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Financial Decoder: Season 3 Episode 7

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Whether it’s stock options, restricted stock, an employee stock purchase plan, or some other form of equity compensation, most companies offer this vital benefit to employees. But once you have it, what should you do with it?

Today, many startups and most of the companies on the Fortune 500 list allow their employees to take ownership in the company through stock awards, employee stock purchase plans, stock options, or some other form of equity compensation. That’s a good thing because aligning the interests of employees and owners makes sense. But employees receiving equity compensation can feel overwhelmed. The details may seem like a confusing swarm of acronyms, tax challenges, and timing decisions that can obscure the benefits of a potential windfall.

In this episode Mark talks with Amy Reback, vice president of Schwab Stock Plan Services. They discuss how equity compensation has evolved and what strategies might be best for employees holding various types of stock options or restricted stock. Mark also dives into the biases that might be preventing you from making the best decisions about your equity compensation—and how you can guard against those mistakes.

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MARK RIEPE: The financial system is fairly fickle in the way it names important features. Sometimes they’re named after a person.

For instance, the Roth in “Roth IRA” comes from William Roth, a senator from Delaware who sponsored the legislation that brought these accounts into existence.

Sometimes they’re named for a number from a federal rule book, like the 401(k) account, which refers to section 401 subsection k of the Internal Revenue Code.

And sometimes we call things exactly what they are. Employee Stock Ownership Plans are a good example.

This last naming convention may be a victory for clarity, but it doesn’t provide a lot of clues about its origins. Few people know that Employee Stock Ownership Plans were the brainchild of lawyer and economist Louis O. Kelso.[1] During World War II, Kelso was stationed in the Panama Canal Zone, where he found the time to write a treatise on his theory of employment.[2]

After leaving the military he continued to refine his ideas and a decade later, Kelso laid out his proposal for what he called an Employee Stock Ownership Plan, or ESOP for short.

Part of Kelso’s theory was that technology and machines would continue to evolve rapidly and become more efficient, and that this would mostly benefit the owners of those machines. Human capital and productivity, on the other hand, would remain largely unchanged, so employees would not participate in the benefits of that progress. Kelso reasoned that if employees could become owners as well as workers, they would progressively receive more capital.

His plan was first put into effect at Peninsula Newspapers and then was widely copied by several large companies in the late 1950s. Influential politicians such as Senator Russell B. Long[3] championed the idea and passed laws protecting employee-owned stock from other existing tax laws.

Today, many startups and most of the companies on the Fortune 500 list allow their employees to take ownership in the company through stock awards, employee stock purchase plans, stock options, or some other form of equity compensation.

That’s a good thing because aligning the interests of employees and owners makes sense.

But an employee receiving equity compensation can feel overwhelmed. The details may seem like a confusing swarm of acronyms, tax challenges, and timing decisions that can obscure the benefits of a potential windfall.

On today’s episode, we’re going to get to the heart of one of the most important decisions you can make as a worker—what should you do with your equity compensation?

I’m Mark Riepe, and this is Financial Decoder—an original podcast from Charles Schwab.

It’s a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.

There are at least two biases that are relevant when it comes to decisions about equity compensation. The first one is our tendency to err on the side of optimism.

If your company is doing well and you have confidence in the strategic plans of the firm and its ability to execute them, then it’s easy to be even more optimistic than usual. This is hard to combat as an employee. So much of what employees hear from companies is about what’s gone well already, what’s going well right now, and what will go well in the future.

When obstacles are discussed, much of the discussion is about how the company has anticipated those obstacles and has plans to mitigate them. My point is not to be critical of companies. I suspect most of us have no desire to work for a firm that is always talking about its failures and how the future is dark.

But when it comes to equity compensation, you’re no longer just an employee; you’re an investor in the company as well, and it makes sense for you to evaluate the company somewhat differently.

The second bias at play in your equity compensation decisions is cognitive dissonance. This refers to the difficulty we have in simultaneously holding apparently contradictory beliefs.

Most people want to feel good about the prospects for their employer. After all, if your general perception of the firm is negative, you probably don’t want to work there much longer, never mind owning a stake in the company. However, if your general perception is positive, and you sell an ownership stake you’ve received—well, that might feel a bit inconsistent.

One way of resolving that inconsistency or dissonance is to just continue holding the employer stock, which is exactly the direction that optimism bias reinforces.

Joining me now to discuss some of the decisions you need to consider when deciding what to do with your employee equity compensation is Amy Reback. Amy is a vice president here at Schwab, and she heads up Stock Plan Services. Thanks for being here today, Amy.

AMY REBACK: Thanks for having me, Mark.

MARK: Talk to me a little bit about just compensation. How has the world changed when it comes to employee compensation and how companies incentivize their employees?

AMY: The landscape of compensation has changed pretty drastically, especially over the last decade or so. And the way that I typically describe it is more of an evolution. So when my father went out into the workplace, he was told, “Make sure you get a pension.” When he sent me out into the workplace, he said, “Make sure you find a company that has a 401(k).” And when I go to send my sons out into the workforce, I will be saying, “Make sure you find a company that has a great equity compensation plan.”

Companies are using equity compensation to attract and retain talent in a broader range of employees, and that resonates really, really well, especially with the millennial generation, which is about 50% of the workforce right now. They place a lot more value on ownership, and aligning with the mission and purpose of their employers, and they really view participation in an equity compensation plan as table stakes. It’s absolutely an expectation.

And we’ve really seen the highest increase in equity comp with big tech. I don’t think that’s any surprise to anyone. But more traditional industries are following suit, because every company, public and private, is looking for tech talent who can help them build and implement that technology to drive their next generation of growth. So whether you build tractors, or provide financial services, all companies are fishing in the same talent pool, and those who offer broad-based equity compensation plans will win more often.

MARK: So one of the challenges with this evolution, at least from my perspective, is it’s kind of complicated, and there’s so much jargon. So maybe let’s start with the basics. What are the most common forms of equity compensation?

AMY: The most common forms of equity compensation are stock options and restricted stock.

MARK: I suspect that, obviously, it makes a lot of sense for people to read up on the details of their own particular company plan, but at a high level, could you describe what are the big differences between options and restricted stock?

AMY: Absolutely. So stock options, the way they work is right in their name. It is an option to buy shares of stock at a very specific price, whereas restricted stock is a gift of actual shares. So with options, you receive the potential to buy, hopefully at what becomes a discounted price. And with restricted stock, you receive actual shares and ownership in the company.

MARK: Talk to me a little bit about some of the other key terms that people need to really understand, so they get a sense as to what they have access to if they’re participating in one of these plans.

AMY: Right, so when an employee receives an equity compensation award, typically they get a letter, and there’s going to be a lot of confusing jargon in it. So let’s go over some of those terms, just to set a baseline. The first is a grant or a grant date. I always think of this as “Your wish is granted.” It’s the gift of the award, and the details of what’s in it. Every grant has a vesting schedule, which is the cadence at which a portion of your granted shares will be released to you and become yours to either hold, or sell, or exercise, if they’re options. When shares are vested, it means they officially belong to you.

MARK: So I might be given a grant of, let’s say, 1,000 shares, with a four-year vesting schedule. So I don’t get the 1,000 shares right away. I’ll get 250 one year from now, another 250 two years from now, etc., etc. Is that right?

AMY: Exactly.

MARK: So what are some of the details that people need to watch out for when they’ve got shares, either restricted shares or options that vest over time, as opposed to getting it right here and now?

AMY: So, couple of things with vesting over time that a lot of people overlook is that the stock price could be lower or higher. So the value of what you actually receive might be significantly higher than what was described when the award was originally granted, or it could be significantly lower. But the beauty behind that is it’s all about ownership. So if you’re granting awards to your employees, the better the company does, the better they will do, and the more reward they will get from their equity compensation.

MARK: So talk a little bit about employee stock options, because I think in some respects, that’s a little bit more complicated. How do they go about exercising an option?

AMY: Well, the first step that has to be taken is options and restricted stock are securities, so you have to have a brokerage account. That’s where Schwab comes into the picture. And it has to be administered, typically by another firm or brokerage account, which is exactly what my folks do in Stock Plan Services. We administer the plan. We deposit the shares on behalf of the companies and their participants.

If you’re a participant and you’ve received an award, there’s a couple of options, no pun intended here, of course. And the two options that we have for exercising stock options are pretty basic. There’s either exercise-and-hold, or you can do a cashless exercise, which is almost like a swap. You buy … exercise and buy, and then sell simultaneously, and what the employee receives is the difference between the exercise price and the market price. They have to have a brokerage account in order to do that. And if they go in, there’s also calculators, usually. And I know we have these at Schwab, where an employee can say, “What do I want to do? I want to raise cash. I want to own the shares.” And it’s very simple language that can walk you through and then make a recommendation on what the best action would be for them to take.

Now, if they were going to buy and hold, they would choose to exercise, but it’s exactly what it sounds like. You’re buying the stock. Remember, an option to buy at a very specific price. And they have to put up cash to do that, so they would have to write a check or make a transfer into their brokerage account, have the available cash there to exercise at the exercise price, and then they would hold the securities after the settlement date, and they become theirs.

So the main difference between the two is if you buy and hold, you end up with shares and less cash, and if you do a cashless exercise, you take the cash away.

MARK: So if I … if my exercise price was $50 per share, the stock is trading at $75 after I vest, I could ... if I exercise and hold, I have to pay the $50 per share, but I’m getting a security … I’m getting shares that are worth 75.

AMY: Exactly.

MARK: And I’m going to ... just like you said, I’m going to end up with shares at the end of the day. If I do the cashless exercise, I exercise at 50. I get the shares, but they are immediately sold, and I get the difference, 75 minus 50.

AMY: You would get the $25.

MARK: You get the $25, but you also have to pay taxes, which we’ll cover in a bit. Before that, though, the question employees ask is, “Should I exercise and sell, or should I exercise and hold?”

AMY: It depends on the type of award, and it also depends on what potential tax consequences could be the result of that. So for nonqualified stock options, which means they don’t get any special tax treatment, and they’re taxed as ordinary income, it’s a pretty good idea to exercise and sell right away, if you are deep in the money like your 50 and 75 example, and there’s no real special reason to defer the income. So you would do that versus, you know, holding and hoping that the stock would just go up. You’re already getting the value out of it that you would want to get. For both nonqualified stock options and incentive stock options, if the stock price is falling and the options are in the money, you should exercise. Because if the price is going down, it could go below the exercise price, and then they become worthless.

MARK: What’s the difference between incentive stock options and nonqualified stock options?

AMY: It all has to do with taxation. So the qualified piece refers to the tax treatment. So let me give you an example of what they have in common, and then how they differ.

So nonqualified stock options, also referred to as NSOs, or sometimes NQSOs, and incentive stock options, or ISOs, have a few things in common. They’re both designed to give employees more skin in the game. And if the company does well, then the stock price will go up, it will go beyond the exercise price, and there will be value to the employee. If it doesn’t do well, the options could expire worthless, so there’s some risk there. While a restricted stock, you actually own the shares, right? So a little more skin in the game for the employee. They all have a defined vesting schedule and an expiration date, and they are not taxed when they are granted.

Now, here’s how they differ. Nonqualified stock options are taxed when they are exercised, and the difference between that exercise price and the market price is taxed as regular income. Whereas incentive stock options are not taxed at exercise. The actual shares from an ISO exercise are taxed when they’re sold, and if it is a qualifying transaction—meaning that the shares were held for two years from the grant date and one year from the exercise date—only short or long term capital gains would come into play.

MARK: Got it. What are some of the common tax mistakes that people make when it comes to options?

AMY: Oh, lots and lots of tax mistakes. And the reason is a lot of people really don’t understand the type of awards they have, and what the potential tax consequences could be. And that’s really important to research—what exactly is it that I have, and what should I do and when?

MARK: So by that you mean they don’t know whether they have a nonqualified or an ISO incentive stock option?

AMY: Exactly. Exactly. So if you have a better understanding of the type of award you have and how they’re taxed, then you’ll avoid some surprises, unwelcome surprises, when it comes to tax time. So know whether to sell or exercise, and whether or not it will generate regular income or capital gains. That’s the first thing you need to know. And then the other mistake that they make, the number two mistake, is absolutely selling too soon and paying higher short-term gains versus long-term.

MARK: Obviously, it makes a lot of sense, particularly if this is a big part of your portfolio, to speak with a tax advisor?

AMY: Yes, absolutely. Always.

MARK: : What are some of the ways that people can integrate what... you know, frankly, what a lot of people probably think of as a windfall, you know, if the company is doing extremely well? How do you integrate this into the rest of their financial affairs, into the rest of their financial planning?

AMY: Well, first I’d say equity compensation can really help people reach their financial goals faster, but they do require some careful handling. As I mentioned before, it’s really important to understand what the tax consequences could be, and also what the vesting schedule is. You know, you might need to avoid an unwelcome tax consequence when it comes to April, but it’s really all about managing risk. And I think the biggest thing that people can do to impact their long-term success is managing an over-concentration of stock that can happen very quickly when it comes to equity compensation. So managing risk with a portfolio is always the number one thing you have to watch out for, and it’s very, very important to pay attention to that when you have equity comp.

MARK: That’s a great point, because one of Schwab’s investing principles is to build a diversified portfolio. Many employees, if they’re working in a job where the equity compensation is a big portion of their total compensation, and the company does really well ... as you just mentioned, you could end up with an overly large concentration in company stock, not only sort of your human capital, you’re working for the company, but then also your financial capital. So what are some ways to keep some of that stock, but at the same time be more diversified?

AMY: Well, first, exactly like you said. Have a plan to diversify your company stock over time, so your shares don’t take on a life of their own in your portfolio. You know, one of the lessons I learned in this industry years and years ago is that you might fall in love with a stock, but the stock doesn’t know that. And it’s no different when it comes to your equity compensation and your employer stock. And no one gets a trophy for holding on to their stock, and it definitely doesn’t make you a better employee. And typically, employers will grant shares to their best performing employees to retain that talent, and it’s really important that they do that. It doesn’t mean that you have to hold on to that stock.

So make a plan to sell over time. Make sure you don’t become overweight. Make sure you aren’t overweight in the same sector. You know, a lot of times employees who are familiar with a certain industry, they know the pros and cons of their competitors, and so they end up buying more shares of their competitors’ stock, and then you have a much higher risk. And we saw that happen in 2006, 2007, and 2008, with utilities and financial services.

MARK: Sure.

AMY: When people had way too many. And the reason is a lot of those stocks paid great dividends. So be sure you’re not overweight in that sector.

Another thing you can do that a lot of people overlook is some companies offer share equivalents, which is a security that represents or follows the performance of your company stock in the 401(k) plan. So if your company does that, and you are a recipient of equity compensation, make sure that you really take a look at your overall portfolio. You’re considering what your 401(k) holdings are, and if you’re heavy in equity compensation or your own company stock, maybe avoid buying the share equivalents in your 401(k).

MARK: So Amy, you know, your team, you’re answering thousands, tens of thousands of questions from employees who are kind of going through this exercise process with their employers. What’s the number one question that you get, or what’s the number one point of confusion?

AMY: The number one question that we get on our participant services line is related to stock options, and some confusion on exactly what the value is. So if someone were to go online and look at their statement of stock options ... and I’ll use your example of the exercise price of 50, and the current market price at 75 ... what they will see is the value is $75 if it’s one option. The market value is $75. But remember, with an option, you have to buy, technically, the shares at 50. You don’t own that one share. You own the option to buy it. Your gain is 25.

MARK: Your gain is 25.

AMY: But the number one question we get is, “Where’s my $75? You only gave me 25. You owe me $50.” And explaining the fact that it is not ... they don’t own the share. They own the option to buy it. So when they do a cashless exercise, they’re not bringing cash to it. They’re exercising and then selling simultaneously, because the market value is above the exercise price, so they get the difference between the two.

MARK: Yeah. And I think when it comes to financial planning, it’s really important to understand … essentially, these are assets, right? These are securities, as you … as you mentioned before, and it’s really important, when you’re making planning decisions to understand how much your securities are worth. And so in the example you just gave, thinking something is worth 75 when it’s really worth 25, that could make a big difference.

AMY: Exactly.

MARK: Lots of great advice. Thanks for being here, Amy.

AMY: Thanks very much, Mark. My pleasure.

In the introduction we talked about two biases: over-optimism and cognitive dissonance. I’m going to talk about one more bias and then we’ll wrap up with some suggestions for how to combat these.

It has to do with how we frame decisions. Many people frame decisions in an overly narrow way. A narrow definition of wealth would be to just include your financial assets. A broader, more accurate view is to define wealth as all of your assets including your human capital. By that I mean the earning power that is made possible by your skills, knowledge, and experience.

As Amy pointed out, tying an appreciable amount of your financial portfolio to the fortunes of a single company is a risky choice. However, the value of your human capital is also at last somewhat tied to the performance of your employer.

Think back to some of the notable corporate collapses over the years. I’m talking about companies like Enron, Lehman Brothers, and more recently, Toys R Us.[4]

As those companies shed employees, some of those employees were not able to get a job as good as the one they had. In effect, their human capital was worth more to their former employer than their new employer. Imagine if these same employees had a significant portion of their financial assets also tied up in the stock of their former employer, and that stock collapsed.

This isn’t merely a theoretical concern. Last month Schwab Stock Plan Services conducted a survey of 1,000 employees who participated in an equity compensation plan at their employer. The value of the equity compensation made up, on average, about 27% of the net worth of the employees. If you tie your human capital and your financial capital to one company, then it’s great if that company goes from a tiny start-up to a world class firm that dominates an industry. Because of survivorship bias, it’s easy to come up with examples of where that happens, but those are actually exceptions rather than the rule.

Last year an important study was published that looked at all individual stocks that had traded on US stock exchanges since 1926.[5] The study compared the returns of each individual company with Treasury bills over the life of the company. Only 43% of the individual companies beat Treasury bills. That’s why diversification is so important. Any single company has a lot of risk associated with it so you want to spread your money around because the winning companies tend to do so well they more than make up for the ones that struggle—and greatly outperform T-bills.

So what do you do about all of this?

Suggestion #1: Do your homework on your grants. Equity compensation is complicated. Make sure you understand the details of your specific plan and get help if you’re confused.

Suggestion #2: Do your homework on your company. Equity compensation is a great tool, but you need to periodically ask yourself what the prospects of the firm really are. You should be evaluating the stock objectively, as you should with any individual stock you own.

Ask yourself the question “What could go wrong?” If you’re not capable of asking or answering those questions then take advantage of the services of an advisor. The advisor can serve as an independent, third party who can be more objective. If you don’t combat this then you run the risk of getting sucked into the hype and hold onto too much of our equity compensation and end up with an unbalanced portfolio.

Suggestion #3: Don’t fall for false choices. Selling company shares isn’t an expression of disloyalty or lack of faith. It’s an act of humility. It’s an admission that we don’t know the future with any degree of reliability. In the face of uncertainty, the best strategy is to position ourselves to benefit from what we think the most likely outcome is, but also put in place some protection in case the future doesn’t pan out as we planned.

In the case of employer stock, feel free to hold a position, but not so much that your financial future is at risk in case the firm gets into trouble or underperforms. It’s really hard to say a specific percentage is too much because everyone has different circumstances, but consider anything above 10% as a warning sign.

Suggestion #4: Put the decision on autopilot. Many companies allow employees to opt into a program where they agree ahead of time to regularly sell shares of their employer stock. As we’ve said many times on this show, you can’t always rely on yourself to make a bias-free or emotion-free decision in the heat of the moment. To protect yourself, set up a structure that imposes a prudent decision upon your future self.

If you’re interested in learning more about how equity compensation works, be sure to check out schwab.com/EquityCompensation.

And you can always call Schwab at 877-279-4476.

Thanks for listening to Financial Decoder. This is our last episode of Season 3, which means we’re taking a break for a couple of months, but we’ll be back in the New Year with more episodes.

If you’ve enjoyed the show, please leave us some feedback in the form of a review on Apple Podcasts or your favorite listening app.

If you want to go back and listen to previous episodes or read more about our previous topics, you can always visit our page at schwab.com/FinancialDecoder.

For important disclosures, see the show notes and schwab.com/FinancialDecoder.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Schwab Stock Plan Services provides equity compensation plan services and other financial services to corporations and employees through Charles Schwab & Co., Inc. (“Schwab”). Schwab, a registered broker-dealer, offers brokerage and custody services to its customers.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. 

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Apple Podcasts and the Apple logo are trademarks of Apple Inc., registered in the U.S. and other countries.

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