Benefits and Compensation

Executive Compensation 101: Key Terminology

This will help you understand the key elements that every good executive compensation program includes, and ensure you’re knowledgeable about the broad strategies and concepts involved with designing (or re-designing) and administering a successful executive compensation program.

In a BLR webinar titled “Executive Compensation: How to Design an Attractive and Cost-Effective Plan for Your Organization,” David Wudyka outlined some key terminology for us.

Executive Compensation: Key Terminology

When discussing executive compensation, what are some terms used that are typically outside the scope of other compensation discussions? In the webinar, Wudyka gave us some examples:

  • Total compensation. Total compensation has several definitions, and is used both in and out of executive compensation discussions. The first definition is the sum of direct plus indirect compensation (i.e. base salary plus benefits). The next definition actually is similar: base plus bonus. Just be sure you’re on the same page when using this term.
  • Non-qualified plans. Wudyka outlined that “these are plans with no tax advantage to the employee; the proceeds of which must be reported at time of exercise of the stock option.” However, the employer can take a deduction in amount paid to employee. It’s important to note that these do have the advantage (tax-wise) to the employer. Typically, these are supplemental income for the employee. A qualified plan, on the other hand, is tax-advantaged to employee. A qualified plan permits employees to take proceeds, unreported at time of exercise, and treat it as a capital gain at year end.
  • Perquisites. These are “benefits that are unique to executives, and which may not be taxable,” Wudyka explained. For example, you may see executives that receive country club memberships, cars, financial or legal planning, computers, phones, personal assistants, special health plans, etc. Whether or not these are taxable is related to our next point: imputed income.
  • Imputed income. This refers to the fact that a tax is assessed when a form of compensation is considered “of value” or “excessive.” For example, when too much life insurance (over $50k) is paid to an employee, the value over $50k is treated as taxable income to the employee. This notion is imputed income. This comes into play with many executive compensation components.
  • Egalitarianism. Egalitarianism comes into play for executive compensation. It is a belief that pay should be alike for all employees. With executive compensation, we often discuss executive pay in terms of multiples of pay of the lowest paid worker, such as 200:1. This level varies significantly by company. Many companies strive to minimize this gap.
  • Phantom stock. This term describes the value of stock that does not exist. Wudyka explained that “it’s what the stock value of a company would be if the company was publicly traded. So, companies that are not publicly traded have no stock value, but, for executive compensation planning purposes, sometimes such companies create incentive plans around the notion of what the stock would be if they had it.” Often the value is determined by the Black-Scholes method (see next point).
  • Black-Scholes method. This method, based in calculus, it measures the motion or movement of hypothetical stock over time. It is a complicated method, but thought to be the best available. It is not without its critics, especially because it doesn’t account for all factors that affect the value of a share of stock. Using this type of method can allow companies to determine the movement of hypothetical stock value when such stock does not exist.
  • Stock-based plans. Stock-based plans, as the name implies, refer to compensation plans that include stock as a primary portion of compensation. There are some specific types of stock-based plans, such as “restricted” and “performance” stock-based plans. Restricted stock-based plans typically place a restriction on the executive to fulfill an agreement of some kind in order to receive a stock payout (e.g. staying until a designated date in future). Performance stock-based plans are similar in the fact that they typically require the executive to meet a goal (e.g. achieve a company stock price above a certain level, or beating the industry average in some measure of performance.)

While this list is not comprehensive, understanding these terms will give you a good base to begin discussing the design or re-design of your executive compensation program.

David Wudyka, managing principal and founder of Westminster Associates, manages and oversees all company operations, including the design, development, and implementation of all client HR programs. His specialties include human resource analytics, audits of HR operations, employee retention strategies, and group incentive plans.