Author: Nick Prigitano
If you've been following the stock market at all, you know that it has been a bumpy year. After hitting record highs in February, when the coronavirus became more severe the market dropped precipitously shortly after, only to recover much of its losses since hitting lows in late March. As financial planners, a big part of our job is to help our clients navigate the uncertainty and help them stay the course to reach their long-term financial goals.
While severe stock market drops are expected from time to time, historically the stock market has always recovered and rewarded long-term investors who have stayed the course. Although this is true about the stock market, do these same rules apply to your company's stock? Should you alter, or avoid altogether, participating in your company's stock plans because of the market volatility? Here's what you should know about stock plans, how they work, and what changes you might want to make when the market is a little bumpier.
Your stock plan is not the stock market
Right off the bat we want to be clear that your company's stock does not reflect the stock market. They are two very, very, different things. When people refer to the stock market, they are generally referring to the S&P 500. This is a benchmark that tracks the 500 largest publicly traded companies in the US. These 500 companies consist of technology companies, financial institutions, large retailers, manufacturers, and more! When you invest in the S&P 500, you're getting a diversified investment with numerous companies in many different industries. Some companies will perform better at certain times, others worse, but as a whole the "stock market" has always increased historically. Past performance does not guarantee future results, but we see no reason this will change in the future.
Your stock plan on the other hand is just one company, the one you work for. It's not diversified, may not even be a part of the S&P 500, and may not track the "market" closely at all. Unlike the stock market, which is an amalgamation of many different companies and aggregating their performance, in your stock plan, the results are determined by your company alone. Gauging your company based solely on the stock market is likely a mistake. While many companies have struggled since the coronavirus and subsequent lockdowns, others have thrived.
For instance, if you work for a toilet paper manufacturer, business is booming, and your success does not reflect the trials and tribulations of the overall stock market and the many different companies in it. The first thing to understand when analyzing a stock plan is that your company stock is not the stock market, and it comes with different risks and potential benefits depending on how the plan is structured.
General stock plan guidance
As financial planners we deal with a lot of different stock plans and have some general rules of thumb when it comes to managing them. Our general recommendation is to not keep too much of your total net worth in your company's stock because of the risk involved.
First, as discussed before, it is not a diversified investment. You're investing in only one company, your employer. Since it's not diversified, if something negative were to happen to your company it could spell financial ruin. Just ask the employees of Enron how their stock investment is doing. If your company goes bankrupt or is going through a rough patch like during COVID, the stock can drop significantly or even become worthless. That's one of the reasons why we generally recommend selling out of your company stock, and reinvesting in a more broadly diversified investment.
Another concern with holding too much company stock is that not only are your investments not diversified, but your income is not diversified either. Your paycheck is obviously tied to your employer. If your company is not doing well there is always a risk of being let go. If your company is not doing well, that probably means the stock is struggling as well. Losing both your income and a potentially significant decrease in the stock price simultaneously can be disastrous if you're not diversified. That's another reason why we suggest decoupling your investments from your employer.
Of course, there can be a significant financial benefit of not diversifying. Companies that have performed exceptionally well, like Apple and Amazon, have increased in value significantly faster than the overall stock market. If you diversify out of your company stock you don't get to fully realize a meteoric rise. However, we believe that the risk of financial ruin is far greater than the off chance of wonderous wealth, and strongly encourage our clients to diversify the vast majority of their assets.
How to manage certain stock plans during market volatility
Now that we know that your stock plan does not reflect the stock market, we can review how market volatility may impact your stock plans. While stock market volatility in and of itself may not alter how you manage your stock plans, the price, and volatility of your company's stock may. There are various kinds of stock plans, which all operate differently. Understanding how they work, and the tax considerations is key to determining how to manage these plans in the most beneficial manner. Depending on your company you may be offered none, one, or a few of these benefits as part of your overall compensation package.
1) Restricted Stock Units (RSUs):
The first type of stock plan we'll review are restricted stock units (RSUs). The way these plans work is you are "granted" a certain number of shares of your company's stock, but you won't actually receive those shares until a certain amount of time later (ex: 3 years) when they vest. Until they vest, you do not own the shares and can do nothing with them. Also, since you do not yet own the shares you are not taxed on anything either. When the shares vest, the value of the shares at that time becomes taxable and will be reflected on your paystub. The value of the shares when they vest also becomes the basis of the stock for determining any gain/loss on the sale after.
Example: On January 1st, 2020 you are granted 100 shares of XYZ company which will vest 3 years later on January 1st, 2023. The price per share is currently $100. On January 1st 2023 the shares are valued at $150, and you will be taxed on the total value of $15,000 (100 * $150), which will be reflected as a line item on your paystub. You then sell the shares 6 months later on July 1st, at $175 a share. Since you received the shares at $150, you will report a short-term capital of $25 per share ($2,500 total) from the sale.
We like to think of RSUs as an alternative bonus. But instead of straight cash, you're receiving company shares. If the stock market is volatile, and your company is performing poorly, the value of this bonus will be less. In the same example as above, if instead the stock was valued at $50 per share when it vested, you would only be taxed on $5,000 and your basis would now be $50 per share.
When it comes to managing RSUs during market volatility our advice is the same as when the market, and your company stock, is performing well -- diversify. Since the basis is the value of the shares when they vest, if you're selling the stock right away you won't realize a significant gain or loss on the shares themselves. You can take the risk of holding your company stock off the table without really experiencing any additional tax consequences.
This eliminates the risk of the stock dropping further, but also removes the possibility of the stock rebounding significantly. As discussed before, we believe that the greater risk is in holding a single stock and encourage our clients to sell when it becomes possible and reinvest the proceeds into a more diversified investment.
2) Employee Stock Purchase Plan (ESPP):
Another common employer stock plan is the stock purchase plan. This stock plan works significantly different than RSUs. For this plan you will designate a certain amount of money to be withheld from each of your paychecks (similar to a 401k withholding), and at a pre-determined specified time the cash from the amounts withheld will be used to purchase your employer's stock. Where this plan provides a significant benefit is that often when the shares are purchased the employer offers a discount on the purchase price, up to 15%.
Example: Your ESPP plan allows shares to be purchased twice a year on July 1st, and December 31st and offers a 15% discount off the share price on the purchase date. On January 1st XYZ company is valued at $75 a share, and you withhold 5% of your pay to put toward the plan. On July 1st, XYZ company is valued at $100 a share and you've withheld $850 over the last 6 months. Since you have a 15% discount, you purchase the shares at $85 ($100 * 85%) and are able to buy 10 shares from the $850 you set aside ($850 / $85).
ESPPs can be a good deal, but the value of these plans varies, and you must look at the details of your plan before you decide to participate. The important questions to ask are:
1) Is there a discount on the purchase, and if so, how much?
2) When is this discount applied?
3) How soon can I sell the shares after buying them?
Getting answers to these questions will help determine whether the plan is worth contributing to. If there is no discount on the purchase price, you almost always should not participate. Also, if the discount is applied at the end of the period, that is much less risky than at the beginning because you don't have to worry about the shares fluctuating between the start and end dates. Some plans actually take the more favorable (lower) price between the beginning and end dates. Lastly, some plans have holding periods where you cannot sell the shares for a certain number of days after you receive them. This means you are holding the stock, and thus the risk, for longer without having the option to sell.
In the case of ESPPs, your basis is the cost of the shares. Since you are setting money aside to buy the shares, you are not taxed when you acquire them, unlike the RSU. However, when you sell the shares, that's when you may be taxed. If you sell the stock before a certain holding period, when you sell the stock you are taxed at income tax rates up to the discount amount. Anything above the discount amount is taxed as a capital gain. Using our example above, if you sold the shares 2 weeks later at $105 per share, $150 would be taxable as income ($15 discount * 10 shares), and $50 would be taxable as a short-term capital gain ($5 gain above $100 and 10 shares).
Whether you should participate in your ESPP plan really depends on how generous the plan is. Also, choosing whether to participate during a volatile stock market depends on the structure of the plan. If the plan gives you a discount, allows you to sell the stock right away, and values the stock price at the end of the period (or the more favorable price) you should almost certainly participate since the risk is low.
Even if the stock drops, you're getting a discount based on the lower price and are just buying more shares at a lower cost. In the example above, if the stock dropped considerably to $10 a share instead of buying 10 shares at $85, you would buy 100 shares at $8.50 (the same $150 discount in either case). As long as you can sell the shares right away, the risk of participating is low.
However, if your plan does not allow you to sell right away or values the price only at the beginning of the period there is considerably more risk, even if you get a discount on the purchase price. In these situations, you need to weigh the risk of holding the shares for a longer period of time which can be unsettling when the stock market is volatile. Depending on your risk tolerance and financial situation, it may make sense to postpone contributing to the plan, or avoid it altogether. Speaking with a financial advisor about what might be best in your situation can be helpful.
3) Stock Options:
As the name implies, stock option plans give you the option of whether to take action on a stock purchase or not. In these plans your company will allow you to purchase a certain number of shares at a pre-determined price, but only for a limited period of time (ex: 2 years). If you decide to exercise your option, you simply buy the shares at the pre-determined price. If you do not buy the shares before time runs out, the option elapses and is gone forever.
Example: As an example, XYZ company is currently trading at $50 a share. Your company gives you the option to purchase 100 shares at $75 a share for the next 2 years. One year later the stock is trading at $100 a share. You exercise your options and buy 100 shares for $7,500 (100 * $75) even though the stock is currently priced higher.
The taxes on this plan are similar to an ESPP plan discount. The amount of the discount from the current price is taxed as income unless an exception applies (such as with an incentive stock option, ISO, which goes beyond the scope of this post). Any gain above the discount is taxed as a capital gain. So, if XYZ company is sold at $105, only $5 is taxable as a capital gain.
What's great about stock option plans is that it puts you in control of the situation. If the stock market is volatile, and your company's stock has dropped, you just won't exercise your option. If XYZ company is trading at $25 a share, it doesn't make sense to buy it at $75, so you would just let your option sit and hope the price increases later. The key with this plan is to know that you have options and don't forget about them and let them expire if it is advantageous to exercise them.
Another concern is that you need the cash to buy the shares. In the example above, if you don't have $7,500 lying around, you may not be able to buy the stock and exercise the option. Thankfully, many plans do allow you to exercise and sell simultaneously. This allows you to use the proceeds from selling the shares to cover the cost of buying them. If you did this in the example above, you would buy all 100 shares, sell 75 of them to cover the cost, and be left with the remaining 25 to either sell or continue to hold.
As with the other plans we don't usually recommend holding onto your company stock for the same reasons as before. If it is beneficial to exercise an option, we suggest exercising and selling all your shares and don't hold any remainder. Like before, we generally recommend reinvesting this back in a more well-diversified investment vehicle.
Stock plans can be an incredible employee benefit regardless of whether the stock market is volatile or not. The most important part is knowing how they work, how they're taxed, and what you're allowed to do with your specific stock plan.
We understand that stock plans can be complex, and volatile markets unnerving. If you need assistance with your overall financial plan, please reach out to our team for guidance.