The risks are clear concerning an investment portfolio with holdings concentrated in a small number of companies. In many cases, executives and other highly compensated individuals cannot sell their stock easily. Sometimes stock options bar the holder from selling for a given period, and other factors can make an outright sale disadvantageous. Here are a few methods that can be used to diversify without liquidating the underlying stock.
An exchange fund (not to be confused with an exchange-traded fund), is a pool of stock shares from different companies, created by an agreement among a group of investors. In an exchange fund, a stockholder contributes shares of a single company’s stock in exchange for shares of the diversified pool. Capital gains tax is not assessed until the holder cashes out shares; no shares are bought or sold at the time of exchange. Deferral of capital gains is one advantage of utilizing exchange funds as a diversification vehicle, and restricted stock holdings or options can sometimes also be traded in an exchange fund in situations where an outright sale is prohibited. (1)
A VFPC allows an investor to diversify stock holdings while still retaining ownership, preserving voting rights, and deferring capital gains tax. A VFPC creates a sale agreement where the investor receives an immediate payment equal to 75% to 90% of the current stock value, but where the sale is not finalized. The contract functions like a loan, with a draw against the shares in the future, usually several years. The contract functions like a loan, with a draw against the shares in the future, usually several years. The number of shares due at the time of maturity is variable (hence the word “variable” in the title) based on the market price. (2)
A VFPC provides a collar, or a tradeoff whereby the shareholder gives up some upside potential in exchange for limiting the downside. The contract includes minimum and maximum strike prices, which limit the downside potential for the current shareholder. If the stock is trading below the minimum strike price, the shareholder is not obligated to compensate the buyer for the loss; if the stock trades above the maximum strike price, the shareholder is obligated to deliver additional shares or cash equivalents.
One other way to limit the risk associated with a heavy concentration of stock is to use a zero-premium collar, otherwise known as a hedge wrapper. A shareholder can sell a call option (which gives the option purchaser the right to buy at a given price) and use the funds to purchase a put option (the right to sell at a given price). In a perfectly balanced scenario, the put option and the call option are priced identically, resulting in zero net cost to the shareholder. Balance can be achieved by adjusting the option strike prices.
An investor can gift shares of stock to a charitable trust, which can provide a way to diversify and save on taxes while providing a gift to a charity the investor wants to support. Gifting stock to a charitable trust can also allow the present shareholder to draw income in retirement while realizing a stronger philanthropic impact than what might be possible through cash donations.
Rule 10b5-1 was established to create a way for insiders to legally trade their stock while steering clear of insider trading accusations. A Rule 10b5-1 Plan allows executives in a publicly traded company to sell their company stock on a predetermined basis, so long as the trades are pre arranged at a time when the shareholder does not have visibility of any material non-public information (MNPI). For instance, an investor might decide to sell shares on a monthly or quarterly basis, with the schedule and transaction details predetermined. (3)
A concentrated stock position is a situation that can easily develop for senior executives who receive a substantial portion of their compensation in the form of stock or stock options. Understanding your options for diversification and risk mitigation is a crucial element of your retirement plan. If you’d like to discuss how we can help you create an appropriate financial strategy for your situation, call 440-505-5704 or email jbrown@Wadvocate.com to schedule an appointment.
John Brown is a wealth advisor at Wealth Advocate Group, LLC, an independent, fee-based wealth management company. With over 10 years of experience in the financial industry and a background in accounting, John provides sophisticated and specialized services to his senior executive clients who need the expertise of someone well-versed in concentrated securities, stock options, and restricted stock strategies, as well as the risk and tax burdens that come along with their compensation. John has a bachelor’s degree in accounting and financial management from Hillsdale College and is a CERTIFIED FINANCIAL PLANNER® (CFP®) professional. John is known for his thorough approach, often asking questions and bringing up details his clients have not considered. He strives to address every piece of his clients’ financial picture to make sure they are set up to achieve their goals and experience confidence in their future. In his spare time, John and his wife, Christina, enjoy traveling and staying active. You can often find him spending quality time with his friends and family. To learn more about John, connect with him on LinkedIn.
____________
