If you’re a corporate executive or other employee of a public company, a meaningful part of your compensation may come in the form of company stock or stock options. You may also have a chance to invest part of your cash compensation in company stock. What should you do?
If you strongly believe that your company stock is likely to appreciate dramatically, you can keep your company stock—but you’ll probably need to save more, as a buffer against the potential for large losses, our research suggests.
If you feel that your livelihood is already tied to your company’s health and that company stock and options increase your risk exposure to the company too much, you should consider selling at least some of those holdings.
As this case history shows, how much you need to save to support retirement spending will depend to large degree on whether you keep or sell your company stock—or, how many eggs you keep in one basket.
Concentrated Stock Risk
Cooper and Charles are both 35. Much of their combined annual income comes from restricted stock and options that Cooper receives from the technology firm where he is an executive; Charles is a chef. They’d like to retire at 55 and draw $100,000 per year in today’s dollars from their investments to supplement other retirement income.
As the Display below shows, we calculated that the couple would need to build $2.3 million in target financial capital to support retirement spending if they invest it in a diversified portfolio, with 70% in stocks and 30% in bonds. If they invest just 25% of their wealth in employer stock and the rest in a 70/30 portfolio, they would need slightly more: $2.4 million. But if they invest 75% of their wealth in employer stock, their target would increase by more than a third—to $3.2 million!
This is the result of something called risk drag. The high volatility of a single stock tends to drag down its growth over time. Large holdings of a single stock tend to increase target financial capital requirements, making them harder to reach.
Many executives think that they can offset risk drag by investing the rest of their portfolio in ultra-safe holdings, such as cash or bonds. Our research suggests that if half of your portfolio invested is in a single stock, it doesn’t matter how you invest the rest of the portfolio. You can see this in the next Display, which shows that the odds of a 30% peak-to-trough loss for portfolios that have half their value in a single stock and half in asset allocations ranging from all cash to a 70/30 mix of stocks and bonds. The odds barely change, regardless of how the rest of the portfolio is invested.
We recommended that Cooper sell his restricted stock when it vested and not buy more company stock. Although the couple would lose some potential upside, in most cases we estimated that they would be better off with a diversified portfolio. They could lower their target financial capital requirement with regular stock sales. Restricted stock is subject to ordinary income tax upon vesting, so the tax is unavoidable. Selling it is typically an easy choice.
The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.