long. Good to see you. We each got a haircut between the first recording and the second. So if you're watching us on YouTube, in the comments, let us know what you think about our haircuts. We wanted to break this episode into two parts, though, because when you think about executive compensation strategies, it's really hard to cover everything in a way that's very concise. So we covered a lot of the basics in our first episode. This episode, I'd like to get into the nitty gritty. And we closed out part one talking a little bit about deferred compensation plans, but just so that we're level setting, ready to dive deep on some really interesting strategies.

1:56Can you just give us an overview of deferred compensation plans again, what they are and how do they work? Yeah, I think this is worth spending a little bit extra time on. So I think I'd mentioned in the last episode, like they're kind of like 401ks and that it's a way to put pre-tax dollars in to a retirement plan. And then whenever you take the money out, you pay taxes at that point. But the limits, you can do way more than the 401k limits that are out there. There are some pretty key ways that they're very similar to 401k plans, and there's some really, really important ways that they're different.

2:28And so I thought it'd be helpful to chat through those a little bit today. Both 401k and a deferred comp plan, you're going to make contributions to them through payroll. Oftentimes, a deferred comp plan can be tied to a bonus. And so you would just make some sort of election to say, I want this percent of a future bonus to go in. And then it would just automatically go into there through payroll when that bonus hits. You can also potentially do it through salary too, but both of those go through payroll. You can't just like plot money in with outside cash. And so in that way, they're similar.

3:01You invest contributions in a similar way. Sometimes the investment elections with a deferred comp plan and just the regular 401k plan are exactly the same. I always think that's nice. I feel like the fewer the options, the better. It just can get kind of overwhelming. Like, wait, this is a whole new set of investment options? If they're not exactly the same, they will be pretty similar and you would invest those the same way. And the third one is that they're all taxable as ordinary income upon withdrawal. And And that's kind of where the similarities stop. So from your listener's perspective, a really important difference is that deferred compensation plans are a lot more rigid than 401ks.

3:39So there's a ton of flexibility with a 401k, especially once you've hit 59 and a half. Some certain exceptions apply if you're 55 and retire from an employer you keep a 401k with, but you can take the withdrawals out kind of at any pace that you want to without penalty. You just pay ordinary income tax. And then eventually Uncle Sam says, hey, you've deferred long enough. if we're going to make you start taking distributions, but that's at 73 or 75. But you decide how much and when you want to take money out. And you can just make that decision and process the distribution within a day or two.

4:10With deferred comp, you actually make not only a contribution election upfront, but how that money is going to be distributed. You decide that in advance too, before the money's even earned and put in there. So that can be something like, I wanted to pay out in three years. I wanted to pay out the year after I retire, or maybe you want to pay out frequently. What we look at doing is to say the year after you retire, when you're going to be in a lower income tax bracket, that makes sense. This is how you win this game, right? You defer taxes when rates are high and you want to take money out and pay taxes when your rates are lower.

4:45But not only do that after retirement, often makes sense to kind of spread that out too. And so maybe you want to start the year after you retire over a five-year installment schedule or a 10-year installment schedule. And you got to have an idea of what cash needs might be then, right? Because if you turn around and decide later, like, oh, well, this works great the first year, but year two, it'd be nice to just kind of have the rest. That's not an option. You can't change that. So you decide distribution elections up front, you decide contribution elections up front. And for the most part, there's an exception I can talk about, you're kind of stuck with those distribution elections.

5:22Number two, something that people probably think about less Yes, but it's also really important. There's no free lunch here. The reason that you get to make pre-tax contributions to a deferred compensation plan way above and beyond 401k limits is because technically that money is at risk. So unlike a 401k, where if you put money into your 401k and the business goes under and there's no situation where you don't get your 401k money because the business is no longer here or they filed for bankruptcy and they just can't pay you your 401k money. Those are vested, they're yours, and you can roll them to IRAs or other 401ks, and they're yours to keep.

6:00With a deferred comp plan, you are technically a creditor of the company, and their ability to pay that to you is only subject to they actually can do that, right? And if they do file for bankruptcy, you're kind of in line with all the bondholders and other creditors trying to get money from the company. And so in that sense, there's a company-specific risk component here, similar to owning an individual stock in that company. I think it's different. It's less of a impact as I'm thinking about how much to have in a deferred comp plan versus how much to have in a single stock position, because that stock position is probably going to move all over the place.

6:37It's kind of how it works, right? That company risk only comes to bear if the company is unable to honor that commitment to pay the compensation that you deferred down the road. So it could be catastrophic. I think it's much less likely to matter, but still really important to know because that money may not come back to you. That's really an interesting call out. And so if you have a deferred compensation, what are some general planning strategies or thoughts that you would share on contributions, distributions, and even investment elections? Yeah. So again, since you're deciding this in advance, you really need to be thoughtful about cash flow, about taxes, about the overall portfolio.

7:17So I think upfront deciding how much you want to contribute is important and really want to compare, A, how much money can I put in here, right? Oftentimes they're tied to long-term bonuses or even a short-term bonus, but maybe it didn't pay out for 12 or 18 months. Maybe it doesn't pay out for three years, right? How do you know exactly what you're going to need three years from now and make informed choices there? Like it's hard, right? So I don't want to go all the way to the brink. Leave some cushion for yourself if you may need some of that money. But I think it's really easy to fall into a trap and something I see all the time when clients first come to us, just to think, all right, the goal is to minimize taxes today.

7:55And I get it. No one likes paying taxes. I think it's important to have a long-term perspective here and to be less concerned about minimizing taxes today and have more of a focus on minimizing taxes over the course of your life or over a five or 10 year period because some of the most impactful tax planning we do here at PlanCorp, even outside of deferred comp, is just sometimes it makes sense to pay the tax today because it's a good deal. And if you don't, you're going to pay way more later. So you can fall into a situation where you're putting$200 ,000,$300 ,000,$400 ,000 a year into a deferred compensation plan, and you're doing that for 10 years.

8:33That's a lot of money to go in there. And even if it comes out over a five-year period after retirement, I've seen time and time again with executives that I work with that come to us, you know, hey, I'm going to retire here in 12 months or so. It's like, gosh, your taxable income is going to be higher over this five-year period where funds are being distributed than it is right now. And you're going to end up paying more in taxes because you put too much in. So yes, future tax rates are unknowable. I fully will honor that. I will say I don't imagine them getting lower from here, but I can make projections as far as what taxable income will be.

9:08And that's going to be the big driver, ultimately, of how much tax you pay, regardless if it's 5 % higher or lower, where exactly it kicks in. If you're going to have a million dollars a year of taxable income, that's going to be a lot of money in taxes. So think about current versus potential future tax brackets. That's really important in deciding how much that you want to put in. And then also how much of that company-specific risk you're willing to take on, knowing that the money will probably come back to you, but it might not. And do you feel like there are any frequently missed opportunities that you see with the people you're working with in these plans?

9:40I think with a contribution specifically, and you have to make the same election every year, right? I think they kind of get on autopilot of, oh, I'm doing like 25 % of my bonus. If you realize, hey, I'm starting to get a big balance in here and it makes sense to kind of slow down a bit, reduce your election for the next year. Usually they have like right about now towards the end of the year is when you make an election for a bonus to be earned in the next one to three years. And you can also change distribution elections too, by the way, it comes at a cost. So this is something I have conversations with, even CPAs, like, gosh, I had no idea that you could do that.

10:14So say that you originally, maybe you didn't make an election upfront for distributions and usually the default is, well, it's pay out the year after your retirement, but you decide, gosh, that just doesn't make sense at all. You can change it to say maybe a five-year installment, but it has to happen at least 12 months before that first payment would have gone out. And then you have to delay where that first payment would have been by five years. So maybe if I'm retiring today, say it's the end of December of 2023, I was going to have everything pay out January 10th of next year. I can spread it out over five years, but it's going to be January 10th, five years later, and then it would start over a five-year installment schedule.

10:58So that's something that, look, maybe we can do Roth conversions in the meantime to take advantage of lower brackets, right? And so there's a lot of opportunity there to kind of spread this out. Even if it's not exactly what you'd planned originally, sometimes the cost is not that big of a deal in terms of flexibility because we can work around it. So we've really hit in on deferred comp, some do's, some don'ts, some opportunities that people miss. I think last time we touched a little bit on the exercising of stock options, where I think that is probably another place where we can go a layer deeper.

11:31Let's just take this pretty broad. How do you think about deciding when to exercise stock options? Yeah. I mean, number one context is, do you have a need to sell, right? Do we have more company stock than we want? And if so, do we want to look at stock options as a way to get out of that? Or maybe it's just really attractive to do it. So I'm a big fan of using the Black-Scholes model. It's a pretty convoluted formula, but just the core components are there's an intrinsic value, which is just the pre-tax value of the option. And then there's time value. So intrinsic value, if I can exercise at a hundred bucks and it's worth 105 bucks, there's$5 of value there per share, right?

12:08Per option times the number of options I have. That's pretty straightforward. Time value is what's kind of the potential upside. Obviously we don't know what the price is going to do, but there are a couple of key factors that drive that. So the smaller the spread between what I can buy it for and what the price is today, the higher the time value, the lower the intrinsic value, because there's not a lot of value there. And I'll give you a really good example about that. There's a ton of leverage in that scenario that can be pretty beneficial. The second is just like how long until it expires, right?

12:42So if I have five years for an option to run versus six months, right? The time value on something over five years out is higher than something that's going to expire in six months. It's just less likely to have substantial movements in price either up or down. But easy way to think about this is like the higher the intrinsic value, the more real value is there, the more attractive it is to exercise a stock option. The higher the time value, the less attractive it is to exercise it because we want real value, not potential, right? I think a really helpful example, I just had a conversation actually last week with a client that I work with, we'll just say at a large tech company.

13:18She's looking to potentially sell out at a specific price. And it was like$5 higher than where it was today. And we could look at ISO shares from previously exercised ISOs, or we can look at her non-qualified stock options. And the difference, let's say the value at the current price was$400 ,000. bucks. And from 200 to say 205, that might not seem like a ton of extra difference, but that then made the value of her stock options 500 ,000 instead. And so we've got an example, I'm sure we can put it in your show notes, Peter, but if the price of the stock goes up by say 20%, maybe the value of your stock options just increase in value by 200%.

14:00And so that's a really good example of leverage. And by the way, none of your own money is there, right? So you're getting upside potential without putting your money in. The bigger the spread, I can buy for 90 and it's worth 180 now, like that difference of increase in value is going to get less and less. And that's when it becomes more attractive to say, hey, let's just go ahead and pull the trigger on exercising this. Your leverage isn't there like it was previously. We'll capture this, take the profits and do something else with it instead. So that's a Black-Scholes driven way to think about it of what's the percentage of time value versus intrinsic when you're looking at the overall Black-Scholes value of the option.

14:36Now, you mentioned working with somebody at a large tech company. A lot of people get stock options when the stock is at a private company. How do people deal with that if there's little to no liquidity available in that situation? Yeah, there are definitely extra considerations. If I've got a public company, I can just exercise, buy the stock, sell it right away and have money to pay the taxes. If you're in a private company, there's really no market. There are some really helpful ways to finance the purchase or the exercise of stock options. that I think not a lot of people are aware of, some specialized lenders out there that do it.

15:08These are really interesting to look into. So if cash flow would be a problem to either buy the shares or pay the tax, there are companies out there that will say, hey, look, we'll do a deep dive into how likely we think the company is to go public and what we think the price might be there through an underwriting type scenario. They will give you the cash to exercise and pay the taxes on this stock. And these are often non-recourse. So if the company never goes public, there's no cost. You don't pay the loan back. There'll probably be a tax consequence, right? Loan forgiveness, but you don't pay that loan back.

15:40They make money when it does go public. They get a certain percentage of the upside. They have interest that then kicks in over the time between financing and IPO. But just know there are really helpful ways to finance that. And actually, there's an added benefit there because they're taking some of that risk off of your shoulders. Because if it doesn't go public, then they're the ones that really took the hit for that, more so than you. Derek, I feel like when we're talking about exercising stock options, especially with incentive stock options, I always immediately go to the AMT rules. And I always think, oh my gosh, I rely on my accountant.

16:17I rely on people like you around me at the office to help me through those scenarios. Let's talk about some general AMT planning thoughts. Yeah. As a quick refresher, two calculations, my regular tax calc, my AMT calculation, you pay the higher of the two. So if I have$100 ,000 regular tax liability,$110 ,000 AMT liability, I'm paying a$10 ,000 AMT tax, which can then come back to me as a credit in future years in the reverse example of that. I think especially with publicly traded companies, there's some really important things you can do from a cashflow perspective. If you're looking to do like a really big exercise of ISOs that you know is going to trigger potentially a huge AMT bill for you, it might make a lot of sense to exercise those ISOs in, say, January or February, early on in the year for a couple of reasons.

17:06In order to get the favorable tax treatment, you have to hold on to those shares then for more than 24 months after the grant date and more than 12 months after you bought them. You're going to have a tax bill to pay on that, right? What triggers AMT is holding those shares to the end of the calendar year. What's really helpful about a January, February exercise is you can hit qualifying disposition status that next January or February, then turn around and sell some shares to help you cover AMT. Versus if you do it in, say, May or June or December, you got to come up with that money out of pocket.

17:38And so that's just a pure cash flow perspective to kind of help avoid a cash flow crunch. If you're going to do a bunch, maybe it makes sense to do in January. the other benefit of that is if the stock price drops substantially maybe it's not worth paying amt right because that's based on the day you exercised there are situations where it makes sense maybe i get to december and think you know what the price is down so much i'd be better off just paying regular income tax on the actual difference between what i bought it for and what it's at today i'm just going to sell this in a disqualifying disposition and not worry about amt because that might take 10 or 15 years for me to get back in that scenario so you leave more options on the table.

18:16The second strategy, if you're not going to do a big exercise in the year is to kind of get to the end of every calendar year. We do tax projections for this all the time where here's all of my sources of income. Maybe I've got RSUs. Here's how that's landed this year and my investment income. How much can I exercise of my ISOs without actually triggering AMT? And think of that as like an AMT budget. So just get as much as you can exercise without having to pay AMT, you chip away at that every year for three, four, five years, that adds up. Then you can turn around and sell those and you never had to worry about AMT.

18:51So that's a really good exercise in say like November or December when you have most of the year behind you, how much can you exercise without triggering AMT? And when we talk about triggering AMT, one of the conversations I'm noticing that are coming up in client meetings a lot are that the Tax Cuts and Jobs Act that was passed in 2017, a lot of those tax provisions are sunsetting in 2026. And I'm fairly certain, but please walk us through it if I'm wrong, I'm fairly certain that that has some pretty big implications for people who would otherwise be subject to AMT. Maybe you've been exercising options the past several years, haven't really had to deal with AMT, but that's about to change.

19:32Yeah. So starting in 2018, the rules around AMT got way more favorable. So it was, and currently still is harder to trigger AMT. So it takes a way bigger ISO exercise or more value in exercising ISOs to actually trigger AMT, which is great on the inverse. That also means it's easier to get an AMT credit back in future years after you do exercise. I don't know what's going to happen in 2026, but if nothing happens, then we go back to old rules. So that means that you're going to be able to do less if you're doing this AMT budget planning, right? There's going to be less opportunity there moving forward.

20:07It would be more costly from an AMT perspective to do a bigger exercise. And it would also be harder to get the AMT credit back because if AMT is easier to trigger, you get the AMT credit by saying, well, my regular tax bill is a hundred thousand, my AMT calculation, it was 90 ,000. So I've got a$10 ,000 AMT credit. That math isn't going to be the same, especially when I throw in the state and local tax right now is currently capped at$10 ,000 for itemized deductions. That's also a preference item. So there's some people that trigger AMT just on that, but they don't even have ISOs. That could make it impossible to get your credit back.

20:44And so this is a consideration. It's not like the only thing to account for, but it's one of many votes to say, maybe I want to be a little more aggressive and exercising now and taking advantage of more favorable AMT rules. And worst case scenario, they stay the same for another five years or 10 years, whatever. But I just know that the opportunity exists today. And it's an important thing to consider. Yeah, I appreciate you laying that out so simply makes perfect sense. There's one topic that we didn't touch at all in part one of this executive compensation conversation, and that is 10b51 plans, obviously, not broadly available to everybody.

21:22But could you start by just telling us what exactly that is? Yeah. Actually, they are broadly available to everyone, but not a lot of people do them. Usually it's just kind of - Well, see, that's why we have it here. Maybe you should think about doing one. So they were originally adopted in 2000. The SEC rolled out this rule. The whole point of a 10B5-1 plan is to create an affirmative defense against insider trading because there are some very serious penalties, fines. I mean, SEC is serious about enforcing insider trading rules. This can be really hard if you're a corporate executive or a key employee or someone that just has access to material, non-public information all the time.

22:01Because we talked about open windows last week, where you can place trades usually once a quarter for four to six weeks. If you have material, non-public information, you can't. It doesn't matter if you're an open window, you still can't trade. That can be really hard. As a corporate executive, you probably have inside information all the time. And so a 10B51 plan allows, in a way that fits very nicely with the stock management plan we talked about, just a preset way to have trades be placed even through blackout periods, right? Even not in an open window period. If the price hits X, I want to sell Y shares.

22:35If this certain event happens, I want this action to be taken. You set this up when you don't have any insider information, then it doesn't matter. Six months down the road, I do, but I made this plan before I had this and it's all preset. I can't influence anymore. It can all execute as planned. So extremely helpful for people at the corporate executive level that have this inside information frequently. I also think it's a really great way to just kind of automate good decisions, which I know you're a fan of, Peter, and we're a fan of too, of the fewer decisions I have to make, that's more advantageous.

23:10And so you can put a plan in place for 12 months, 18 months, just to say, hey, look, I want to sell X shares per month. I want to sell or exercise this many options at these price points. And it just does it. And you don't have to be held up by blackout periods either. And so it's a really helpful tool that you can get really customized with and have multiple layers and pick different tax slots from different grants and different types. And it's just a really helpful tool that I think not just corporate executives can benefit from, but really anyone that has equity comp. It's a nice way to just automate good decisions and making sure you're staying within parameters for how much stock you want relative to your portfolio.

23:48I'm a big fan. I think they're fantastic. So how would someone go about setting or establishing one of these plans? Favorite answers, it depends. So kind of company specific, either you're gonna start with your company or the plan administrator. So like maybe E-Trade or Carta or Fidelity. I'd probably start with E-Trade, for example, and say, hey, I wanna do a 10B51 plan or just call. It might be available on like your website. I would just call. You have to set these up when you don't have material, non-public information. And so like legal, we'll have to sign off on that just to verify like we're all doing this the right way.