This article was contributed by Pathfinder Financial Planning Associate, Davis Byrd.
In the aftermath of the COVID-19 pandemic, U.S. employers found themselves fiercely competing to hire and retain talent in their organizations. More than 47 million Americans quit their jobs over the course of 2021, a period that economists have appropriately titled “the Great Resignation” or “the Big Quit.” Job quits were fewer in 2022 (roughly 38 million), but the number remains historically high and represents a changing landscape in which employees are more frequently able to leave their jobs for new, and often better-paying, positions. As a result, many companies, both public and private, are leveraging equity compensation plans to manage attrition risk and attract new talent. Prior to this trend, equity compensation (or equity comp) was generally reserved for the top executives at a company, but it is now expanding more broadly into the salaried employee group.
Equity compensation is an employee perk that gives you an ownership stake in the company where you work, therefore providing the opportunity for employees to hit a financial “home run” as their company grows. However, this form of compensation comes with a unique set of risks beyond that of a traditional salary. This article defines two common types of equity compensation and discusses how individuals can leverage them as an effective wealth-building tool.
Employee Stock Options
Employee stock options (ESOs) are probably the most well-known form of equity comp, although perhaps not the most favorable from an employee’s perspective. An ESO is a contract that gives the employee the right (called the “option”) to buy a set number of company shares at a fixed price, which is typically lower than the stock price at the time the option is granted. The contract usually requires the employee to wait a certain period before the shares “vest” and can be purchased. ESOs also have an expiration date, at which point the employee loses their right to buy the shares at the predetermined price. If the company stock price rises during the vesting period, the employee can then purchase the stock at a less-than-market-value price and profit the difference. If the price goes down or stays the same, the contract is worthless and offers no benefit to the employee.
Restricted Stock Units
Restricted stock units (RSUs) are a bit more straightforward and, as a result, have become much more common. A 2021 survey found that 86% of publicly traded companies issued RSUs, up from just 3% at the turn of the century. A RSU contract gives an employee the right to receive a specific number of stock shares at a certain point in the future. Unlike ESOs, RSUs do not need to be purchased by the employee; the shares are essentially gifted by the company to the employee at full market value. If the company stock price rises in the period between when the RSUs are granted and when they are received, the employee benefits from a greater market value of shares. If the stock price falls, the employee receives a market value less than when they were granted, and in effect takes a reduction in their expected total compensation.
The Complexities of Equity Comp
Due to the risk that is inherent in all forms of stock market investing (past performance is no guarantee of future results), ESOs and RSUs add an element of uncertainty to one’s total compensation in ways that a traditional salary does not. This risk can cause serious budget and cash flow planning issues, and may have large tax implications, for a person who does not fully understand the intricacies of these plans.
For example, imagine a worker, Sarah, is granted $100,000 in RSUs as part of her 2023 total compensation and plans to use those RSU’s to pay off her outstanding mortgage balance of $90,000 at the end of the year. However, the company stock falls 25% during the vesting period, so Sarah receives a value of only $75,000 when her RSUs vest. At this point, Sarah not only has to continue carrying her mortgage longer than expected but also has $25,000 less cash flow to cover other expenses and obligations. Let’s assume Sarah believes the company stock price will rise back to the original $100,000 value soon, so she chooses to continue holding the RSUs instead of selling them for cash. Three months later, after a favorable earnings report, the company stock rises back to the original $100,00 value, so she decides to sell her vested RSUs for cash and pay off her mortgage. Fast forward to tax time, Sarah learns that a $25,000 short-term capital gain was realized when she sold her RSUs, and she now owes an additional $6,000 to cover those taxes.
Over time, equity compensation can also lead to an overconcentrated position of one stock in an investment portfolio, reducing the benefits of diversification and adding another layer of market risk to the mix that is critical to manage.
Getting the Most Bang for your Buck
At Pathfinder Wealth Consulting, our team of CERTIFIED FINANICAL PLANNER™ Professionals have extensive knowledge and experience helping employees take full advantage of the power of these wealth-building tools, while managing and mitigating the unique risks along the way. We help individuals make decisions that are appropriate for their risk tolerance and time horizon, and we look at their entire financial picture to ensure their equity compensation package is working towards their long-term financial goals, not causing unnecessary financial stress and confusion. If you have questions about how to put your equity compensation package to work for your long-term financial plan, give us a call at 910-793-0616, or visit the Investment Planning page on our website today. We are here to guide you forward.
Advisory services offered through Commonwealth Financial Network®, a Registered Investment Advisor.
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