Many investors receive company stock or stock options from their employer as part of their overall compensation. What may seem like a small part of their overall portfolio, company stock can become a much larger part of an investor’s overall assets as time goes on, thus potentially exposing them to risks associated with concentrated positions.
Let’s take a seasoned executive from Exxon Mobil as an example. Over the course of 15 to 20 years in the industry, they can have accumulated many shares or potential shares (stock options) of Exxon Mobil. In the last 15 to 20 years, Exxon Mobil stock has more than tripled, creating the possible situation for the investor of having a significant part of their wealth tied to Exxon Mobil and, therefore, exposed to risks associated with the oil and gas industry.
As we know, the oil and gas industry has taken a large hit over the last 2.5 years. Exxon Mobil stock alone is still down approximately 20% from its last high of around $100 per share in 2014. These types of shocks can have significant repercussions for those who have a large part of their wealth tied up in their company’s stock.
Our recommended course of action will be dependent on how much of the investor's total wealth is tied up in the concentrated position. If, for example, the investor’s assets outside of their company stock are well-diversified and they are able to meet the retirement needs of the investor, then the concentrated stock position may not be an immediate threat to the investor. A prudent course of action may be to slowly divest the position as the stock options become available to exercise and sell.
On the other hand, if a significant part of the investor’s wealth is tied up in company stock with restrictions in terms of selling it, then we may have to get creative in terms of hedging the immediate risk that client faces. The two main risks faced by the investor include the systematic risk, which are the economic factors associated with the oil and gas industry, as well as the idiosyncratic or firm specific risk associated with Exxon Mobil.
When handling a concentrated position, we are looking to accomplish 3 specific tasks:
- Reduce risk
- Create liquidity
- Optimize tax efficiency
We typically recommend that investors sell their position as soon as it becomes available as long as it doesn’t create an overwhelming tax burden on the investor. Single stock positions have historically exposed investors to risk that is not expected to be compensated with additional return. The chart below shows the historical performance of 20 IFA Index Portfolios as well as the individual stocks found in the Dow Jones Industrial Average for the 41-year period ending 12/31/2016.
As you can see, individual stocks carry firm specific risks that increase the overall risk of the stock (standard deviation) without additional expected return. In our example, Exxon Mobil stock has delivered close to a 12% annualized return with a standard deviation of approximately 17%. An investor could have achieved a similar return with significantly less risk by investing in a diversified IFA Index Portfolio 70 that targets an asset allocation of 70% in stocks and 30% in bonds. Globally diversified index funds helps to decrease the amount of risk taken for a given level of expected return.
Working with an independent wealth advisor can help investors assess the risk of their concentrated position and what course of action is appropriate in terms of hedging the risks associated with that position.
What about when you decide to retire or switch jobs?
Deciding how to handle your concentrated stock position once you retire or switch jobs is a very delicate process that shouldn’t be done without the help of a professional.
The majority of the time, most company stock positions are awarded to employees through Employee Stock Ownership Plans (ESOP), which grant employees stock ownership as well as creating tax benefits for the company, or through the company 401(k) plan.
Once you retire or switch jobs, you have 2 potential options in terms of what to do with assets:
- Roll the assets over into a Rollover IRA: similar to what you do with 401(k) or other qualified employer sponsored retirement plans.
- Transfer the stock to a regular brokerage account: you pay income taxes on the income portion of the stock, forgo the capital gains taxes on the net unrealized appreciation, and possibly pay a 10% penalty if it is before normal retirement age.
Let’s first define Net Unrealized Appreciation. It is defined as “the value of the stock at the time of purchase and the time of distribution.” What is crucial to understand is that only the portion of the position that is subject to ordinary income taxes is the value of the stock when it was first acquired (i.e. cost basis) by the ESOP or other retirement plan. If the stock were acquired in individual lots, then each lot would have a portion that is subject to ordinary income taxes.
Again, regardless, of where the investor decides to transfer their assets, we would highly recommend that they divest the position. This can happen by:
- Selling shares back to the ESOP Plan at market value and then transferring
- Rolling shares over into an IRA and then selling at market value
- Transferring shares to a brokerage account and then selling at market value
How we decide to go about it depends on 3 key variables:
- Location of the concentrated position (ESOP vs. 401(k))
- Current age of the investor (younger or older than normal retirement age)
- Percentage of the entire portfolio made up by the concentrated stock position
If, for example, we have an investor who is younger than normal retirement age, transferring the position to a brokerage account would incur a 10% excise tax penalty on the value of the assets, but allow them to pay less in tax when they decide to divest the position. They would pay long-term capital gains taxes at lower rates than ordinary income tax rates on the net unrealized appreciation of the asset. On the other hand, they could roll the assets over into an IRA and sell the entire position tax-free, but this would subject them to paying income taxes on the entire position once they start to take distributions.
Remember, what we are trying to prioritize is reducing the overall risk of the position, create liquidity, and optimize tax efficiency. We have flexibility in terms of accomplishing these three items and there is not universal answer in terms of what is best for the investor.
Let’s go back to our Exxon Mobil executive. Let’s say she is about to retire (past normal retirement age), has a concentrated position in Exxon Mobil stock that has a total cost basis of $200,000 and a net unrealized appreciation of $600,000 for a total current value of $800,000. Let’s also assume she has $3,000,000 in other retirement assets that are well diversified in IFA Index Portfolio 50. She lives in the State of Texas where she pays a 33% Federal tax rate and no state income taxes. Given her Federal tax rate, she pays a 15% tax on long-term capital gains. She can live comfortably off of the $3,000,000 in retirement assets and is not dependent upon her concentrated stock position for her retirement living needs. In other words, the wealth tied up in the concentrated stock position is just icing on the cake that is likely to be part of her bequest to beneficiaries. Here are 3 possible scenarios.
Scenario 1: Sell shares back to ESOP and roll assets over to IRA.
Pros: Eliminated risk associated with concentrated position, pays no initial taxes, and she can diversify assets into her IFA Index Portfolio 50
Cons: Will pay taxes at ordinary income rates when distributed from IRA. This asset will also be included in her Required Minimum Distributions (RMDs) once she reaches age 70.5.
Estate Planning: It is also important to note that if the assets are transferred to beneficiaries once she passes away, they will have to continue taking distributions and pay income taxes.
Scenario 2: Sell shares back to ESOP and transfer assets to a brokerage account
Pros: Eliminated risk associated with concentrated position and she can diversify assets into her IFA Index Portfolio 50. She also will not have to worry about these assets being a part of her RMDs.
Cons: Will pay approximately $264,000 in income taxes (33% tax rate x $800,000) and will disqualify her assets from creditor protection afforded by the Employee Retirement Income Security Act (ERISA).
Estate Planning: Assets will be transferred to beneficiaries where the assets will receive a step-up in basis, thus removing a large tax burden from being transferred to beneficiaries
Scenario 3: Transfer shares “in-kind” to a brokerage account
Pros: Pay ordinary income taxes on the cost basis and pay 15% on the net unrealized appreciation of the stock position once she decides to sell. She also will not have to worry about the assets in terms of RMDs.
Cons: She has not eliminated the risk of the concentrated position if the position is not sold. Also, these assets are disqualified from creditor protection afforded by the Employee Retirement Income Security Act (ERISA).
Estate Planning: If she does not sell the assets, they will receive a step-up in basis once transferred to beneficiaries, thus removing a large tax burden from being transferred to beneficiaries.
The investor’s particular situation would dictate the proper course of action. But let’s look at this through the lens of, “why wouldn’t you just transfer in-kind to a brokerage account?” If you need the assets to live off of, then we would recommend that you sell the asset immediately and diversify. If you don’t need the money, you just hold onto the asset and allow it to pass on to beneficiaries, who will receive favorable tax treatment with a step-up in the basis of the stock.
Going back to our Exxon executive, she would incur $66,000 in income taxes ($200,000 cost basis x 33% ordinary income tax rate) and $90,000 in long-term capital gains ($600,000 x 15% long term capital gains tax) for a total tax liability of $156,000. This is still below the $264,000 she would pay if the assets were transferred to an IRA and distributed. Even if we tack on the 3.8% Net Investment Income tax, she will still come out ahead. This means she would lose approximately 20-23% of her position ($154,000/$800,000) due to taxes. Going back to our chart of individual stocks versus indexes above, you can see that the standard deviation of Exxon Mobil stock (XOM) is about 17-18%, so we would expect the price of Exxon Mobil to fluctuate by a similar amount 2 out of every 3 years anyway. In other words, there is a high probability that you could lose around 20% of the value of your stock just from market fluctuations alone.
One element that is important to note is that assets in qualified retirement plans or that have been rolled over from qualified retirement plans are legally protected from creditors under the Employee Retirement Income Security Act (ERISA). Transferring these assets to a brokerage account disqualifies them from further legal protection. For investors who find themselves in a line of work where litigation is common, this needs to be considered before making a decision.
Also, a special 10-year averaging on capital gains treatment may apply to an investor if they were born before 1936.
Again, there is no universal answer on how to handle a concentrated stock position. We have laid out the variables that we think are involved in coming up with a prudent solution for investors focusing on mitigating risk, creating liquidity, and optimizing tax efficiency. Depending on variables unique to the investor, we will illustrate different scenarios, weigh the pros and cons, and then make a recommendation based on what we think is prudent.
This is one of the many benefits of working with an independent wealth advisor.
About the Author
Derick Kann - Senior Vice President, Wealth Advisor, CFP®
Derick Kann is a Senior Vice President and Wealth Advisor (Series 65) at Index Fund Advisors, Inc. and specializes in long-term investment and retirement planning for a range of clients including high net worth individuals and families, investment committees for endowments, foundations and pension plans, as well as working with companies to construct highly diversified, low-cost 401(k) retirement solutions for their employees. To contact Derick, click here.