Wall Street’s ups and downs have made it painfully clear that stock market plunges can wipe out the value of employee stock options in an instant.
On-paper millionaires have seen their on-paper fortunes vanish overnight.
But market risk is understood to be part of the game. The whole idea behind granting options–the rights to buy company shares at a fixed price for a set number of years–is to link employees’ fortunes to those of their employers, for better or for worse.
What is less obvious is that, as the number of workers receiving options swells, employees can, and do, decimate the value of their options grants all by themselves, for lack of information and guidance about how to handle these complex forms of compensation.
A recent survey of U.S. workers by OppenheimerFunds Inc., for example, found 11 percent of respondents had allowed options to expire worthless, even though they had value.
“They just left cash on the table,” said Marci Rossell, chief economist at the New York-based mutual fund company. “They must not understand, or they wouldn’t do it.”
The survey also found 52 percent of respondents knew little or nothing about the tax implications of exercising options, which can vary dramatically from one plan to another.
Many individuals don’t realize that profits on exercised options often are taxed as ordinary income, even if the shares are held, rather than sold. And if the share price plunges after that, the result is wiped-out profits, plus a potentially horrendous tax bill.
One corporate executive who lives on the North Shore sought help from Schaumburg-based financial planner Mark Balasa after he found himself with a $200,000 tax bill, and no money to pay it, because his company’s stock had plummeted dramatically.
“There’s not much he can do right now but hope the stock price goes up,” Balasa said. “He should’ve thought through what he was trying to accomplish.”
The need to understand stock-option plans has grown exponentially in recent years as the perk once reserved for top executives has increasingly been extended deeper into the workforce, particularly at high-tech companies, where options play a vital role in enticing and compensating employees.
An estimated 10 million Americans receive stock options now, up from 1 million in the early 1990s, according the National Center for Employee Ownership in Oakland.
And the rapid rise of the compensation tool appears to have outstripped the availability of good financial guidance, particularly for the middle and lower echelons of the workforce.
“Most financial planners are not up on this stuff, most attorneys are not and most CPAs are not,” said Michael Beriss, a senior financial adviser for American Express in Bethesda, Md.
And many businesses are rushing to fill the information gap.
Web sites, such as myStockOptions.com and StockOptionsCentral, have cropped up, offering free information and calculators to individuals, and customized products for financial advisers and employers. Financial services companies are rolling out tools for financial advisers.
Employers try to steer clear of providing advice, which can leave them open to lawsuits, but many make sustained efforts to provide education to workers.
At Lisle-based Tellabs Inc., for instance, where all new hires receive at least 200 stock options, a significant portion of the two-day orientation seminar focuses on how the options work. This effort is reinforced with written materials.
Deerfield-based Walgreen Co., which this spring made a one-time stock-option grant to nearly all employees, has issued two explanatory booklets, one general and one personalized. And more detailed information will be issued before the options vest in three years.
Dominique Sanford, assistant manager at the Walgreens at Monroe and Halsted, said she understands the options programs after reading the explanatory materials, but noted that in every workplace, some employees will disregard such materials.
“Some will feel, `This doesn’t apply to me,'” she said.
To prevent shooting themselves in the foot, option-holders should take some basic steps, planners say, including understanding the specifics of their employer’s plan.
In general, stock options give an employee the right to buy a certain number of company shares at a fixed price for a certain number of years, once a vesting period has passed. If the stock rises, the difference between the grant price and the stock price when options are exercised is profit. If the stock price falls below the grant price, the options are virtually worthless, and are referred to as being underwater.
Employees should keep track of when their options expire, noted Beriss, who provides advice for myStockOptions.com. This may sound obvious, but many employees stop paying attention after a while, especially if their options are underwater for a period of time.
Second, don’t exercise your options as soon as you can, unless you work for a company whose stock is more volatile than you can take.
“Generally speaking, you should hold on to the midpoint, at least,” said Freida Kavouras, director of employee financial education at Ernst & Young LLP in Chicago. “You’re sharing in the appreciation and you haven’t had to put out any money.”
Several experts also suggested selling as soon as options are exercised, in part to avoid becoming too heavily invested in their company’s stock.
Third, learn which of two types of options you hold.
With “non-qualified stock options,” common in many broad-based plans, the spread between the grant price and the exercise price is taxed as ordinary income, even if the employee does not sell the shares after exercise.
Planning becomes more complicated with the other type of options, known as “incentive stock options.” The spread between the grant and exercise price is not subject to income tax until shares are sold, possibly at long-term capital-gain rates. But there’s a hitch: The spread is considered taxable income under the alternative minimum tax aimed at high-income Americans. And if the value of the exercise sends your income high enough, you will have to pay AMT on the spread, even though you still hold the shares.
“The way to prepare is to find out how much AMT you will owe before you exercise,” Beriss said. “That’s the last thing you want to find out later.”
A number of planners also suggest exercising stock options in increments to avoid kicking yourself into a higher tax bracket.
Whatever you do, look at the big picture, Kavouras said, considering not only the outlook for the stock and the tax implications of exercising, but also how exercising will affect your cash flow situation and your overall portfolio.
And plan ahead.
“People just sit on them until they expire,” said Bill Briggs, head of financial-services firm Net Worth Strategies of Bend, Ore. “Then you’re out of options.”
