RSUs: Understand and Maximize Their Benefit For You
Restricted Stock Units (RSU) are a very common form of executive compensation that helps align the values of employees and employers toward building long-term success for a company. While the intentions may be easily understood, the mechanics require some explanation.
I recently received a question from a client about their stock award. While they were excited to receive the award, they were not sure what it was exactly or what they should do about it. The starting point for us is always to help our clients understand the situation, then find the best strategy that applies to their unique financial goals.
Clients often need clarification on the type of stock award they are receiving. And for good reason. The internet boom of the late ’90s popularized retail stock trading (remember the e-Trade baby?), and stock options turned people into paper millionaires (seemingly overnight). So naturally, I recall how everyone wanted to be paid in stock options, which was an acceptable strategy while company valuations continued to rise. Then, the music stopped. With valuations plunging, the values of many stock options and the companies behind them went to zero.
Yet, stock options remained popular, and companies continue to use stock options as a way to attract, retain and reward talented employees. Part of the reason this was an attractive option to companies is that the US accounting rules, known as GAAP1 , allowed companies to report stock options based on the “intrinsic value2 ” of a company, which many times was zero, allowing companies not to record any compensation expense on their books. In 2006, the accounting rules changed, where stock options were required to be expensed based on the stock’s fair market value on the grant date instead of intrinsic value. In other words, the change in accounting rules resulted in companies recording a compensation expense (that was greater than zero), impacting their accounting bottom line. When this law changed, companies began favoring RSUs more, and in fact, during the period from 2004 to 2010, the use of RSUs for executive compensation at Fortune 500 companies increased by 88%3.
RSUs Defined
In my client’s case, it turned out they received Restricted Stock Units (RSU). So what is an RSU? An RSU is a form of deferred compensation where an employer promises to transfer shares of company stock to you as compensation at some future date, known as the vesting date. The date the promise is made is known as the grant date.
Vesting usually occurs over a period of time. In pre-IPO companies, you may have heard the phrase “1-year cliff, 4-year vest.” This means that a portion of your RSU, typically 25%, vests after one year of employment, then the remainder of your RSU vests over three years. You will want to pay close attention to this vesting calendar as it is critical in managing your RSUs because every company can have different vesting calendars. For example, at Google RSUs vest 36% in the first year, 28% in the second year, 20% in the third year, and 16% in the fourth. Whereas at Amazon, RSUs vests 5% in the first year, 15% in the second, then 40% in the third and fourth year.
RSUs and Taxes
The vesting date is when you reap the reward of your efforts and receive company shares. It is also the date your RSUs are subject to tax. RSUs are taxed as ordinary income when your shares vest. Your employer will typically withhold taxes at the federal supplemental wages withholding rate of 22% for up to $1 million of income and 37% for wages over $1 million. This is usually accomplished by selling shares of stock and issuing you the net amount.
Financial Planning Considerations
So, now that we have a basic understanding of what an RSU is, how it vests, and how it is taxed we can evaluate the RSU award in the context of what it means for your financial goals.
The first step in doing so is to evaluate the concentration risk of the award relative to your net worth. We call this your vulnerability index. Let’s assume that you have total investable assets of $3,000,000 and your RSUs make up $2,500,000 of this total. We calculate your vulnerability index to be 83% ($2.5M / $3M). As you can see from this simple calculation more than 80% of your investable assets are concentrated in your company stock, not to mention 100% of your income.
Next, we would look at your financial plan to determine how much money you would need to retire with dignity. We call this your critical capital. Let’s assume now that your critical capital is also $3M. Would you feel comfortable with 83% of your critical capital concentrated in a single company’s stock? Or, put another way if you received $2.5M in cash would you turnaround and buy company stock with that cash? That is exactly what someone is doing when they hold RSUs. This is where matching your investment allocation to your retirement goals becomes vital in getting you out of harm’s way. At Quantum, we believe in creating goal-focused, planning-driven investment strategies that strive to give you the best chance of reaching your financial goals.
In fact, a key principle of our investment philosophy is total market diversification. As the saying goes the only free lunch in finance is diversification. We have learned in our experience and in the data we study that a globally diversified portfolio invested in over 10,000 companies over 44 countries can provide a strong probability for one to achieve a positive investment outcome over the long term.
Our hope is that with a bit of history on RSUs, a better understanding of what they are, and how they may be applied to your financial plan, you can make better decisions on how to apply them to your overall financial wellness. When reviewing your RSU award, you will also want to pay attention to other important items, such as any performance requirements or clauses such as a double trigger. Meaning your shares must meet two triggering events such as meeting a vesting period and the company going IPO. And, most importantly you will want to understand what would happen to your unvested RSU’s in the event the company is sold (aka change in control) or if you were to take a leave from the company such as when you have a new baby, termination, death or disability.
Receiving executive compensation is both an exciting and potentially confusing time. The key is enlisting the help of a professional who can help ensure that you maximize your hard-earned reward by aligning it with your overall financial plans.
Sources:
1GAAP – Generally Accepted Accounting Principles
2Intrinsic Value for purposes of recording stock option expense is FMV of stock on the grant date minus Exercise price of option.
3Petra, Steven T. and Dorata, Nina T. (February 2012). "Restricted stock awards and taxes: What employees and employers should know". Journal of Accountancy. Retrieved 19 August 2013.
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