Pros and Cons of Accelerating vs. Continuing Vesting Upon Retirement

It is very common for companies to pay out service-based restricted stock units to retirees. As illustrated in the Data Snapshot column of the Fall 2021 issue of The NASPP Advisor newsletter, over two-thirds of companies allow retirees to vest in all or a portion of their equity awards.

Among the companies who pay out service-based RSUs to retirees, however, practices are nearly split between accelerating vesting to the time of retirement and allowing vesting to continue after retirement. In this blog entry, I explore why companies might choose one approach over another.

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.

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: One of the most significant advantages is that it is not necessary to continue to track the whereabouts of the retiree. Their 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. When vesting is continued, the company will need to communicate with retirees about their vesting events and will have ongoing tax reporting obligations, which makes it necessary to maintain current contact information for them.

Company’s Tax Obligations Are Fulfilled at Retirement: Another advantage of accelerating vesting is that 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 your payroll and you are issuing a Form W-2 to the employee anyway. When vesting is continued after retirement, the company will have an ongoing tax withholding and reporting obligation.

Limited Mobility Taxation: It is common for retirees to relocate to another state. Doing so will likely affect which state jurisdictions retirees’ awards are subject to tax in. Depending on whether the company has a corporate nexus in the states retirees relocate to, this could also affect the company’s state tax withholding and reporting obligations. Settling awards at the time employees retire minimizes the likelihood that retirees will move to another state before their awards are paid out.

More Flexibility for Retirees: Yet another advantage is that retirees receive an immediate payout of their awards and can then choose to hold the stock or diversify. 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: One benefit of continuing vesting is that retirees don’t get special treatment; they receive the stock underlying their awards at the same time as current employees. When vesting is accelerated, retirees receive a benefit that isn’t available to current employees.

True Neutralization: Continuing vesting truly neutralizes the effect of equity awards on employees’ retirement decisions. Assuming full payout, the award outcomes are the same, whether the employee continues working or retires.  Accelerating vesting could motivate employees to retire earlier than they otherwise would have.

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, they will have less income during the years the awards are paid out (both because the payouts are smaller and because they presumably have less wage and other income). They’ll be in a lower tax bracket, which will reduce the amount of income tax they have to pay on the awards.

With accelerated vesting, the whole award is paid out at once, in a year when the retiree has other wages, maximizing the retiree’s income tax liability for the award.

Clawbacks: Although the equity awards are substantially vested once the employees are eligible to retire, the ongoing vesting schedule functions as a required holding period. Preventing retirees from immediately selling their stock facilitates enforcement of any clawback or noncompete provisions they might be subject to, should these requirements be triggered.

Reduced Fair Value: Another advantage of preventing retirees from selling immediately when their awards are substantially vested is that this condition 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.”

No Section 16 Reporting: Finally, a further advantage of continuing vesting after retirement is that the vesting and release events will clearly occur after cessation of insider status. Any exempt transactions occurring in connection with these events will not be reportable for Section 16 purposes (and even nonexempt transactions won’t be reportable if six months have passed since the insider’s last pre-retirement, opposite-way, nonexempt transaction).

With acceleration of vesting, there can be some doubt as to whether the vesting events occur before or after the retiree is no longer subject to Section 16. This may result in the need to report transactions that occur in connection with the vesting event.

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.