Jim is an executive at a large publicly traded insurance company. As part of his compensation every year, he is granted stock in his company. And, as part of our annual review, we talk about it. How much stock should Jim own? Should he sell it? Gift it? Or keep it?
Often, Jim thinks his company stock has room to grow. I find that is quite common. In my experience, most owners of their company stock tend to believe their stock is above average.
It’s like the classic IQ study where 94% of those questioned believed they were above average … if only. Psychologists call it the “better-than-average effect.”
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In my 25 years of advising executives, I have seen the good and bad of clients’ accumulating stock from their employer. For some, the company stock was a good investment. For others, not so much.
If you are like Jim and are paid in company stock, you too might be wondering if this is a good thing. Though everyone’s circumstances differ — each investor has their own unique set of goals, objectives and tax situation, plus the fundamentals of the stock itself — I find there are common points to consider:
1. First, understand the risk
Owning a large amount of any one stock is risky. A question to ask yourself: Is it worth the risk? One measure of risk is the standard deviation of a stock’s price. The standard deviation is the variability in the price of a stock.
Often, the standard deviation is greater for one stock than for a portfolio of diversified stocks. Owning different stocks across different industries tends to decrease the volatility of a portfolio.
In theory, you should be rewarded for the risk of owning one stock, like your employer stock. The more risk, the more reward, right? Well, that’s not always the case.
To find out for yourself, try to compare the three-year, five-year and 10-year standard deviation, or risk, and the return of your company stock to a broad index, such as the S&P 500. Check any of the large financial websites for this information.
You’ll want to know how much more risk you’re taking with your company stock, based on how great its standard deviation is, and then see how well its returns compare to the benchmark index. Past performance is not indicative of future returns; however, it can help put things in perspective.
In other words, you may be less excited about accumulating large amounts of your employer stock if you knew the risk/return tradeoff in the past was not that favorable.
2. Determine how important your employer stock is to your financial security
The more your financial security depends on the performance of your company stock for your retirement, or some other goal like paying for college, the more fragile your financial planning.
One way to test this is to run a scenario analysis. You can start with an online retirement calculator and play with the assumptions.
We run retirement cash flow projections for our clients assuming a base case and several stress tests. The base case assumes the investment portfolio continues to perform.
Then we stress the projections:
- What happens if the client loses his or her job?
- What happens if the company stock drops 20% or 30%?
- What is the impact on the client’s retirement goals?
If there is a substantial impact, such as pushing back the retirement date to an unrealistic age, then the client should be more careful about how much of their company stock to own.
3. Develop a plan
If a client is concerned about the risk of owning too much employer stock, we plan accordingly. I may, for instance, encourage my executive client to set up a planned sale. Here, we schedule in advance how many shares of his or her employer stock to sell and when to sell.
This approach takes the emotions out of selling.
I find most clients tend to think their stock is undervalued and will want to hold on to it, or, if it is doing really well, they want to see it continue to grow.
Either way, personal biases can cloud our objectivity. A planned sale can help. Keep in mind: Corporate insiders will have to get pre-clearance.
There are other strategies. For instance, having an active tax-loss harvesting strategy can help offset the gain when selling employer stock. Or if charitably inclined, consider gifting appreciated employer stock.
You can gift your employer stock to a charitable trust and receive an income stream to help with retirement expenses.
There is no income tax on the gift to the trust, though some of the retirement income received can be taxable. At the end of the trust term, the remaining balance left in the trust goes to the charity. You must be comfortable with gifting the stock, as the gift is largely irrevocable.
I suggest running retirement projections with the gift to see whether you can afford it. Trusts can be complicated and there is a cost to administer them. It’s best to speak to a qualified tax or financial adviser.
The bottom line on company stock
There may be many reasons to own your company stock, but you want to be smart about it. First, know the risk. Having a concentration in any one stock can substantially increase the risk for your whole investment portfolio.
Try stress-testing your retirement projections to see how a large drop in the company stock affects your goals and objectives. If you want to sell the company stock, a planned sale can take the emotions out of selling.
Or if you plan to hold the company stock, ensure you have a balanced portfolio elsewhere to help mitigate the risk. Having an active tax-loss harvesting strategy can help minimize income taxes if and when you decide to sell your appreciated employer stock.
There are other approaches to minimize the risk of owning a large amount of employer stock, and there are many other ways to minimize the taxes when selling your employer stock. As you might have guessed, it all starts with a financial plan.
For more information on creating a plan for your employer stock, please email the author, Michael Aloi at maloi@sfr1.com.
Investment advisory and financial planning services are offered through Summit Financial LLC, a SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Summit is not responsible for hyperlinks and any external referenced information found in this article.
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