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How Equity Compensation Fits Into Your Clients' Financial Plans

Company stock can be a significant wealth-building opportunity, but uncertainty still surrounds its role in a portfolio.

As a financial advisor working exclusively with the technology community, one of the most common questions I get from clients is, "How can I maximize my equity compensation?"

Historically, equity compensation at meaningful levels was largely reserved for senior management and executive roles. Nowadays, more companies--particularly in the tech and startup world--offer equity plans to the majority of employees as a means of attracting and retaining the best talent.

As financial planners, we know that money and wealth themselves are not the end goal, rather they are tools that provide the means to accomplish other aims. Because the rewards from stock grants can be a significant wealth-building opportunity, we can help clients take a holistic approach to managing stock compensation.

Equity Compensation Is Important to Many Clients

From my experience, most employees and even some company founders are uncertain about how equity compensation fits into their portfolios and financial plans. Yet, it plays a significant role in their lives and decision-making.

According to a recent survey conducted by Charles Schwab, while the majority of participants are planning to use their equity compensation for retirement, there was a slight uptick in those turning to their equity compensation to help meet immediate financial needs, such as paying off debt and short-term emergencies. At the same time, most are looking for more education on their equity comp plans.

To better understand the value we can add as advisors, let's take a look at a few key statistics from this survey:

  • Five in 10 millennials say that equity compensation was the main reason or one of the main reasons for accepting an employment offer.
  • Equity compensation makes up 43% of a millennial respondent's net worth.
  • Forty-three percent of equity plan participants have exercised or sold equity compensation.
  • Ninety-five percent of millennials who recently exercised or sold equity compensation report that the pandemic influenced their decision.
  • The top areas where employees need the most help are retirement planning, investing, and taxes, followed by developing a financial plan and balancing equity compensation with other investments.

Lead With Education

I've always felt that a financial planner's role isn't to tell the client what to do but to furnish them with the knowledge and guidance they need to make informed decisions for themselves. Meanwhile, company stock plan administrators often struggle with the communication aspects of their equity plan.

Considering this, make it a point to help clients fully understand the basics of equity compensation, such as:

  • The different types of equity compensation: restricted stock, RSUs, ISOs, NSOs, ESPPs, performance shares, and so on.
  • What a vesting schedule is, the difference between cliff vesting and graded vesting, and what happens to unvested shares when an employee leaves a company.
  • The income tax consequences associated with exercising options or receiving RSUs.
  • The basics of the Alternative Minimum Tax.
  • Short-term versus long-term capital gains taxation.
  • The principles of investing.

Balancing Act: Company Stock and Diversification

One of the most challenging conversations to have is the one centered around how much company stock to hold. This is particularly complicated for millennials, where the potential value of a stock grant can easily outstrip the amount they have contributed to their 401(k) or socked away in other savings.

After all, how much company stock is too much? While some financial experts recommend that no more than 10% of a portfolio should be invested in company stock, there is genuinely no one right or wrong answer. So much of that decision depends on one's goals, lifestyle, and values.

Some clients are assertive and optimistic about diversifying away from a concentrated company stock position because they are aware of the risks or have an immediate need for cash.

"Do they plan on working at a company they enjoy for a few decades? If so, a dual-income household maxing out their 401(k)'s every year could grow their net worth to $5 million in their 50s," says Aaron Agte, financial advisor and founder of Graystone Advisor. "This couple may not need their company stock to provide for their financial independence."

Others will be a tougher sell on diversification, especially if they don't need the money in the near future and they are comfortable with the additional risk. There's also an element of being emotionally invested in the company that they work for.

Plus, there's the potential math of the reward that can come with holding the stock of their company. "It is not realistic that a $1 million diversified equity portfolio is going to grow to $10 million in 10 years, but it's possible for a single stock to jump that much," Agte says.

Dig Deep Into Your Clients' Thinking

One conversation when it comes to concentrated stock positions is getting clients to think about what it would mean for their ability to meet their goals if their company stock goes down significantly in value, or even to zero. Still other questions to ask include:

  • Do they enjoy their job enough to continue working long term?
  • Do they live where they would like to live long term?
  • Do they want to pursue an earlier financial independence?
  • Do they want to put this new wealth toward a home?
  • Are there any other short-term or intermediate savings goals or needs, such as children's college education?

Or take this example: Perhaps a client says that he wants to go work for another exciting startup that doesn't pay as much. But with company stock, it's possible that the client could get his net worth to $10 million in a relatively short time, so that a 3% withdrawal rate generates $300,000 per year. If that's the case, it may be beneficial to take on some greater level of risk with the stock, says Agte. Additionally, although prudent investing for retirement is accomplished with a diversified portfolio, a stepped-up allocation to company stock could also be the difference between retiring at 55 years old versus 65.

"It's important to help clients understand that diversification is needed for lifestyle goals, while concentration is for money they don't need but could change some of their big dreams," Agte says. "It's OK to hold on to company stock, just as long as clients don't depend on it."

Agte recommends other questions: "How will you feel if you sell the company stock and it goes up? How will you feel if you hold the stock and it goes down?"

The Big Picture

All in all, my conversations around equity compensation always begin with financial planning. We start by assessing where clients are now: what they own, what they owe, what they earn, and what their expenses are. This is simply collecting baseline data, not focusing yet on where they're going or how they will get there. However, it does give us a clear and shared understanding of the very first thing we should know in any journey.  It's from there that we can work on how can equity compensation play a role in the bigger picture.

Samuel Deane is a financial advisor and CEO of Deane Wealth Management, an independent investment advisory firm for millennials in technology. He specializes in comprehensive financial planning, equity compensation, and tax planning. The views expressed in this article do not necessarily reflect the views of Morningstar.