Clients whose employers offer equity in the company as part of a compensation package may experience income volatility, unlike with predictable all-cash salaries.
Strategies to manage such volatility include creating a portfolio diversification plan and helping the client overcome any emotional attachment to the stock they hold.
When employees have company equity as part of their compensation, they may receive restricted stock units (RSUs) or stock options, in addition to their cash salary. An advisor can help the client understand the implications of drawing from each type of compensation, said Lukas Fleck, an associate portfolio manager with PWL Capital in Ottawa.
If the compensation package doesn’t provide enough cash to cover expenses, RSUs are often the first source to help fill the gap, as they can be sold for cash as soon as they vest without incurring additional taxes, Fleck said. Monthly and quarterly vesting periods are common, but it varies from company to company.
However, RSUs come with the risk of stock price volatility, as they vest at fair market value. For example, if an employee is granted RSUs that are worth $10 a share now, they would end up with less if the price falls to $8 when they vest in the future.
Stock options come with the highest risk of volatility. During an exercise period, an employee has the right to buy company stock at a predetermined price, but the stock would be worthless if the fair market value were to fall below the exercise price.
Although income planning is simpler when a client’s compensation package has a larger cash portion, company equity has advantages, said Danny Popescu, founder and CEO of Harbourfront Wealth Management in Vancouver. For example, RSUs have potential to increase in value by the time they vest, and stock options could receive preferential tax treatment.
The client’s comfort with risk and personal situation must be considered when planning for income from the various sources.
“A younger high roller [who] maybe is not married [and] doesn’t have any kids could afford to roll the dice a little bit more and take a bigger chunk of the compensation by way of stock,” Popescu said.
Popescu suggested that clients who work in cyclical sectors and receive equity compensation should build larger emergency funds to account for income variability as well as have a larger portion of savings allocated to stable, liquid investments. Income volatility can also be more easily managed if the client’s spouse has a predictable income.
While salaried employees can make pre-authorized contributions to savings accounts, clients with variable incomes can make lump-sum contributions at the end of the year or adopt a hybrid approach, in which a portion of contributions comes from cash income and additional contributions come from realizing equity compensation, Popescu said.
Another risk to equity compensation is overweight exposure to a single stock. Diversifying beyond the company stock is important to maintain a resilient portfolio in the long term, said Oliver Yoon, managing director with Advisor Solutions by Purpose and chief operating officer with Harness Investment Management in Toronto. For example, a Canadian tech worker might want to invest in non-technology stocks to diversify the rest of their portfolio.
Clients with a large position in a single company may need to divest from the single stock, Fleck said.
“We look at how much do we need to diversify and come up with a systematic plan to gradually sell off the securities in order to fill up that diversified bucket,” Fleck said.
The divestment plan would include a strategy to minimize tax obligations.
Even though it’s logical to have a diversified portfolio, some clients who have worked for the same employer for a long time or built their own company may feel an emotional attachment to a stock and be reluctant to divest, Yoon said.
“Clients that have been executives at a company for 20, 30 years have a natural bias towards the shares that they own,” Yoon said. “But from a portfolio manager standpoint, obviously it’s suboptimal to be so concentrated on one position.”
Advisors could run alternative scenarios to show clients they could have a more secure financial future or afford to spend more during retirement if they diversify, Fleck said. If it’s emotionally difficult for clients to sell, they could maintain a small position as long as it’s not consequential to the overall financial plan.
“Keeping some skin in the game leaves them with that emotional benefit without risking the financial plan,” Fleck said. “Let’s take the meaningful money out of that single security, diversify it, secure your lifestyle [and] go live a happy life.”