Stock grants remain a key component of many employees' total compensation and a major wealth-building opportunity. Common forms include incentive stock options and nonqualified stock options; restricted stock and restricted stock units; stock appreciation rights; and performance-based stock grants. (The use of the phrase "stock grants" in this article encompasses all these types of equity awards.) The tax aspects range from simple to complex, and the stock compensation landscape is constantly changing as tax regulations and your company's objectives evolve.
Three Investor Types
Successful wealth-building strategies for equity compensation begin with a discussion of the role that stock grants will play in your financial life, along with identifying your core values, beliefs, and activities. The greater the value of grants, and the greater the proportion of your wealth they represent, the more important this process becomes. While the nature of these reflections depends on individual circumstances, for the purposes of this article I will classify people with stock grants into three broad categories: the Wealth Accumulator, the Corporate Insider, and the Financially Independent. Note that these categories can sometimes overlap.
If you are a Wealth Accumulator, your planning for stock grants usually involves qualifying and quantifying goals related to financial milestones, along with managing risk. Your goals may include:
- Planning for retirement (or being wealthy enough to make work optional)
- Funding college education
- The purchase of big-ticket items (e.g. a vacation home)
For you, the primary role of stock compensation is to provide a greater share of the funding for these goals.
Your income, your net worth, and often your health benefits are tied to the success of your company. You will benefit most from planning strategies that do the following:
- Prioritize risk management
- Promote diversification
- Generate cash flow as needed to fund goals
Tax minimization should play an important but secondary goal for the Wealth Accumulator: many a fortune was lost during the bear markets of 2000–2002 and, more recently, 2008–2009 because of a misguided focus on tax results over profit maximization and risk protection.
Alert: Accumulators who implement strategies based primarily on tax optimization risk seeing their plan self-destruct at highly inopportune times, when the markets prove uncooperative. It is far better to keep a small fortune (and pay some taxes) than to lose a large one (while possibly still having to pay some taxes). Accordingly, do not focus so much on potential future tax increases that you compromise other financial goals.
If you are a Corporate Insider (usually an executive), you face additional planning considerations because your actions are highly visible and are watched by regulators, shareholders, and employees. You are subject to blackouts when you are prohibited from trading stock (unless you arranged a schedule of stock trades beforehand in a Rule 10b5-1 trading plan). During open trading windows, significant sales of company securities by Corporate Insiders may be perceived by the markets as a pessimistic outlook on the company. There are often political pressures within the company to discourage selling.
Lastly, because of your intimate knowledge of the company, and because of the natural tendency to see things close to us with optimism, you may discount risks involved in holding a concentrated position in your company's stock. Consequently, the decision framework is more complex for high-level corporate executives.
If you are the type of investor I call Financially Independent, you do not face critical planning concerns with stock grants since, by definition, you are not reliant on them to fund retirement or other accumulation goals. However, maximizing and preserving the value of your grants is often still important.
Once you have considered your primary objectives and the role played by your grants, the focus can turn toward quantifying specific goals and developing actions.
Using Equity Compensation To Fund Accumulation Goals
For all but the Financially Independent, planning strategies for stock compensation begin with the larger plan first: traditional financial planning using a lifetime cash-flow analysis. This involves your lifestyle and goals. Consider your ideal vision of the life you want and the financial milestones you want to attain, and for any community and family legacies you may wish to leave. From this vision, the goals may then be quantified in time-bound, dollar-denominated terms.
For example, if your goal is retirement (or not needing to work), then by the end of the planning process you should know, at a minimum, the answers to the following questions:
- When do you want to retire?
- How much will you spend (in retirement, while working, or annually), and on what?
- How will you spend your time?
- How much capital do you need in today's dollars to fund your desired retirement lifestyle?
- What is the minimum rate of return needed to sustain your retirement?
- By when do you need to have accumulated your retirement capital?
- To what extent can/should you protect against downside risk in your investment portfolio to avoid jeopardizing your ability to retire (and stay retired)?
Once you have answered these questions, you (and perhaps an experienced advisor) will be better prepared to analyze the role played by stock grants, and understand how they fit with your goals. This should include diversification targets, and identifying the timing of any desired cash flow from your stock compensation. In other words, decisions about your stock grants can be optimized only when they are seen in the context of your total current circumstances and hopes for the future.
When the time comes to implement the plan, a basic decision flowchart becomes an important way to keep you and your financial advisor working in concert. This flowchart consists of one or more "if/then" statements that translate into specific actions based on metrics that are both quantifiable and easily monitored.
Actions may be based on the price of the underlying stock, they may be driven by events or dates, or they may be based on a formula. Defining trigger points helps to make your exercise and/or sale decisions much easier. For example:
These action triggers can operate individually or in combination. For example, if the value of the grants were sufficient to provide more than enough after-tax wealth to meet your financial goals, a combination strategy might involve first capturing enough wealth to reach financial independence and then attempting to maximize the value of the remaining grants.
Alert: Implementation based on quantitative data such as price, event, or formula metrics must be monitored regularly to facilitate timely decisions
Complications For The Corporate Insider
The use of a price-based decision flowchart is particularly useful for Corporate Insiders who are subject to trading windows and other restrictions. Price-based strategies can be implemented using a Rule 10b5-1 trading plan, which bases a specific exercise-and-sell strategy on trigger points established before you know secret market-moving information and ahead of related blackout periods. The plan thus provides a safe harbor that can act as a defense against any later charges of insider trading. Rule 10b5-1 plans are put into place during an open trading window, and typically run for a fixed period (e.g. two years).
Once established, a 10b5-1 trading plan can operate during blackout periods or closed trading windows. In addition to helping you work toward your overall financial goals, 10b5-1 trading plans can help you avoid the risk of being forced to watch the expiration of in-the-money stock options that you cannot exercise because of a closed trading window.
Remember Your Goals
Money and wealth themselves are not the end; rather, they are means to an end. It is important to first understand what you want and the role your stock grants can play in building your wealth toward those life goals. Once you understand this, you can develop the action triggers and then monitor them.
- Goals should be identified and quantified to determine how your grants can help fund them
- Establish a decision flowchart using quantifiable price, event/date, and formula metrics that can be easily monitored. Consider obtaining the help of a financial advisor
- Monitor your decision triggers, and/or consult a financial advisor, and take action when thresholds are met. Corporate insiders should consider Rule 10b5-1 trading plans to take pre-determined action during blackout periods
- Periodically review the plan and make adjustments that reflect changes in your goals and circumstances, and as external factors warrant (e.g. tax laws and market swings)
Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters.
Diversification does not assure a profit or protect against loss in declining financial markets.
This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Individuals executing a 10b5-1 should keep the following important considerations in mind:
(1) 10b5-1 trading plans should be approved by the compliance officer or general counsel of the individual’s company
(2) A 10b5-1 trading plan may require a cessation of trading activities at times when lockups may be necessary to the company (i.e. secondary offerings, pooling transactions, etc.)
(3) A 10b5-1 trading plan does not generally alter the restricted stock regulatory requirements (e.g. Rule 144, Section 16, Section 13D) that may otherwise be applicable
(4) 10b5-1 trading plan that are modified or terminated early may weaken or lose the benefit of the affirmative defense
(5) Public disclosure of 10b5-1 trading plans (e.g., via press release) may be appropriate for some insiders
(6) Most companies will permit 10b5-1 trading plans to be implemented only during open window periods
(7) Morgan Stanley Smith Barney LLC, as well as some issuers, imposes a mandatory waiting period between the execution of the 10b5-1 trading plan and the first sale pursuant to the plan
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