Last October, we published “The ABCs of Stock Compensation” to help our readers understand some of the jargon. When we started Bristlecone almost 18 years ago, receiving compensation in stock, stock options, or RSUs was typically reserved for employees on the highest rungs of the corporate ladder. This is no longer the case today, and the practice has expanded quickly over the past two decades beyond the executive suite and the technology industry. As the number of millionaires minted by Amazon, Facebook, Google, and other tech companies attest, the most critical factor determining young people’s future wealth today might be which company they work for.
Yet, these lucky employees are pretty much left fending for themselves when it comes to strategies for making the most of these forms of compensation. The available approaches will also depend on your employer, so be sure to check with your HR department. We identify three main challenges below and some suggestions on dealing with them.
Restrictions on Trading
To prevent insider trading, i.e., based on material non-public information, the U.S. Congress passed laws to restrict when employees can buy or sell shares. Most companies find it too burdensome to monitor who may have access to such information. To avoid running afoul of such laws, they frequently mandate that all employees refrain from trading during blackout periods (typically around earnings and other corporate news releases). Such limitations can create problems for those who may have a pressing need for liquidity or are trying to diversify their portfolio.
In the case of a short-term temporary liquidity need, one option is to use shares or RSUs as collateral for a margin loan or a line of credit. Typically, interest rates tend to be very affordable on those types of borrowings. Note, however, that if the stock price drops, the bank or broker-dealer might require selling shares at an inopportune time to make sure that you meet your obligations (margin call).
Now, suppose you need cash for a more distant need (e.g., a house purchase), other tools at your disposal might be to set up a pre-agreed staged plan (i.e., at regular intervals) or a block sale with your company. These agreements typically allow you to sell even during blackout periods.
Reducing Concentrated Positions
After a few successful years with a company, and particularly when approaching retirement, you may find that a very significant percentage of your wealth is tied up in your employer’s stock. We highly recommend diversifying your portfolio away from your company’s stock over time, the extent of which is up to you. Everyone’s risk tolerance is different, and it depends on both your employer’s and your own financial situations.
To help you assess how comfortable you might be with such concentrated positions, it is useful to run some downside scenarios and to quantify the impact on your wealth. The mistake is to get caught up in stories about overnight millionaires and only focus on the upside: there are plenty of companies whose stock price declines wiped out significant portions of their employees’ net worth. For some, it meant no longer being able to retire. Getting feedback from a professional investment advisor could prove very valuable.
Here too, some strategies can help: As previously discussed, the first one to consider is selling shares according to a schedule, either executed on your own or through a pre-agreed plan with your employer. The second strategy involves using publicly traded options, such as protective puts, covered calls, and collars. These financial instruments are complex and volatile, and not all companies allow employees to use them. It is beyond the scope of this presentation to expand further on their risks, costs, and benefits. While challenging to implement, options can provide flexibility in timing stock sales, reduce volatility, and even generate ancillary income.
Managing Tax Liability
Depending on the nature of the stock compensation received, the tax liabilities embedded in the unrealized gains and your ability to defer them will vary. Additionally, RSUs, NSOs, and ISOs offer various levels of leverage and flexibility that impact their net after-tax present value. One issue frequently trips up employees: not withholding or setting aside enough cash to cover taxes due when RSUs vest or ISOs are exercised.
Increasing contributions to retirement or Health Savings Accounts can help employees offset a portion of the additional tax liability from RSU’s or stock options in any given year. When these strategies are already maximized, an additional tool that can be used very effectively for those charitably minded is bunching a few years of anticipated gifts into one big contribution to a Donor Advisor Fund (DAF) or charitable trusts (e.g., CRTs, GRATs…).
Effectively managing these tax liabilities requires a holistic understanding of your current financial situation, your personal values and unique objectives and constraints. It also involves making assumptions about the future. Unfortunately, finding an advisor who can help with such comprehensive and complex tax planning is not always easy, and companies offer little support.
We anticipate that equity compensation plans will continue to gain broader acceptance because they offer advantages to companies compared to the typical wages and cash bonuses schemes. For employees, it means a higher potential for great wealth, but also more risks. We recommend treating equity compensation like one would approach buying a home: it could very well have one of if not the most significant impact on your wealth. So do not speculate, exercise caution, and get opinions from experts.
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One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward-looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward-looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward-looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
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