By: AnnaMarie Mock, CFP®
In contrast to the first half of 2023, the second half has had volatile, lackluster returns for some of the stock market and pharmaceutical stocks. Market fluctuations can significantly impact wealth creation, especially when navigating stock compensation.
It's not uncommon to have NQSOs (non-qualified stock options) included in a benefit package with new awards granted annually. Your employee stock comes with complexity and tax considerations. Leaving your employer's equity on autopilot can be tempting to avoid making mistakes.
However, if you're apprehensive, it's best to step back and start with the basics before making any decisions or not acting at all.
What Are NQSOs?
Like restricted stock units (RSUs) and incentive stock options (ISOs), NQSOs provide an alternate form of compensation. NQSOs give employees the right to buy company shares at a preset price (strike price) when the options vest.
There are no taxes when NQSOs vest. However, exercising NQSOs will increase taxable income and trigger ordinary income and payroll taxes. The taxes are usually withheld in the form of shares. Typically, 22% is automatically withheld unless you earn over $1m, at which point it increases to 37%.
Depending on your company, you may be given the option of a cash exercise, meaning no options are consumed to cover the taxes and instead are paid out of pocket.
What Should I Consider When My NQSOs Vest?
The first pivotal point of awarded stock compensation is when the stock vests. At this time, you have the right to buy it through exercising. Once exercised, you own the stock and can sell or maintain it.
A well-structured stock compensation plan provides financial clarity, manages risks, optimizes taxes, and ensures that your stock compensation aligns with your broader financial objectives. It is a proactive approach that guides the decision to sell or maintain the stock and leads to a better financial outcome.
Stock Price, Markets, Diversification: Watching the ebbs and flows of the market is part of the process. A patient long-term investor with a strategy that separates money from emotions will have a successful outcome over time. When the outcome is uncertain, investors flock to what feels safe and create a stable environment by turning to ad hoc decisions or not acting.
Stock compensation plans often result in a significant concentration of wealth in a single stock, increasing risk. We’ll demonstrate this using Merck's (MRK) stock price over the past five years.
The highest price was about $59, while the lowest was about $27, meaning the median price is $43. That's quite a large spread! The price history is anything but smooth looking further back.
There is no way to predict the markets. If an investor retained shares in 2022, they may have made a gain. However, the years leading up to that point were relatively flat, with many dips in the price. Looking forward, if another investor exercised in 2022 and held into 2023 expecting a price increase, they would be at a loss. Investors may retain shares, hoping the price will increase, but timing the markets does not work.
Lifestyle Needs: Many people lose momentum over time and make rash decisions about one goal without considering the impact on other goals. This often leads to making short-term financial decisions for long-term goals or ignoring their short-term goals.
Equity compensation, if appropriately used, can be a way to generate wealth for future lifestyle needs or provide capital needed now. Financial planning is making all your financial pieces work together for a common purpose. It's difficult to envision where you want to be in the future if you don't know where you're going or how you will get there.
If you've ever assembled a jigsaw puzzle, the picture on the box's cover is the most important part. Without the end picture, you randomly attempt to fit pieces together.
Likewise, financial planning starts with the end in mind – where you want to be and all of your goals. Your goals, of course, need to be funded. Being intentional with your salary, stock compensation, and investments can be a considerable addition to making your goals a reality. Being mindful of the trade-offs allows adjustments to expectations and behaviors to maintain progress on your financial plan.
Liquidity: Stock compensation proceeds can be valuable for building liquidity in your financial portfolio. When you exercise stock options or sell vested shares, you convert illiquid equity into cash, increasing your readily available funds. It provides a financial safety net to cover unexpected expenses without resorting to high-interest debt. It enables savings for short-term goals or taxes without disrupting long-term investment strategies. In essence, liquidity provides the financial resilience and freedom to navigate life's uncertainties and capitalize on opportunities, ultimately contributing to overall financial well-being.
When's The Most Advantageous Strategy at Vesting?
Exercise & Sell: Some may choose to sell immediately after exercising to lock in their gains and reduce exposure and concentration to potential stock price fluctuations. This approach can be especially prudent if you need the proceeds for pressing financial needs or are concerned about the stock's short-term volatility. It also applies if the proceeds will be reinvested in a diversified portfolio, reducing the concentration in one stock.
Exercise & Hold: Holding the shares for a more extended period, often more than one year, may allow you to benefit from long-term capital gains tax rates, which are usually more favorable than short-term rates. This strategy is often preferred by those confident in the stock's continued growth and aligns with their long-term financial objectives. There is no restriction on the length of time the stock is held.
Nothing: Some investors may choose not to exercise if they believe the current stock price is not sufficiently higher than the exercise price to justify exercising the options, especially if they anticipate further stock price appreciation. Also, exercising NQSOs can have tax consequences, spread between the exercise price and the stock's fair market value. This may either be covered through shares or out-of-pocket. The cost can be quite substantial if not properly planned for. Additionally, people may be hesitant if the stock price is likely to materially decline after exercising, resulting in a financial loss.
Case Study: We will use Merck (MRK) to model the economic benefit of three different scenarios.
Key Takeaways:
If the stock price is expected to increase, waiting to exercise to hold more shares for longer may result in a greater amount of retained shares.
Even though the taxes are greater in Scenario 3, the overall amount received was greater in value by $4,117 by waiting to exercise and sell on the same day. More shares were taken for taxes and the cost to exercise in Scenario 1 & 2 because the price was lower, meaning fewer shares were available to participate in the price appreciation.
Scenario 1 had the lowest amount received from Merck's stock because there was no additional time for the stock price to grow.
This example is based on the increase in stock price, which, in reality, may not be the case.
What if the investor in Scenario 1 invested the proceeds within the broader US stock market?
Merck's one-year return from November 2022 was 4.4%, while the 1,000 largest US company index had a return of 20.6%. If investor 1 sold the stock and invested, they would have a value of $24,467. You might think it's still lower than the amount received in Scenario 3.
This analysis can be deceiving as it looks at the stock price in isolation. In reality, there may be better investment options that add more total return and value over time. The Large US company index had a return of $16.7% over the past five years, while Merck was 10.6%.
At What Price Should NQSOs Be Exercised?
With some pharmaceutical stock prices decreasing this year, what does this mean for executives with options potentially now underwater or close to the strike price?
Exercise NQSOs when the exercise price (current price per share) exceeds the strike price, also referred to in the money. If the exercise price is below the strike price, the option is considered out of the money. You can wait for the price to surpass the strike price or expire at this juncture.
It's common to think that when the price drops at or near the strike price, your cost to exercise and tax would be lower, and you can capture more upside gain when the price increases later on at long-term cap gain rates. However, you will hold fewer shares after exercising when the price is low.
Why Are NQSOs Important to Overall Financial Health?
By integrating NQSOs into a structured financial plan, individuals can align their stock options strategy with specific financial milestones, progressing toward their desired savings and goals while managing the associated tax implications and risks effectively.
To make the most of NQSOs for lifestyle needs, it's crucial to carefully plan their exercise, considering both the financial goals and tax implications while aligning them with your broader financial strategy.
Keep in mind that the 'optimal' treatment of stock will vary by person, and following one path can lead to missing out on valuable benefits. Enjoying your lifestyle now and adequately saving for the future can be a balancing act.
What's The Best Solution?
Everyone's situation is unique, and what's suitable for someone may not be appropriate for you. Evaluating stock compensation not only considers company price alone but needs to be reviewed through the lens of the total financial picture.
People may make ad hoc decisions without considering the impact on other aspects of their financial lives. This often leads to making short-term financial decisions for long-term goals or ignoring liquidity requirements for short-term goals.
Start with the bigger financial plan - goal setting, defining a purpose for the equity compensation, and creating a path to guide your decisions around equity compensation.
Although you may feel confident managing your equity compensation and benefits, seeking expert advice from your CPA® or CERTIFIED FINANCIAL PLANNER® professional can help you avoid costly mistakes.
A fee-only financial advisor can analyze your stock compensation with your long-term financial plan in mind and create an actionable plan while being mindful of your investment style and prior investment horizon.
The most challenging part is executing the plan; however, this dynamic process will reduce your stress about money, support your current needs, and build assets for long-term goals. The key to effectively using stock compensation is thoughtful planning.
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.