Holding Employer Stock: Managing the Risks
Executive Summary
A growing number of employees find themselves with extensive holdings in their companies' stock. Holdings may consist of stock options, stock bonus plans (including stock, appreciation rights and performance awards, restricted stock, company matches and voluntary deferrals), 401(k) employer stock accounts and other retirement plan accounts that are funded with employer stock. It is not unusual for 90 percent or more of an employee's investable assets to be concentrated in the one investment they feel they know best: their employer's stock.
As the result of this over-concentration in an individual stock, most employees are exposed to risk factors of which they remain largely unaware or underestimate. Loyalty to the company they know best blinds them to the market, business, industry and company-specific risks to which they are exposed. Overconfidence, often based on their closeness to current management (their friends and colleagues), causes them to discount the possibility that future management changes can adversely impact the profitability of the company and the share price of its stock.
Upon retirement, those with defined benefit plans and or Supplemental Retirement Plans (unfunded plans) find that their financial independence is heavily dependent on their employer's continued financial success and viability. Unfortunately, the Pension Guarantee limits often fall far below the promised benefit payments on which retired employees depend.
Employer stock has been the source of great wealth creation, especially during the bull market that began in 1987. Small companies experience the most volatile price movements and often generate the highest percentage of stock-based compensation. With minor swings in stock prices, balance sheets may shift abruptly; major price swings may place financial independence at risk.
During an employee's career, many decisions must be made to take advantage of investment and tax planning opportunities. Many plans or awards have trigger dates that can be anticipated and planned for, such as disability, death, retirement and separation from service – events that require significant decisions within tight deadlines. Without proper advanced planning, employees or their family members find themselves ill equipped to make important and irrevocable decisions.
Trends
The National Center for Employee Ownership estimates that more than 11 million employees are currently covered by some 10,000 employee stock plans (Brown), and that employees own the right to a total of 5.8 percent of the stock in their companies under broad-based stock option plans (McMillan).
For the chief executive officers of 350 major companies, realized options gains totaled $1.02 billion last year, fueling a 29.2 percent median increase in total compensation for the group. From 1992 to 1997, the value of options grants to CEOs and other executives at about 2,000 companies surveyed by Sanford C. Bernstein & Co. quintupled to $45.6 billion from $8.9 billion. From 1996 to 1997 alone, the value of the grants jumped 57 percent (Helyar).
While the media often focuses on the compensation packages of CEOs, many companies offer stock options to all levels of employees, from top executives to assembly line workers. According to a survey by ShareData, 45 percent of companies with option plans and 5,000 or more employees now grant options to all their workers. Three years ago only 10 percent did (Morgenson). The number of non-executive employees who receive them at companies like AT&T, Eastman Kodak, Merck, NationsBank and PepsiCo has more than doubled over the past four years to 5.5 million, according to the National Center for Employee Ownership. At smaller companies, the devotion to stock options is even greater: 74 percent of companies with less than $50 million in sales offered stock option plans to 100 percent of their workers.
Although stock option plans are most common in the high technology, telecommunications and pharmaceutical fields, companies across many industries offer the benefit to employees. For example, about 10 percent of General Electric Co.'s 276,000 employees hold stock options – and more than 1,200 of them own options now valued at more than $1 million. PepsiCo Inc. has "SharePower" for its employees, while Wendy's International Inc. offers "WeShare" to its forces.
For the third consecutive year, the diversified financial/brokerage sector led all other industries with an annual share allocation exceeding 35 percent. The entertainment industry ranked a distant second, with an average allocation of almost 20 percent of their companies' outstanding shares to stock plans. High technology companies, previously the leading users of equity incentives, and commercial banks followed closely behind the entertainment industry, with allocations of 19.2 percent and 17.3 percent, respectively (Meyer).
At a time when more and more companies are moving to stock-based compensation for their board of directors, small to midsize public companies grant more than twice as many stock options as large public companies (Society of Certified Public Accountants). That is one of the key findings of a study conducted jointly by The Segal Company, a leading employee benefits, compensation, and actuarial consulting firm, and Grant Thornton LLP.
According to the study, small to midsize companies grant directors a median of 2,500 one-time stock options, two and a half times as many as are granted by their large company counterparts. Similarly, small to midsize companies offer current-year stock options of 1,000 shares to directors, on average, which is more than twice the average of options on 450 shares granted to large company directors.
Issues
The lack of financial planning by stock option holders is a major issue, whether the holder is a young employee or an executive who will soon retire. Unlike many top officers who often receive company-paid financial planning advice, other employees are usually on their own when it comes to figuring out how to benefit from stock options. As a result, many employees view their option proceeds as current income and spend the money on luxury items, such as a vacation home or a yacht, without planning for the future. They often believe that they have plenty of time to save for retirement and that future stock awards will cover their needs in later years. Cashing a stock option too early also can affect the option's potential value and the amount an employee will receive in the long run. A 1996 study of 60,000 employees who received options at eight companies found that many workers cashed in their options within six months of becoming eligible to do so. By cashing in early, the typical employee in the study sacrificed an estimated $1 in future value for every $2 he realized (Scherreik).
Financial planning becomes even more critical for employees who are within five years of retirement. Not only do they face more decisions as their retirement date approaches, the decisions they do make are far reaching and often irrevocable. Timing also becomes critical for effective tax planning and asset allocation becomes more of a concern as employees must match their expected sources of income with their expected expenses. While it may benefit employees to hold stock options while they are receiving salaries and bonuses, they may need to convert some portion of their holdings to income- producing assets once they retire and no longer receive a regular paycheck. Proper financial planning can help stock option holders avoid the "forced" or accelerated sale of their options in a short period of time, when employees are most vulnerable to market forces and share price volatility.
There are asset allocation guidelines that employees who are nearing retirement should keep in mind. Although an individual's recommended asset allocation is a function of many variables, such as the need for investment income, investment time horizon, other capital expenditures and risk tolerance, the normal range is 40 percent to 60 percent equities during retirement. Those with no need for current income or other resources may have equity allocations in excess of 60 percent. Most employees approach retirement with equity allocations of 95 percent or greater and should have a strategy for reducing their equity exposure gradually each year during the years prior to retirement.
Following are other issues that many employees face, and that often require professional advice:
- Insider
Trading Issues. Employees that take
part in their company's compensation plans, which
include stock and stock options, should be aware
of insider trading issues. As employee
stock ownership continues to grow, the government
is increasing its surveillance of the market for
signs of insider trading. A trade is
considered illegal when an employee buys or sells
company securities while having material
information not available to the public.
Material means it is important enough for a
reasonable investor to take into account when
deciding to buy, sell or hold a stock. In
addition, the Securities and Exchange Commission
(SEC) says an employee can be guilty even if they
didn't know the information was material
(Rosenberg).
- Monitoring
Trading Windows. Employees should be
well versed in the terms of their options, such
as their restrictions, when they can be
exercised, how long they're allowed to hold on to
them after they retire or leave the company for
another job, and when they expire. They
also should consider the timing of cashing
in. With stock options, cashing in options
too early can mean missing out on large, future
gains. Holding on too long can mean losing
it all if the employee's once promising company
takes a downturn.
- Company
Requirements for Levels of Ownership.
While some companies require CEOs to hold as much
as 10 to 15 times the value of their salary in
company stock, most ask CEOs to hold five to
seven times their salary. Other officers
are often required to hold one to four times
their salary, depending upon their level within
the organization and their total
compensation. Middle managers, who are
sometimes included in ownership programs, may be
required to own .5 to 1 times their salary range
in stock (Meyer).
A recent survey of Frederic W. Cook Co. found that the following requirements are typical when comparing the market value of shares owned as a percentage of base salary (Kroll):
Employee Percentage CEO 500% Group heads 300% Senior officers 200% Division heads 100%
- The
Alternative Minimum Tax. People with
unusually large amounts of deductions are
candidates for paying the Alternative Minimum Tax
(AMT). When employees exercise incentive
stock options, they can buy shares for less than
current market value. The bargain element
is ignored by the regular tax, but it is
considered part of their AMT income.
Including in AMTI (Alternative Minimum Taxable
Income) the difference between what is paid for
shares and their market value when the option is
exercised is often the event that pushes
taxpayers into the AMT.
In the year stocks are sold, however, employees get to reduce AMTI by the same amount. That's because their shares have a different basis for regular and AMT purposes.
- Shareholder
Backlash. There is growing shareholder
frustration as more and more companies re-price
options. Re-pricing benefits executives who
get a second chance to buy options at a better
price, while shareholders lose "real"
dollars. Because of shareholder
frustration, executives should not depend on
re-pricing to increase option value in the
future. Another shareholder concern is
dilution as options are exercised.
- Estate
Planning Issues. Many stock-based plans
do not pass under the terms of an employee's
will. In addition, some plans have separate
beneficiary forms that are signed in the event of
death before vesting, and they may not correlate
with wills and estate plans. Employees
should review beneficiary designations
periodically with a professional financial
adviser, who also can help with tax and
distribution strategies.
- Lifetime
Transfers of Stock Options. More and
more companies are amending their stock option
plans to permit certain employees to transfer
options to their children or to trusts or
partnerships for their children. Employees
can trim their estate taxes by transferring
assets to their heirs while they're still
alive. The transfer may be entirely tax
free if the value is less than $20,000 a year
– the amount an employee and spouse can give
tax-free to an heir. If the value exceeds
$20,000, the employee can start using a $600,000
unified tax credit. The child can exercise
the options, with any luck at a big profit, and
all the appreciation falls outside the employee's
estate (Geer). Because of the growing trend
to gift stock options, the Internal Revenue
Service has stepped in to keep employees from
putting low valuations on options. As a
precaution, employees should take a conservative
stance in timing their gifts and in valuing them.
- Risk
Management. To avoid having all their
investments in company stock, employees should
work with professional financial advisers to
ensure they have broadly diversified their asset
allocations. If investments are all in one
company, the employee stands to lose everything
if that company fails or if the stock market
takes a substantial downturn. For example,
employees at Color Tile and Oxford Health held
company stock that became worthless when their
employer failed. An adviser also can help
employees build a liquidity reserve as an
emergency fund and to develop strategies to
balance short-term advantage with long-term
expected advantage.
- Valuing
Outstanding Options. Special planning
issues arise when a highly compensated executive
leaves a company and must negotiate a severance
package. To determine the value of the
executive's stock options, the Black-Scholes
model is used. It's a formula that uses the
market price of the underlying stock, the
exercise price of the option, the term of the
option, the risk-free interest rate, the
volatility of the stock price and the stock's
dividend yield. Some companies feel the
model is unreliable because it relies on a
variable, a stock's historical volatility, and is
best suited to valuing options with durations of
months, not years (Fox).
- Estate
Liquidity and Valuation Issues. There
are estate liquidity and valuation issues for
employees with privately owned company stock and
thinly traded stock. Specialized estate
planning is required when an employee has much of
his or her estate tied up in stock.
- Special Tax Planning Opportunities. A professional financial adviser can help an employee review tax-planning opportunities and decide on the best strategies. Issues include deciding an employee's ability to take distributions in stock, the source of funds to pay taxes on distribution, or whether to pay tax now or defer taxes in an IRA rollover.
Strategies and Solutions
Professional advice is often required to sort through the above issues, as well as the myriad plans and elections to be made. Proper planning, well in advance of anticipated trigger dates, enables the employee to balance the cash flow, investment, income tax and estate planning considerations of stock-related decisions. Employees must consider how their resources will best enable them to fund their goals (house purchase, debt retirement, education expenses, retirement, etc.). Strategies to reduce the relative position of employer stock in an investment portfolio may include:
- Diversification
elections of 401(k) plans and for those who meet
eligibility requirements, ESOP balances.
- Multi-year
planning strategy (stock options, bonus plans,
deferred compensation, etc.) to manage tax costs
and to diversify investments.
- Charitable
gifting to offset income and estate taxes
triggered by stock-related gains.
- Distribution
planning that takes into consideration tax and
investment perspectives. Exercise dates are
accelerated at an employee's death, disability or
retirement. Three months after leaving a
company, an employee or his family must decide
what to do with the stock options.
Long-range planning with the help of a
professional financial adviser can help the
employee and his family avoid potentially bad
decisions made in haste.
- Planning for unexpected benefits, in case of a disability or death of an employee.
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APPENDIX:
A Guide to Terms
Non-Statutory
Stock Options
A non-statutory stock option permits an executive to
purchase shares of company stock at a stated price
(option price) for a given period. The option price
typically is equal to the market value of the underlying
stock on the date of grant. Therefore, participants
benefit only if the stock price rises (Research
Institute).
Non-statutory options may be exercisable for a period exceeding 10 years and may be granted in any dollar amounts. In addition, executives may exercise non-statutory options in any sequence, even after termination of employment. With non-statutory options, the gain is taxable as compensation at the time of exercise.
Incentive
Stock Options
The unique feature of an incentive stock option (ISO)
is the extended tax deferral. With these options, a
taxable event doesn't necessarily occur at the date of
grant or at the date of exercise. The executive
does not owe personal income tax until the shares are
sold.
Instead of allowing the purchase of company stock now, at a discount from its current market value, incentive stock option plans work the other way. They allow the purchase of stock in the future at today's price. The expectation is that the company's stock price will appreciate over time, so that when employees eventually buy the stock they'll be paying a bargain price (Rankin).
When an executive sells incentive stock option shares, the difference between the option price and the selling price is taxed as a long-term capital gain, if certain holding periods are satisfied. In the event the holding periods are not satisfied, income attributable to the transfer is taxed as ordinary income. To pay the new, lower capital gains rate of 20 percent, employees have to hold the stock for at least 12 months.
Restricted
Stock Plans
A restricted stock program is one granting the right
to buy stock in the future at a fixed price established
in advance but imposing restrictions as to (Research
Institute):
- Percentage of market price
- Time within which an option may be exercised
- Amount of stock owned by the optionee, and
- Non-transferability and minimum holding time.
Under a restricted stock program, an executive is awarded stock that is not immediately transferable and that is subject to a substantial risk of forfeiture for a specific period.
The restrictions and forfeiture provisions generally lapse after the specified period (i.e. five years) or at retirement. The terms of the award normally require the executive to remain an executive of the company for the specified period. Failure to perform continued services results in forfeiture of all or part of the shares.
During the restricted period, the executive has full beneficial rights in the stock, including possession of the stock from the date of the grant, and the right to vote the shares and receive dividends. The dividends are taxed as compensation. Employees should begin developing tax-planning strategies early that take into consideration the tax bubble when restrictions lapse and the phase out of itemized deductions.
Deferred
Compensation Plans
With deferred compensation plans, there are special
issues that should be considered during the planning
phase, such as tax deferral benefits versus the lack of
investment flexibility. Often decisions are a
function of the age of the employee, the financial
stability of the company, other holdings, the employee's
tax bracket, the number of years before distributions
start, etc.
Phantom
Stock Plans
Phantom stock plans provide payments based on
hypothetical investments in company stock.
Executives typically are granted units that are assigned
a value based on the fair market value of one share of
company stock on the date of the grant (Research
Institute).
Future payments can be based on future appreciation or on initial value plus future appreciation, and may provide dividend equivalent payments.
Where payments are based on future appreciation only, a phantom stock program is similar to a stock appreciation right, which entitles an executive to a payment based on an appreciation in the price of company stock. Where initial value and dividends are included, phantom stock is somewhat comparable to restricted stock. Payments, which can be in the form of cash or stock or a combination of both, are deductible by the company and are taxed to the executive. The value of phantom stock is a compensation expense that must be accrued over the life of the award, based on the then-current market value.
Stock
Appreciation Rights
Stock appreciation rights (SARs) entitle an executive
to a payment based on the appreciation in the price of
company stock. The amount payable equals the
appreciation, if any, in the price of stock from the time
of the award to the time of exercise. Payment can
be in cash, stock, or both. When granted in
conjunction with stock options, SARs can provide the cash
necessary to pay for option shares and the associated tax
liability (Research Institute). Programs often are
structured so that the exercise of SARs will reduce the
number of shares covered by the related stock
option. Similarly, on the exercise of stock
options, the number of SARs will be adjusted accordingly.
Performance
Award Plans
Performance award plans are categorized into three
groups: performance share, performance unit and
performance cash plans (Research Institute).
Performance share plans are long-term incentive
compensation arrangements that contemplate the payment of
company shares to executives based on objectives achieved
by the company or the executive over a predetermined
period. Performance units are similar to
performance shares except performance units do not
necessarily connote an award whose value (at grant) is
equal to the value of a share of stock. Finally,
performance cash plans are identical to performance share
plans except that the amount participants can earn does
not depend on the market price of the company's stock.
Stock
Bonus Plans
A stock bonus plan is similar to a cash bonus.
Taxes are paid with other resources or by selling
stock. The incentive factor is particularly strong
in a stock bonus plan, because company contributions
generally are made in or converted into company
stock. The value of the stock usually is related to
company profitability, which in turn is related to the
efforts of the executives.
If a stock bonus plan provides for cash distributions, and if stock that is distributed is not readily tradable on an established market, the participant must have the right to require the employer to repurchase the stock. Employees should time the selling of the stock to generate cash for their life goals, such as funding a college education or retirement, buying a new house, etc.
Discounted
Stock Options
Discounted stock options are a type of non-statutory
stock option that can be granted with an exercise price
below the fair market value of the stock on the date the
option is granted. For example, an executive can be
granted a five-year non-statutory option to purchase
1,000 shares of the employer's stock at an exercise price
of $80 per share (Research Institute).
If the fair market value of the stock subject to the option is $100 per share, the executive receives an immediate $20,000 benefit (1,000 shares times the $20 spread between option price and fair market value of stock at option price). However, even though the executive has realized a benefit, he or she can avoid being taxed on such a compensatory option grant if the option is without a readily ascertainable fair market value at the date of grant. The fact that the option is "discounted" does not make its value readily ascertainable at grant. For a non-statutory option to have a readily ascertainable fair market value, it must either be actively traded on an established market or satisfy several conditions.
Stock
Repurchase Agreements
Stock repurchase agreements are essential for the
non-publicly traded company that uses stock compensation
plans. Under these plans, the company reserves the
right of first refusal, which consolidates rather than
dilutes its stock with such agreements (Research
Institute).
Repurchase agreements usually set out the formula to be used to determine the price that the company is willing to pay or the conversion factor that should be used at the employee's exercise of the stock.
Junior
Stock Options
Junior stock options involve creating a special class
of stock for the junior executives of a company (Research
Institute). These options provide an incentive to
the executive to stay and grow with the company.
Often, the shares are less valuable than the common
stock, which can later be cashed in or traded for common
stock. By definition, the junior stock class is for
employees only and is non-transferable, except in a
repurchase agreement with the company.
Employee
Stock Ownership Plans
An Employee Stock Ownership Plan (ESOPs) is a form of
a qualified retirement plan that must invest primarily in
stock of the sponsoring company. The success of the
investment depends on the long-term performance of the
company and its stock. Once employees reach age 55
and have participated in an ESOP for 10 years, they can
move some of their ESOP account holdings into other
investments. At that point, workers usually must be
allowed to diversify at least 25 percent of their total
account; five years later, they must be allowed to
diversify at least 50 percent (Rankin).
At retirement, an employee has several elections on ESOP distribution. A professional financial adviser can help the employee develop a long-range plan and choose the best election for his or her situation.
Stock
Purchase Plans
These plans allow employees to purchase their
company's stock at a discount – usually 15 percent
– to the open market price, without paying any
brokerage commissions. Some plans require workers
to hold the stock for a year before selling; others allow
them to sell immediately (Rankin).
With stock purchase plans, employees often receive an instant return on their money, reflecting the difference between the market price and the discounted purchase price. It's also an easy transaction. Employees determine at the start of the year how much of their salary they want to set aside for purchasing company stock. The transaction is then handled automatically through payroll deduction.
There are no tax advantages to stock purchase plans. The amount employees have set aside for buying their company's securities is tantamount to cash compensation. As such, it is fully taxable in the year the purchases are made. An important consideration with these plans is developing a good accounting system. Accurate record keeping will enable the employee to keep track of the amount deducted from their salary.
Re-Pricing
Options
It is common, should a stock collapse, for companies
to lower the purchase price on options already granted to
employees to stem a mass exodus of talent.
That practice is called "re-pricing." While investors who have risked their funds in a company lose "real" dollars when a stock declines, option holders lose nothing and even get a second chance to buy the stocks at a better price (Welles).
Dilution
Dilution becomes an issue as a company's management
continues to issue new rounds of options to attract and
keep talent. Dilution becomes a threat when a
company's stock rises and employees begin cashing in
their profitable options. That increases the shares
outstanding and dilutes the stake of existing
shareholders, since shares issued by the company through
the exercise of options are not sold in exchange for cash
at fair market value but are exercised at a discount
(Welles).
Works Cited
Brown, Paul B., and Don Underwood. The Merrill Lynch Guide to Retirement Planning: Growing Rich Slowly. Merrill Lynch, Pierce, Fenner & Smith Incorporated, 1993
Fox, Justin. "The Next Best Thing to Free Money." Fortune. 07/07/97
Geer, Carolyn T. "Stock Options: How to Mitigate the Tax Pain." Forbes. 09/25/95
Helyar, John, and Joann S. Lublin. "Corporate Coffers Gush With Currency of an Opulent Age." The Wall Street Journal. 08/10/98
Kroll, Arthur K. "Exploring Options." HRMagazine. 10/97
McMillan, John, and Robert Salwen. "Paying in Stock: The Rank and File." Corporate Board. Vanguard Publications. 03/01/96
Meyer, Pearl. "Stock is no Longer Optional." Journal of Business Strategy. March-April 1998
Morgenson, Gretchen. "Stock Options are not a Free Lunch." Forbes. 05/18/98
Rankin, Deborah, and Editors of Consumer Reports Books. Consumer Reports Books: Investing on Your Own. Yonkers, N.Y. Consumers Union of United States. 1994
Research Institute of America Group. Compensation and Benefits Explanation and Advice. 1998
Rosenberg, Geanne. "The Stock Trap." Working Woman. 04/98
Scherreik, Susan. "A Young Couple Learn How to Convert Stock Options into Long-Term Wealth." Money. 05/98
Society of Certified Public Accountants, N.Y. Study Shows Small Companies Lead Large Companies in Stock-Based Director Compensation. 1997
Welles, Edward O. "Motherhood, Apple Pie & Stock Options." Inc. 02/98