When company stock can jeopardize your financial plan
Many companies now provide various opportunities for their employees to own company stock. This is a good thing. It can provide employees with a sense of ownership and participation when the company performs well. It can also present opportunities for significant increases in net worth if the stock goes up in value.
Of course, stocks can go down in value too. When that happens, if you have too much of your net worth tied up in the value of one company, it can have devastating consequences.
One example comes to mind. In the early 2000s many highly compensated employees at Washington Mutual Bank, one of the largest banks in the US at the time, received much of their compensation in the form of deferred compensation. A requirement of this deferred compensation plan was that the funds be held in Washington Mutual stock. In the financial crisis of 2008, one of the first dominoes to fall was Washington Mutual and its respective stock price. Overnight the bank went from a valuation of $307B to zero, and took with it the value of its employees deferred compensation plans.
So the question then becomes should you even own company stock? And if so, at what point do you own too much company stock?
What is concentration risk
Having too much of one’s investment portfolio in a single company presents more risk than having a diversified portfolio. This type of risk even has a name - concentration risk. Many define concentration risk as somewhere between 10% - 15% of your portfolio invested in an individual position.
When left unchecked, concentration risk can happen quickly if the individual stock price rises in proportion to the overall portfolio. While this can be exciting to see your net worth grow rapidly, the risk is growing just as fast, and has the potential to severely jeopardize your goals and future retirement funding needs.
What is an appropriate amount of company stock to own
According to a 2018 study from Charles Schwab, among employees that receive company stock as part of their compensation package at work, approximately 29 percent of their net worth comes from their company stock.
“Be careful not to put too many eggs in one basket” is a phrase that financial advisors have used ad nauseam, but it especially rings true in this case.
When you have concentration risk in your investment portfolio in your company's stock, you have not only your net worth to the performance of a single company, you have also attached it to your salary, your healthcare and other benefits, and your employment status.
If your company were to perform below expectations, or worse yet faced with a corporate scandal or malfeasance, a stock value can plummet quickly. This could even lead to layoffs and put your future employment in jeopardy.
Should you adhere to a diversified investment portfolio and follow the 10%-15% guideline, your investments may take a hit, but not face devastation.
What are tax implications for diversifying away from company stock
There are various types of equity compensation available today. Each comes with different guidelines and it can get complicated quickly.
Some of the more common types and basic tax guidelines:
- Restricted Stock Units (RSUs) - These are taxed as ordinary income based on value at vesting date.
- Incentive Stock Options (ISOs) - You’ll need to know grant date, strike price, exercise date, selling price, and selling date. The income from ISOs is subject to regular income tax and alternate minimum tax (AMT). It is not taxed for social security and medicare purposes.
- Employee Stock Purchase Plans (ESPPs) - Income is taxed when you sell the stock and depending on how long you’ve owned the stock, can be either ordinary income or capital gains. To qualify for capital gains treatment the stock must be held for both of these:
- At least two years after the option is granted.
- At least one year after you buy the stock.
How should you adjust your exposure as retirement grows closer
The Schwab study went on to say that in addition to the 29% directly holding company stock, that 73% of employees held some form of company stock in a retirement plan.
Many companies provide additional ways to invest in their stock through employee stock purchase plans, stock within the 401(k) or profit sharing, incentive stock, etc.
Also, some employees may face blackout periods or vesting schedules that make it difficult to get out of the stock at any given time.
As you approach retirement, your risk tolerance likely will be different than what it was in your 30s and 40s. A significant downturn of a single holding may not have the most important factor necessary for recovery - time.
Evaluating your risk tolerance and the tax consequences can become extremely complex. This is why it is critical to formulate a plan and coordinate with a tax professional or financial advisor and determine a strategy to diversify as the opportunity arises.