Humancapital

RSUs, Stock Options and ESOPs, oh my! How best to spend your risk budget with employer incentives

When you look closely at your investment portfolio, you can usually identify stocks in which you might have a concentrated risk–for example, if you have a 10% holding in XYZ Company. However, if you receive any compensation tied directly to the performance of your employer (stock options, restricted stock units (RSUs), and employee stock purchase plans), you may be underestimating the concentrated risk you’re taking by not diversifying your investment capital in these benefits from what we call “human capital”–your salary.

Don’t get me wrong: Executive compensation components can be a great way to build wealth. The leverage provided by stock options, the cash-flow boost of RSUs, and the discounts associated with stock purchase plans are all attractive. However, it’s also important that you not open yourself up to too much risk with these benefits.

It’s important to factor in your “human capital”—your anticipated earnings from your company—and not just your employee stock benefits when making investment decisions. Let’s say, for example that you earn $100,000 annually, increasing with inflation, and plan to work for your employer for 10 more years. The current value of your anticipated earnings is approximately $1 million in round numbers.

If you owned $1 million in your company’s stock, that could represent a significant portion of your net worth and be viewed as a “concentrated position” in a single company. You should similarly view your salary as a concentrated position. If, in addition to your base compensation, you earn annual stock options or RSUs, you’re actually further concentrating your portfolio’s stake in one company (your employer).

So what should you do with your executive compensation options to make sure you’re both limiting your concentrated risk and taking advantage of valuable benefits?

Stock Options

The benefit of stock options is that they can be a good opportunity to make a profit, as long as you’ve established a disciplined exercise strategy. However, the risk is that you might fail to exercise your options at the right time. One method of valuing options is through what we call the Black Scholes model. This is the typical approach that large corporations use when determining how much compensation hits their income statements every quarter. Black Scholes not only tells you the value of the grant, but helps you determine how much leverage the stock option has remaining so you can choose the best time to exercise your options. For instance, when your option is deep “in the money” or close to maturity, you have very little leverage left and it’s very much like owning the stock outright. At this point, it generally makes sense to exercise your stock options. If you have a significant amount of RSUs, stock options, or human capital (salary) with your company, you may want to sell your shares after exercising your options in order to better diversify your portfolio.

Restricted Stock Units

With RSUs, you don’t have to decide when to exercise them, since your vesting date is set in stone. On that date, you get either the cash equivalent of the units’ value, or the actual shares. If your company gives you individual shares, in general you would be wise to sell them promptly to reduce your “investment concentration” with your employer. Selling RSUs upon vesting doesn’t create much of a tax consequence for you, since your basis is equal to the fair market value of the units as of the date of vesting.

Employee Stock Purchase Plans

A Section 423 ESPP allows you to buy company stock at a discount of up to 15%. To take advantage of the greatest amount of tax deferral at preferential rates, you need to hold the shares for two years from the beginning of the purchase or offering period, and one year from when you actually purchase them. If you participate in an ESPP, we recommend developing a systematic program for selling the shares once you meet the requirements for preferential tax treatment.

 

Diversifying yourself when it comes to your employer seems to make a lot of sense, right? Then why do many people fail to do it?

  • They’re huge fans of their company. If you’re working for a firm, it’s natural to feel that its doing great things, and to genuinely believe it will succeed. But if you asked an outsider to review the company objectively, would they say the firm was so outstanding that it was worth taking a concentrated investment risk?
  • They’re on the “inside track.” Many folks assume that because they work for the employer, they’ll know if things are headed south well before the public does. Sadly, that may not always be the case. Certainly the employees of Enron, WorldCom and Lehman likely thought that too. In reality, only a handful of individuals–if any, really–have this level of insider information on a company.
  • They hate taxes. When it comes to stock options and ESPPs, once the shares are exercised or sold, there’s a tax impact. Many people avoid taking action on stocks because they don’t want to pay taxes. However, don’t let the tax tail wag the investment dog. Investment decisions should first and foremost be based on the actual fundamentals of the investment, including the risk of it being tied to your human capital. The tax component of the decision should generally be secondary with your tax advisor.

Still have questions about limiting your risk while capturing the advantages of the above-mentioned compensation components? Consult with your RegentAtlantic Wealth Advisor.

 

 

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