Diversifying Executive Compensation: 6 Considerations

May 04, 2017
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Executive compensation can leave you with a substantial equity concentration and you may wish to think about diversifying the risk involved in this. Although such equity concentration can be enviable while the company is doing well, there is the danger that wealth can be seriously devalued if the stock underperforms. We are going to look at some of the considerations you will need to take into account if you are to (1) limit exposure to a volatile market and (2) enjoy the benefits that diversification can bring.

#1 Limiting Overexposure

It can be preferential to limit your exposure to employer stock in the first instance; not only is a significant portion of your investment wealth tied up in a single company, but that company is also the source of your personal income, with all the financial liabilities that brings. If you are able to negotiate your equity compensation, you may wish to consider the value of the compensation as well as the vesting and expiration timelines, which can draw out the risk of your investment. Of course, this is not always possible; employment contracts or restrictions on how you exercise your option may limit your negotiating power. It may not even be desirable, if you expect the stock's current value to rise with time.

#2 Diversification

If you have made the decision to spread your risk, diversification into other, non-correlated, assets is the obvious next step. The taxation consequences of an immediate sale, as well as restrictions on the types of stock you hold, may mean you will choose to stage the sale of your stock over time, and diversify gradually. This will allow you to defer capital gains taxes, although you will be more susceptible to any rise in capital gains taxation over time, given that we are currently at a historic low in capital gains taxation levels. Another benefit of a staged sale is that you can make gradual decisions about how you will diversify as your situation and financial needs evolve over time; you have made the decision not to have all your "eggs in one basket", but there may be new "baskets" available to you in the future that you do not have access to today.

#3 Insider Restrictions or Regulations

As well as taxation considerations, there are various legal and other legitimate roadblocks that may bar you from selling stock. The Securities Exchange Commission (SEC) takes "insider" selling very seriously and there are compliance issues around the sale of securities by directors and other executives. You may also need to bear in mind the public perception of the sale of your stock if your stake in the company is considerable: anyone holding more than 10% of a company's stock is obliged to report any transactions involving the stock. Any sale of this magnitude could also impact on the value of the stock, reducing its worth.

#4 Utilize a 10b5-1 Trading Plan

If you are considered a company "insider" but would like to set up a trading plan for selling your stocks, you can use Rule 10b5-1 established by the SEC to sell a predetermined number of shares at fixed intervals, and so avoid accusations of insider trading. You will then be able to execute a strategic sale plan over time, lowering risk and diversifying your portfolio.

#5 Examine your Investment Policy Statement

Once you have diversified your portfolio, you need to ensure you have an Investment Policy Statement that specifically restricts investing in employer stock within your other investment assets. Without this, you could find yourself back at square one, with a portfolio that has the same exposure to risk as your initial situation.

#6 Meet your Holding Requirements

Each company will have its own requirements for how long executives must hold a certain percentage of their shares in order to maintain a personal stake in its interests. This may vary with the level of the executive, so be aware that a career promotion could affect your plans for the staged selling of stock.

Conclusion

Diversifying your investments will not only help to reduce your exposure to risk, but can alter your potential tax liability and increase your liquidity. It is also easier to plan ahead with lowered exposure to market volatility and respond to your changing circumstances over time. You need to be aware of the many legalities and restrictions around selling stock, and this is why we would recommend hiring a specialist to manage the tax implications and other considerations to bear in mind when looking to diversify. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.