By Peter Mastrantuono
The first rule of investing is never to put too many eggs in one basket. Individuals who have a disproportionate share of their assets in a single stock are at heightened risk of adverse developments in the business undermining their wealth accumulation and retirement goals. Especially vulnerable to this risk are corporate executives and managers who receive grants of stock options in their employer’s stock.
There are two basic approaches individuals can pursue to reduce this risk—Hedge or protect existing stock option positions and then adjust asset class exposures in other non-retirement and retirement accounts.
These strategies are very complex and have a range of tax and investment implications. Consequently, individuals should work in concert with a financial advisor experienced in stock option strategies and their own tax advisor.
Protecting/Hedging Stock Option Strategies
Individuals have several ways to protect against the steep losses that single-stock ownership can bring. Some of the more common ones are:
- Equity Collars—This type of hedging strategy is designed to limit the downside price risk, while maintaining the ability to participate in further price appreciation. One approach is a zero-cost collar, which pairs the use of put options and call options, buying a put to place a floor on downside risk and writing a call at a strike price above the current market value, using that premium income to pay for the cost of the put.
- Pre-paid Forward Sale—This is a generally a privately negotiated sales in which the option holder receives a tax-deferred, interest-free up-front payment (at a discount to market value) in exchange for selling the shares at a future date.
- Exchange Fund—Option holders can contribute stock to an exchange fund and receive units of ownership in the exchange fund, which is comprised of a more diversified portfolio of investments. This exchange can be done on a tax-free basis, but is available only to “qualified purchasers” with a net worth of $1 million or more.
There are several other strategies, such as creating a blind trust, investment swaps, donating shares to a charity, and the issuance of exchangeable equity-linked notes.
Diversifying Other Investments
Most asset allocation services never ask about stock option grants and thus overlook the single stock exposure risk when creating a portfolio allocation recommendation. This is unfortunate since it may expose an individual to greater equity risk than he or she is comfortable with.
For example, an individual’s risk tolerance, time horizon and investment objective may indicate a portfolio allocation of 70% equity and 30% fixed income. However, when including the stock option value, an individual may have a much higher exposure to stocks, perhaps 80-90%.
To mitigate this risk, non-retirement and retirement assets should be adjusted to include a higher proportion of fixed income, alternative investments and cash than a conventional asset allocation may otherwise recommend.
The equity allocation should also avoid further investments in the company stock and the industry sector in which it operates. Investors may even elect to carry elevated exposure to stocks or sectors with a low to negative correlation to the company stock.
Changing corporate fortunes are an unavoidable feature of a dynamic economy. Individuals caught on the wrong side of change, especially near to or in retirement, face enormous risk to their financial health. Nonetheless, proactive and careful planning can mitigate such risk, and that begins with a conversation with a financial advisor.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
