The ancient Romans used to pay their Legionnaires a lifetime income, like a pension, if they survived various wars in 13 B.C. Likewise, contingent upon survival of the Revolutionary War, our U.S. military agreed to supply our soldiers with payments for life for their bravery and commitment.
In 1875, it didn’t take long for the private sector to pick up on this idea as well; To reward their longstanding employees for years of devotion and loyalty.
Fast-forward to today, 401ks and the idea of employees and employers splitting the cost of funding retirement essentially put the lid on pensions. But, regardless, pensions aren’t entirely gone these days. You might immediately think of teachers, police, or other public service members. It’s not that pensions are only for public sector employees; it’s just that they’re exceptionally uncommon. Clearly, the idea of a pension, or regular payments for life, has been around for a long time.
Today, equity compensation is taking center stage as one of the more desired forms of employee benefits.
Equity compensation is the new pension.
It’s enough for someone else to hear you have it and say, “hmm. That must be nice.”
Equity is a critical component of everyone’s favorite buzzwords, generational wealth. So, if you’re a recipient of some type of equity compensation, you should consider yourself lucky. But, now you have bigger and more expensive problems to deal with: additional taxes, the stress of when to and not to sell, when you should buy, and when you should exercise.
It can all be exhausting. As a result, many are finding they need the help of a financial advisor now more than ever. This is by far an exhaustive list of all things equity comp, but here are a few ideas to consider when faced with equity compensation.
How to make the best decisions for it
I won’t spend too much time diving into the ins and outs of the various types of equity compensation. If you’re already receiving at least one of these from your employer, then you’re probably familiar with the main premise of your package.
However, here are some quick notes about three common forms.
- Most straightforward form – you should know the grant and vesting dates.
- They are taxed as ordinary income based on the stock price on the date of vesting. However, if you can hold them for more than a year, you will pay long-term capital gains taxes on any gain above the vesting price when you sell those shares.
ISOs and NSOs
- Three dates to always know: Grant date – Exercise date – Date of Sale.
- You must put some “skin in the game,” your own money, to purchase the shares.
- ISOs could subject you to AMT tax. (Not fun stuff)
- You’ll have to purchase your employer’s stock out of pocket, often through a paycheck deduction.
- However, this form of equity comp allows you to buy your employer stock at a discount, which could be as much as 15%. Limited to a $25,000 contribution limit.
Some people try to get fancy with hedging options, Bollinger bands, checking resistance and support bands, and so on. Listen, if your initial investment or work perk has doubled or tripled in value, you’ve already won. Adding more complexity is not the solution to an already complex decision.
However, I’ve come to respect that some people enjoy the sensation of squeezing every bit of opportunity they can get out of these types of situations. Just be aware of the risks and costs involved in extra complexity.
What To Do With Your Equity During a Bear Market?
For the last 13 years, many of us have only known of a market that goes up and up. In hindsight, the decision to exercise and then sell was less complicated, because it was almost impossible to lose.
When the market seems like it’s doing the opposite of what we might have grown accustomed to, making a decision whether or not to exercise or even sell your shares is difficult. Consider these strategies when facing a bear market:
- In my opinion, there is no real benefit to holding 100% of the vested shares beyond the grant date.
- Letting these shares accumulate and become an outsized position in your portfolio/total net worth is one thing to be mindful of. I recommend divesting out 80-90% of each vesting block and letting the rest accumulate over time so that you always have a stake in the company’s growth.
- It is a good time to sell if you have a large expense or expensive goal in mind. Young professionals could use their RSU proceeds over five years to help fund a first-time home purchase, family planning, and so on.
- Be aware that if you leave your company you forfeit any shares that have not vested.
- First and foremost, you should hold your ISO shares for at least two years from the grant date and one year from exercising to get preferential (long-term capital gains) tax treatment. This is called a qualifying disposition.
- Taking into account inflation, unless you have a cash flow need, during a declining market it’s probably best to hold on to any exercised positions.
- “It can [also] be advantageous to exercise ISOs in the beginning of the year; then, if stock prices decline from the fair market value at time of exercise, consider selling the stock. Although this strategy will create a disqualifying disposition, it will also avoid becoming an AMT preference item.” – Darrow Wealth Management
- If you don’t have your eyes set on retirement any time soon, being able to buy employer securities in a down market at a 15% discount is godsent. Your purchase price is permanently in a recession while your sell price is at current market prices (which should be higher).
- This is an excellent time to diversify your holdings and tax liability. If you’re still looking for retirement savings in what could be the best environment for it, you could trim some of your positions to today and fund a Roth IRA.
- Also subject to qualifying/disqualifying disposition rules.
It’s important to note that there is no absolute right answer when it comes to these decisions. What we try to focus on is regret minimization. By making the most informed decision today with the best information that’s available today — current financial situation, current market conditions, expected tax liability — you will at least be able to sleep at night. That’s whether your employer’s stock continues to go up and you missed the peak, or down and you missed a slightly better buying opportunity.
Making an intelligent, educated decision like this requires an unemotional frame of mind and rules to bypass emotions. And that is much easier said than done.
Don’t Do It Alone
The Charles Schwab 2019 Annual Equity Compensation Survey noted that 36% of the Millennial respondents plan to use their equity compensation to finance their retirement.
Sure, it doesn’t perfectly translate to guaranteed income, but more importantly, equity is one of the most powerful tools when it comes to accumulating long-lasting wealth. Which, arguably, seems more important these days.
It probably goes without saying that stocks are the best hedge against inflation. They’re a key component to building wealth and allow you to become an owner of what you’re building. However, the nuance between managing, monitoring, and even the tax implications of equity comp goes beyond its initial benefit.
Working with your financial professional is the best way to take this stress off your hands and reap the benefits of what your hard work earns.
Lastly, one of my favorite things about equity compensation, and what makes it so different from pensions, is that it completely shifts the focus from how long you work with your employer to how well you work with your team.
Your output has a meaningful effect on your compensation and that of your co-workers. Remember, you too, are building this rocketship!