What is a concentrated stock position, and what can I do to protect myself and get cash for other purposes?
A concentrated stock position occurs when a significant portion of your net worth is invested in a single stock. Experts do not agree on exactly what constitutes a concentrated equity position. No universal rule defines when holdings become overexposed.
Some define concentration as 10% or more of investments or net worth in a single stock. For example, an article at Forbes.com makes the case for the threshold of 10% of investable assets in company stock (including vested stock options). Some experts put the overconcentration threshold at 15% when the remainder of the portfolio is diversified (see a commentary from the IZA Institute of Labor Economics). Others believe the threshold of overconcentration is higher if you also have substantial real-estate holdings or if you are an entrepreneur.
The conjectured percentages are only guidelines. Whether you truly have concentrated wealth depends on a host of individual factors, such as the total composition of your assets, the volatility of the stock price, the time horizon for when you need money, your life goals, your risk tolerance, and your overall investment strategy.
Studies show that having concentrated wealth places your investments at risk of underperforming the market (see a white paper from JP Morgan Chase with case studies). An article in the Louisville Courier Journal about GE employees and retirees shows the risks for employees who have their wealth tied up in one company's stock. As many at GE believed the company's stock price and dividends would simply keep rising, they kept their investments concentrated in GE stock. Unfortunately, however, their financial plans and retirement savings derailed quickly after the company's stock price fell.
Wealthy individuals who have concentrated single-stock positions often engage financial advisors to develop strategies for hedging, diversification, and liquidity. As explained in an article series about hedging, the strategies include protective puts, covered calls, equity collars, exchange funds, and variable prepaid forwards. (For the basics of VPF transactions and their tax treatment, see IRS Revenue Ruling 2003-7 and, from the IRS Chief Counsel, AM-2007-004; and see Technical Advice Memorandum 200604033 for issues that arise when the counterparty borrows shares that were originally pledged to that party.)
Alert: The IRS carefully analyzes large, creative transactions. A case in the US Tax Court involving billionaire Philip Anschutz dealt with the lending of shares covered by a prepaid contract to a firm providing an upfront payment. The court decided that the contract and the lending arrangement were part of the same deal, causing the transactions to be recharacterized as a sale at the time of the upfront payment.
Liquidity and diversification strategies can involve stock sales at regular intervals under an SEC Rule 10b5-1 trading plan, explained in articles elsewhere on this website (hedging is not permitted in these Rule 10b5-1 plans). If you are charitably inclined, the use of charitable remainder trusts (CRTs, discussed in an article series elsewhere) provide another liquidity approach. All of the techniques discussed above involve complex legal and tax issues and may be prohibited by your company. A newly developed method using financial products is a stock-protection fund that provides some downside-risk protection without requiring any stock sale (for an example, see StockShield).
Alert: For stock that you have not held for one year, hedging strategies will stop the capital gains clock. In addition, dividends on hedged stock may not be considered qualified dividends (i.e. taxed at the favorable rate of 15% or 20%, depending on your yearly income). Before undertaking these transactions, speak with financial and tax advisors who are experienced in handling them. In addition, confirm that your company does not ban hedging or require special approval for transactions that it broadly considers to be forms of hedging.
New Option For Options
In May 2009, the CBOE and the ISE proposed a margin requirement change to the SEC, which approved it on June 17, 2009. This change in the rules lets vested employee stock options be considered usable collateral for selling listed call options on the underlying stock. If your company agrees to allow this, you will not need to put up any additional collateral. You will need to pledge your vested options to a broker-dealer and provide it with an irrevocable power of attorney authorizing it to exercise the options on your behalf when required. For more details on this technique, see an article about it elsewhere on this website.