The workload for financial advisors in Seattle and Austin lessened somewhat over the last few years, as big employers such as Microsoft and Dell curtailed their use of stock options.Across the nation, an increasing number of companies have moved toward alternative forms of employee incentive compensation in response to the sweeping changes in accounting rules regarding options expensing dictated by the Financial Accounting Standards Board.
Despite a drop in usage, this form of compensation still creates wealth for clients and planning challenges for advisors. In addition to the task of keeping up with the changes in details of options plans and taxes, advisors draw on special skills to manage the emotional side of owning an employer's stock.
The goal behind employee stock options is to tie some compensation to company performance. The challenge for many employees is that the resulting holdings come to be a large chunk of the client's overall wealth. Encouraging diversification becomes the planner's task, often against the resistance of what Consider Your Options author Kaye Thomas, JD, calls the "reluctant client."
"Clients rationalize keeping the concentrated position because they work for a great company and the stock is predicted to rise," said Thomas. "They also counter with the argument that, while owning this stock is risky, being in the stock market at all is risky."
Thomas has showed employees how the risk levels in stock options often rank off the scale. Employees incur concentration risk, overexposure to equities, leverage, illiquidity, employment risk, and the risk of loss of objectivity. Leverage multiplies all the risks. "With 99 percent leverage, a holding is five times as risky as one leveraged by 50 percent, and 10 times riskier than one without any leverage," said Thomas, who is also the founder of the Lisle, Ill.-based National Board of Certified Option Advisors.
Other advisors often employ psychology to help clients make good decisions.
"I catch people off guard when I ask them if they'd go buy their company stock with a suddenly received $100,000 windfall," said Glenn Frank, CPA, PFS, of Wachovia Wealth Management, based in Waltham, Mass. "They tell me that would be nuts for them to buy more of the employer's stock."
Advisors differ on what comes next, however. Eventually the employee must exercise the option and buy the stock. The steps must come in order, but when to initiate the process is a matter of opinion. Frank suggested that his approach is somewhat controversial. "In general, employees should exercise as soon as possible," he said. "I think this whole process could be a lot simpler."
Clients who think the stock is going up in value establish the potential for a long-term holding period upon exercise. If they think the stock is going down, they can sell immediately after exercise. "There are thousands of folks out there caught in inaction, like deer in headlights," said Frank, who teaches stock option treatment to students in the graduate financial planning program at nearby Bentley College. "But until they pull the trigger, any appreciation in the position becomes ordinary income to the holder."
Exercising the options right away is wasteful, according to Thomas. For employees who think the stock is going up, he recommended using the cash that would have been used to exercise to buy more stock in the open market. "This is especially obvious for options at the money," said Thomas. "But even when out of the money it works. The employee makes money on the stock holding, as well as having greater profits in the option."
Thomas suggests a balanced approach to the question of when to exercise for most situations, however. Called the "E-minus" approach, the advice seeks to balance the timing of exercise to be soon enough not to waste too much option value, with a period as late as possible given the amount of risk in holding the options. He suggests a measure of the balance as a comparison between the intrinsic value and the time value of the option.
"It makes sense to harvest options when the intrinsic is still very large relative to the time value," says Thomas. "If the time is still large relative to intrinsic, the optionee should be reluctant to cash in."
Still, the value of diversification for a particular client weighs in.
"If the stock options represent the bulk of the client's new worth, then this client could give up a substantial amount of time value in exchange for the high value of diversifying," Thomas said.
As the fuss dies down
Planners should expect changes to the option arena to slow. However, some predict that holders of options could be affected by a possible repeal of the alternative minimum tax and standardized disclosures on compensation. "If they repeal AMT, then those who moved to nonqualified plans will be kicking themselves," said Thomas. "But while something has to be done with the AMT, it's unlikely that will happen now, after all the commitments to hurricane rebuilding."
What is more certain is that the Securities and Exchange Commission will release improved rules on compensation disclosures to allow investors to compare the impact of executive compensation across companies. Currently, employers choose their own method of valuation. Most likely a market-based approach will be developed for all companies to use.
From the planner's perspective, this could encourage more employers to move back to stock options as a form of compensation. "Expensing has dampened use somewhat, but it hasn't eliminated it," says Thomas. "It's turned out to be more of a psychological factor on the part of management worrying about how the public views their stock. Stock prices don't seem to have been affected in those companies that are expensing already."
While the number of options granted has diminished, the need to help investors plan for their use is still on the task list of many advisors. Thomas recognized the need by creating the training program and designation for professionals seeking in-depth knowledge for the task. The publishing and training industry keeps focus on the skills through new publications and offerings.
Advisors might also find that, while employees are experiencing a lull in incentive compensation today, keeping up on advising skills in this area might be particularly needed if we hit another wave of tech-boom-like activity out there in the future.
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