Designing Retirement Provisions for Awards

It’s common to pay out RSUs for retirees, but how should payout be structured? In this blog entry, I explore the pros and cons of acceleration, continued vesting, and full vs. pro rata payouts.

Why Pay Out Equity Awards to Retirees?

Before we get to the pros and cons of accelerating vs. continuing vesting, you might first be wondering why companies would pay out equity awards to retirees at all.

One reason for this is the nature of the separation event. When employees resign, they have failed to provide the requisite service necessary to earn their awards. This is why awards are generally forfeited in the event of a resignation. But this isn’t the case for retirees; they have fulfilled their service to the company. Given this, many companies feel they have earned the right to keep their equity awards.

In addition, vesting requirements are imposed to discourage employees from leaving. This works great for preventing resignations. But this same strategy can be counterproductive when it comes to retirees. It may not be helpful to have employees who are ready to retire, possibly even already mentally in retirement-mode, sticking around just so that they don’t forfeit their equity awards.

Paying out equity awards to retirees removes the awards from employees’ decisions about retirement. It frees up employees to make a decision that is right for them based on them.

Finally, companies in the technology and life sciences sectors are notably less likely to pay out equity awards to retirees than companies in other sectors. Only 35% of companies in the tech and life sciences sectors pay out service based full value awards to retires, compared to 81% of companies in other sectors. I suspect that this may be due to several factors:

• Tech and life science companies are more likely to offer equity awards to lower ranking employees, who traditionally do not qualify for retirement benefits.
• The employee populations of many tech and life science companies may be younger than in other sectors, and thus retirement may not be a life event many employees in these sectors have encountered yet.
• Many companies in other sectors at one time offered pension plans. As these plans have been widely eliminated, these companies may have looked to their equity programs to provide a substitute benefit to retirees.

What Are the Design Choices?

When companies want to provide for equity award payouts to retirees, they have two primary choices to make regarding how the payout will be structured:

Acceleration vs. Continued Vesting: With accelerated vesting, the awards are paid out immediately upon retirement. If vesting is continued, the retiree does not receive a payment at the time of retirement; instead the awards continue vesting according to their original vesting schedule.

Full vs. Pro Rata Payouts: If awards are paid out in full, retirees receive their entire award; no portion of the award is forfeited. With a pro rata payout, retirees receive only a portion of their awards. The amount of the award that is paid out is typically commensurate with the amount of service the retiree has completed. 

For trends in the treatment of equity awards upon retirement, see my blog entry "How Companies Adjust Equity Awards for Retirement."

Why Accelerate Vesting Instead of Continuing Vesting?

When vesting is accelerated, retirees receive whatever portion of their awards that they are entitled to at the time of their retirement. This has a number of advantages over continuing vesting:

No Ongoing Tracking: Awards are settled at the time of their retirement, so no further communication with the retiree is necessary, other than year-end tax forms for the year of their retirement.

Company’s Tax Obligations Are Fulfilled at Retirement: All required tax withholding and income reporting for the retiree’s awards will be completed in the year the employee retires, while the employee is still on payroll.

More Flexibility for Retirees: Retirees receive an immediate payout of their awards and can then choose to hold the stock or diversify into less risky investments. When vesting continues, retirees are forced to hold their stock until the vesting conditions are met; remaining invested in company stock may not be advisable for retirees.

Why Continue Vesting?

When vesting is continued, the awards continue to vest, usually in accordance with their original vesting schedule. A different set of advantages applies to this approach.

No Special Treatment: Retirees don’t get special treatment; they receive the stock underlying their awards at the same time as current employees. Assuming full payout, the award outcome is the same whether the employee continues working or retires.  

Ongoing Income: As the awards continue to vest, the resultant payouts will provide ongoing income for retirees.

Lower Tax Rate: When vesting continues after retirement, the awards are paid out in smaller amounts at a time when retirees are no longer working. As a result, the retiree could be in a lower tax bracket, reducing their tax obligation for the award.

Reduced Fair Value: Preventing retirees from selling immediately when their awards are substantially vested may enable the company to apply an illiquidity discount to the fair value of the awards. See my blog entry “Accounting for Continued Vesting Upon Retirement.”

What About Performance-Based Awards?

The overwhelming practice for performance-based awards is to continue vesting after retirement. Only 7% of companies pay out immediately upon retirement (i.e., accelerate vesting), whereas 65% pay out performance awards to retirees at the end of the performance period (i.e., continue vesting). [What about the other 28%? At 6% of companies, the payout is at the discretion of the board and the remaining 22% don’t pay out performance awards to retirees.]

Companies pay out awards to retirees only at the end of the performance period for one very important reason: this way the payout remains tied to achievement of the performance conditions.

Let’s imagine a situation where the end of a performance cycle is approaching and it is clear that the company is not going to meet its performance target: all performance awards tied to this cycle will be forfeited. If the award is paid out upon retirement, executives who are eligible to retire might be motivated to jump ship because this will ensure that their awards are paid out. It is the exact opposite of the behavior the performance award is intended to incentivize.

To avoid this disaster, companies pay performance awards out to retirees only at the end of the performance period and only to the extent that the performance conditions are fulfilled.

Full vs. Pro Rata Payouts

The decision to pay out equity awards in full or on a pro rata basis has no bearing on the timing of the payout; in either case, vesting can accelerate or can continue according to the original schedule. This decision affects only the amount of the award that is paid out.

For example, say that a retirement-eligible employee is granted an RSU that cliff vests over four years and the employee retires after 82% of the cliff period has elapsed. If the RSU will be paid out in full, the retiree receives the entire award. If vesting is accelerated, 100% of the award is paid out to the employee upon retirement. If vesting continues, the award is paid out in full at the end of the four-year cliff vesting period.

If the RSU provides for a pro rata payout, the retiree is entitled to only 82% of the award (because 82% of the vesting period has elapsed at the time the employee retires). The retiree forfeits the remaining 18% of the award. Here again, the portion of the award that the retiree is entitled to can be paid out at the time of retirement or at the conclusion of the four-year cliff vesting period.

Advantages of Pro Rata Payouts

• Retirees receive only the portion of award that has been earned.
• Less dilution and share usage if retirees don’t provide service through their full vesting date.
• FICA payments for RSUs are smaller and spread out over several years. Where RSUs are paid out in full to retirees, the entire award becomes subject to FICA in the same year.
• No special accounting is required; expense is accrued at the same rate as awards held by employees who are not eligible to retire.

Advantages of Full Payouts

• Paying out awards in full entirely removes the awards from the retirement decision. With pro rata payouts, employees have to choose between retiring and earning their full award; some employees who are otherwise ready to retire may continue working to earn more of their award.
• FICA calculations for RSUs are less complicated and are once-and-done for each award. With pro rata payouts, RSU awards are repeatedly included in FICA until employees retire or achieve their full vesting dates.

Learn More

To learn more about the advantages and disadvantages of accelerated vs. continued vesting and full vs. pro rata payouts, see the article "Retirement Provisions for RSUs."

To learn about the tax consequences of retirement provisions, including the FICA considerations, see the article "Taxation of Retirement Provisions in Equity Awards."

The NASPP Webinar "Understanding the Administrative Impact of Retirement Provisions" provides a great summary of the technical accounting and tax implications of retirement provisions.