Equity Compensation Part 1: RSU's, ESPP's, and Little-Known Risks
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On August 31st, 2000, General Electric's share price peaked at $56 a share. Just two years later, the stock price was down by more than 50%. And by the end of 2018, the stock was trading at $7 a share, an 85% drop from its all-time high. In 2018 alone, $140 billion of investors' money had vanished.

By comparison, that's twice the amount lost when Enron collapsed in 2001. It's also twice the combined market cap erased by the bankruptcies of Lehman Brothers and General Motors during the '08-'09 crisis. While some of those affected were just investors and speculators, many were dedicated employees of the company who never planned on needing to go back to work after putting in 40 hard years of service.

Those who were hit hardest by GE's collapse were company retirees, including former factory workers who took advantage of the equity compensation packages to save for retirement. And that's what we're going to be talking about for the next two weeks here. Equity compensation. Equity compensation is typically used by a company as an incentive to its employees, with the most common forms being employee stock purchase plans, or ESPPs,

restricted stock units or RSUs, and stock options like ISOs and NSOs. To help us talk through equity compensation plans and the most prudent way to manage the company stock you might acquire during your career, I asked fellow financial planner Odaro Iswini to join us today. Odaro is a first-generation Nigerian-American who grew up in Texas and currently works as a financial planner at PlanCorp in St. Louis, Missouri.

He also has a blog called No Money, Mo Problems, where he takes complex financial topics and makes them easy to digest for the average investor, injecting humor and entertainment along the way. So if you want to better understand equity compensation and learn about some of the little known risks that you're being exposed to, you're going to love today's episode. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 132.

The fall of GE's stock price was a big enough problem on its own, but to make matters even worse, the collapse also put pressure on the company's pension. With more than 600,000 people eligible for pensions from GE in 2018, their pension plan became one of the worst funded corporate pension plans in the United States.

In summary, many retirements were absolutely destroyed due to the rise and fall of General Electric, a blue chip stock that was a member of the Dow Jones for 110 years and historically pitched by stockbrokers as a safe, stable investment.

While those retirement savers didn't have much control over the financial health of the company, they did have control over how much company stock they bought and held onto over the course of their careers. And like many retirement savers today, they believed so much in their company that they acquired a lot of stock during their career, never sold it, and assumed it would continue growing and be there for them in retirement.

But unlike an index fund that might own thousands of companies around the globe, these equity comp participants were investing in just one single company and betting a large chunk of their retirement on its future performance. While not every company is going to be the next Enron, many companies we all know and love have gone through very challenging time periods. I recently shared on the podcast that Amazon at one point lost 95% of its value.

it's a giant risk to have a large allocation to one single stock, let alone stock of a company that you work for because not only are you at risk for the value of the stock going down, you're also at risk of losing your job. And in some cases, like the GE retirees, you could be at risk of losing your pension.

Even knowing these risks, many people who participate in equity compensation plans hang on to their company stock and don't choose to diversify. And that's what I wanted to ask Odaro about to kick off our conversation. Why do so many people continue to hang on to large allocations of their company stock? I think it usually comes down to two things. Either one, you have people who are probably a little lazy.

and they get these shares and it's just like, I really don't know what to do with these. So I'm just going to keep them. Um, or you have people on the other side who feel really bullish about their company and they feel like a sense of more ownership whenever they get more equity from, uh, their company, which this is even a part or an incentive of companies giving people, you know, like chances to buy more company stock with their ESPP program. So, uh,

I would say it usually comes down to one of those two things. While it's not uncommon for people to neglect their investments and as Odaro puts it, get lazy. I personally think the biggest reason retirement savers end up hanging on to large allocations of their company stock is more along the lines of Odaro's second point around people feeling a sense of ownership about the company that they work for.

I've talked at length on this show about how emotional we are about money and investing, and we're often our own worst enemy. And I think that's often the case with employees buying and owning more company stock than they probably should. I'm not sure I've ever met a successful professional employee at a publicly traded company who told me that they loved their job, but they hated the company stock.

Most insiders, most employees are overly optimistic. And overall, that's a good thing. That's what you want from your employees and from your leadership team. But allowing that optimism to lead to irrational investment decisions is another story.

Before we begin to dig deeper into this from an investment standpoint, let's first define what exactly equity compensation is and highlight two of the most common types. RSUs, those are restricted stock units, and ESPPs, those are employee stock purchase plans.

So in plain English, equity compensation is the practice of giving partial ownership in a company in exchange for work. It's a way to reward employees with compensation other than just cash. And it also helps align their interests with the goals of the company, which are often to grow the revenue, grow profits, and of course, retain good employees.

Equity compensation can again come in many different forms, but as mentioned the two most common types are RSUs and ESPPs. RSUs, restricted stock units, are shares of stock given to an employee through a vesting plan and distribution schedule as a result of achieving certain milestones. While the employee technically has interest in the company stock when they receive those RSUs, there's no tangible value until the vesting is actually complete.

Unlike RSUs, an employee stock purchase plan, again, ESPPs as it's known, is a program where the employee has to use their own money to buy shares of company stock. It's not given to them like RSUs. They have to voluntarily elect to participate and process their purchases through the company payroll.

While the employee does use their own money to buy the stock, the company lets them purchase the company stock at a discount, usually up to 15%. And that's why it's considered a form of equity compensation. The company is giving participants 15 cents for every dollar used to buy stock through the ESPP plan. Odaro shares another big difference between these two programs as well. Biggest difference between them is really the tax difference between them both. With RSUs,

it's taxed immediately as it vests to you. So usually what happens with most people who are, which you see it, I would say more commonly in the tech space, but really a lot of companies, they will give someone an RSU package once they sign on and they start employment. And usually it's over a

a time period. So you might have like a four year vesting period. So over that timeframe, these shares will start to vest to you. And whenever they vest to you, the IRS sees it as income. So all of it will be taxed as ordinary income. So it's almost like a bonus. Like I, whenever I'm talking to any clients, I always tell them it's better to frame your RSUs as income. Whereas ESPPs, you actually are purchasing

the stock. So you're actually contributing to this program over a set amount of time. And then on a specific date, you technically get to purchase those shares and or you have look back periods, which we can get into that a little bit later if needed. But really what's happening is you're participating into this program. And on a certain date, you're actually able to purchase the company stock at a discount, which is really the big incentive for people participating in ESPP programs.

As shared at the top of the show, most people don't sell the stock that they receive from their company, whether it's given to them through RSUs or purchased through an ESPP program. In fact, among workers who receive company stock options or participate in an ESPP, about 29% of their net worth comes from these equity comp packages. And according to CNBC, millennials have 43% of their net worth in company stock.

Gen X and baby boomers have half that amount, but comparing the percentages between these generations is a little apples to oranges because I'd argue that older generations likely have other assets like residential real estate or private businesses that have grown in size over the years and have started to make up a larger percentage of their overall net worth. Even so, half that, 20% of your net worth in company stock is considered risky by most measures.

And CNBC went on to share in the same story, which I'll link to in the show notes, that almost 75% of employees own additional shares of company stock in other investment accounts outside of their equity compensation programs. It's clear that the majority of employees are bullish about the future of the company that they work for. It's also clear that they have a hard time selling the shares that they've acquired.

One reason for that is they might just not know how to approach creating a plan to sell those shares. It might seem easier just to hang on to them than to try and become an expert at navigating around concentrated stock positions and the corresponding tax consequences. So to help our listeners maybe begin to start thinking through a strategy to sell, I asked Odaro to share some additional thoughts around this.

I think if anything, our issues make the absolute most sense to sell immediately because, I mean, you're already taxed on it. So the reality is once these shares vest... So to give an example, let's say that you had $20,000 that were vesting to you. Really what you're theoretically doing, even if it doesn't feel like it, you're taking $20,000 of a cash bonus and then just reinvesting it into your company.

And I really don't think that that's the smartest investment decision because, I mean, you could use that money for home renovations. You can use that money to then max out your child's 529. Like, you know, there's a lot of different options that you actually have with actually using that money for renovations.

in other places and or investing it in something that's broadly diversified and not being overly concentrated into the company that you work for their stock. And then ESPPs, usually what happens with ESPPs is whenever they become available, a lot of people say, okay, well, I want to wait a year so I can get the preferential tax rate of long-term capital gains.

And usually what I tell people is for that to actually be beneficial, two things have to happen. Either one, the stock price has to either stay the same or two, the stock price has to go up. And that's a really big if. That's a really big if that you're actually banking on. And we...

I would say that no one actually knows what the stock price is going to be tomorrow. And if they're telling you that they do, then either they're lying or they're an executive and they can't actually sell the shares whenever they want to. So I would say that's the reason. That's probably one of the biggest reasons is people think that it's preferential as far as the tax consequences. But in reality, it's really not that big of a difference.

As Odaro said, nobody actually knows what the stock price of a company is going to be tomorrow. However, as an employee who's dedicating their career to a particular company, it's often hard to be objective and it's hard to imagine the stock price going in the wrong direction. Again, I don't think I've ever heard someone tell me that they love their job, that they're participating in equity comp programs, and that they think the stock price is going to go down.

Even though we all know it's risky to put all our eggs in one basket and invest a large chunk in the future of one single company, our emotions can get the best of us and can lead to us taking unnecessary amounts of risk.

I've come to realize quickly since I've been in the industry that people are not as risk tolerant as they think. And I think that there's a necessary risk to take, but then also there's an unnecessary amount of risk to take. And I always use the analogy because for those that don't know, I'm from Houston, Texas. And if you haven't been to Houston or really anywhere in Texas, the reality is you have to drive around.

really far to get places even just within the city that you live in. So me and my friends would have to drive a lot growing up, but my friends were some of the worst drivers. It was completely unnecessary. And to add to that, my friends were reckless drivers. And I remember we would drive down 45 and sometimes my friends would weave in and out of traffic and I would get really frustrated about it. And whenever we would get to the destination, I would say like,

what is your, like, why are you driving like this? And they're like, well, we got here faster. And I'm like, well, we, it was so marginal that it really wasn't worth it. You know, like it was so much exposure to, you know,

crashing, dying. And to even add to it, I said this in a video. I remember one of my friends said, well, did you die? And I was like, well, death isn't the benchmark. When has death been our benchmark of driving? And I would say the same thing with investing. It's like we have a benchmark or we have benchmarks. So it's like, if you know that you cannot consistently outperform market returns, I mean, you might as well join them rather than try to beat them. And the reality is like...

we have not seen many companies, if at all, outperform market returns for decades to come, which a lot of this money, people are seeing it as a part of their retirement fund. So I just really see it as an unnecessary amount of exposure and an unnecessary amount of risk. So how much risk is appropriate as a smart, prudent investor? What percentage should most retirement savers limit their company's stock ownership to? Well,

Well, a conservative approach would be to treat your equity compensation programs as your cowboy or cowgirl account. In other words, limit your company stock allocation to no more than 5% of your investable assets, knowing that it's one single company and anything can happen tomorrow.

Now, with that said, I'd probably agree that buying company stock of the company you work for and know a lot about, assuming it's not a startup or something, is likely less risky than just buying a random ticker that you saw trending on Reddit or something. So I could go along with increasing that allocation up to, let's say, 10%, assuming you had a buttoned up financial plan that supported that decision and could survive a GE-like event if it were to occur.

So if we agree that somewhere between 5 and 10% is an appropriate allocation to company stock, how should we then approach the shares that we earn and buy that exceed that limit if we're regularly participating in equity comp programs? Well, when it comes to ESPPs, remember, those are programs where you can buy your company stock at a discount.

A popular strategy here is to immediately sell those shares right after purchasing them. If you buy at a 15% discount, which is common, and immediately sell, you're quickly and easily capturing a very attractive rate of return. Sure, the stock could go higher and you might have some FOMO, but again, we don't know the future and we don't have a crystal ball and we're trying to be smart, prudent investors here.

Also, remember, you don't have to just sell the stock and put the proceeds in your checking account. You can add those proceeds to a diversified portfolio. So if the market does continue to go up, you'll be participating just in a more disciplined manner. I shared this with Odaro and asked for some of his thoughts, and he had a unique way of framing this opportunity to his clients. The one thing that I would add to it is in today's day and age with

with the high yield savings account not being as good as they were in the past as far as like the rates that are associated to it. Like I see that ESPPs are just really sexy high yield savings accounts if you view it as something that you're going to actually sell or liquidate once that purchasing period comes. So I think a lot of it is usually just framing to a lot of clients.

Because I think on the front end of things, they see that there's a 15% gain and they're like, I don't know why I'm going to sell. I don't know why I'm going to sell this. But I think whenever you frame it in that way of like, well, you've been talking about saving for a house. This is a really good vehicle to help you with the savings towards your house because you're talking about you're not getting the best rates in your high yield savings account. So if anything, you know you're going to have a 15% gain.

discount on whatever you put in. So yeah, I would say that I agree with you. And I think of it as a really sexy high yield savings account. Now, just because you should sell company stock that you acquire during your career doesn't mean that you can always sell it. The SEC does have rules around when insiders, including employees like you, can sell your stock.

If you do not know what the SEC rule 10B5-1 is, then you do not know enough. Because people who are actually aware of that rule, there's strict stipulations that the SEC has set for some of these company executives on the way that they have to go about selling some of these equities because they actually have the information to affect

the stock price or they know what is actually going to affect the stock price. So the sad reality, and I know it can sometimes be a little bit harsh and rude, but it's like,

Most people actually really don't know enough. And we've seen this whenever companies have taken drastic turns. Usually, it's the employees that get the bat into the stick because they couldn't see it coming. So that would be one thing. And second, an analogy, I always like talking in stores because I think it helps people. But I say that being overly concentrated in your company stock is like moving in with a significant...

other too early because the reality is like, I think it's healthy for employees to view their job like, you know, a dating relationship. Like you're not married, but you're dating. So there's definitely accountability. There's definitely emotions attached. Like there's a lot there, but you're not married.

married to that individual. So there's a little bit of a difference between... If you actually have ownership in a company, then this is completely different. If you're a head executive, this is different. This is a different conversation for you. But I do think for most individuals, they probably have a little bit of an unrealistic amount of loyalty to their company on one hand. And then B, they have an unrealistic amount of

I would say they think that they know more than they really do because I don't think most people actually know enough information that would actually affect the stock price. So that's my opinion on it.

Telling you what you should do with your company stock or any individual stock that you might own is like a doctor writing you a prescription without any sort of diagnosis. At my firm, we often share with clients that your investments should not change unless your investment policy statement changes and your investment policy statement shouldn't change unless your financial plan changes.

Your financial plan and going through a comprehensive financial planning process is akin to a doctor's diagnosis that leads to a recommendation or a prescription. We have to be careful about taking a prescription or writing ourselves one without first going through a process to determine what action we should really be taking.

In that same vein, Odaro leaves us with some final thoughts around equity compensation and taking a step back before you rush to any conclusions. I think it's a really important thing to recognize, to sometimes just take a step back. Let's really just look at market returns over the long term. And let's look at individual performances of top companies over the long term. And we can quickly start to see that

You're making a really big bet that your company is going to outperform market returns over the long term. Because like I said, a lot of people see this money as we even alluded to as a part of their retirement plan. So I think really just framing the...

the thought of like, okay, when did I get this? When do I need it? Which I would even add as like, you know, the ESPP program, like it has been a really effective tool for people was saving for down payments for their home or, um, our issues have been a really big part of, you know, like,

saving towards children's education for home renovations, like heck vacations. I mean, it doesn't always just have to be an investment decision. It can actually really benefit you just in life in general. So yeah, I'll probably step off my soapbox because I do get really passionate about people liquidating their company, liquidating or diversifying out of their company stock.

A big thank you to Odaro for joining us today and introducing us to the topic of equity compensation. I'll link to all of his information in the show notes, including a great blog post that he wrote on today's topic. And be sure to join me here next week, where I'll be diving into some of the more technical aspects of equity compensation that directly relate to those who are nearing retirement. I'll be discussing advanced strategies to consider, and most importantly, the tax planning opportunities, as well as the pit

falls that you need to know about. To grab the links and resources mentioned for today's episode, head over to youstaywealthy.com forward slash 132. Thank you as always for listening, and I will see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial or other professional services.