Restricted Stock and RSU’s: What are they and what should be done with them?

Compensation at many high tech companies includes some form of company stock. There are a number of different plans that are used singly or in combination. In this article I focus on Restricted Stock and Restricted Stock Units (RSU) granted to employees.

Restricted Stock and Restricted Stock Units  (RSU) are somewhat different. If you are granted Restricted Stock you actually own the stock. With RSU’s the company promises to grant you the stock over a vesting period, typically 3 – 4 years. Dividends earned before vesting are credited to a Restricted Stock owner. The particular company plan determines whether an RSU holder has dividends credited.

In both cases you are restricted from doing anything until you meet the company’s vesting requirements. The main vesting requirement is typically to stick around as an employee. However there may be other requirements such as meeting personal or company performance goals.

Income Tax and the Section 83(b) Election

Both Restricted Stock and RSU’s are taxed as compensation at the time they vest. Income is recognized at the vest date and is the difference between the vest date share price and the purchase price. Usually, you are not required to pay anything at the time of the grant making the purchase price zero.

The income from the vested shares is considered compensation and thus subject to all the associated tax and withholding requirements. Most companies automatically sell enough of the vested shares to meet these withholding requirements. The withholding requirements include:

• Federal Income Tax: at your W-4 specified rate, or a flat 25%. The withholding rate will be the maximum rate if the value of the vested shares is more than $1M.
• State and Local Income Tax: California withholds at the maximum individual tax rate
• FICA: Medicare on the whole amount and Social Security up to the unfulfilled annual maximum.

In the case of Restricted Stock you have the option to make a Section 83(b) Election. This election allows you to be taxed at the time of grant based on the grant date share price. Making this election can significantly reduce the amount of taxes paid for stock that is expected to appreciate significantly over the vesting period. However caution should be used in making this election as there is always the risk of the stock value decreasing.

Vested Shares – What Now?

Assuming no Section 83(b) election you typically have the choice of a same day sale of all shares or the automatic sale of just enough shares to cover the withholding.  If you just cover the withholding you are left owning the remaining number of shares. You can continue to hold them or sell them, subject to any insider trading restrictions that may apply. If you hold the shares for over one year, any gain over the vest date value would be taxed at the advantageous long term capital gain rates when sold (15% in 2012). Any shares sold before 1 year are taxed as short-term capital gains, at the same rate as your salary (i.e., ordinary income rates).

The best approach to take depends on a number of factors, including the employer and your own financial situation. The place to start is to think about the vested shares as part of your compensation. If you do a same day sale of all vested shares you are essentially treating the value of the shares as a bonus.

If you think the company stock will continue to increase you may be inclined to hold onto the shares instead of selling immediately. However, realize that doing so puts the ‘bonus’ for which you have already paid taxes at risk.  (Note: If you later sell the shares for a loss you do have a capital loss. But the FICA you paid will not be recouped.)

This choice requires a clear-headed, objective analysis of the employer company and its stock valuation. If you work for a large, established company with solid fundamentals you might be more comfortable about taking a risk than if you are working for a small startup. But, remember that while the large, stable company may have less risk of outright failure it also may have less opportunity for significant stock increases. And in our current volatile times you are exposed to the fluctuations in the overall stock market in both cases.

Let’s assume you see a reasonable risk and a potential for stock appreciation at your current company. The next place to look is your personal finances. If you do not have budget or debt problems, have significant savings and are on track to meet your financial goals (i.e. college funding, retirement, etc.) it may make sense to hold onto the shares. However, if this is not the case and you really need the funds now consider selling and being happy with your ‘bonus’.

Another factor to consider is the annual vesting of more shares. If you do not sell the vested shares they become an ever increasing percentage of your total assets. Together with the rest of your compensation you end up with a large part of your financial well-being dependent on one company.

Last Word

Do the analysis and determine a strategy for the divestiture of your Restricted Stock or RSU’s. If you also receive company stock from other employer plans consider them as well. If you are not sure how to do this seek help from a qualified financial advisor then objectively execute your strategy.

Using a Reverse Mortgage to Fund Your Retirement

 

Is your Home an Investment?

Real estate is obviously an investment asset class. However in addition to REIT’s is that limited to commercial or residential real estate. You may like to think of your home as an investment that will appreciate overtime. This, together with your decreasing mortgage can result in significant equity available in retirement.

However as a Financial Planner I prefer to consider this equity as a personal rather than investment asset. The primary purpose of this equity is to fund future living situations whether such as your current home, a new home, or a residential living facility. Then your investment assets, pensions and other passive income streams fund your living expenses.

In most cases this works great. That untapped equity in the home becomes an additional emergency buffer. This might reduce the need for long term care insurance. Or if  never used becomes part of the estate to pass on to heirs.

However there are situations in which resources other than home equity are insufficient. This may be by design in which people have put a lot of money on their home. Or it may be an unplanned situation. In either case this home equity becomes an important resource for a successful retirement plan.

Home Equity and Retirement Planning

When using home equity in a retirement plan the standard approach is to hold off using this equity until late in retirement. Most people see that home equity as a safe haven (the 2008 crash notwithstanding) and so would prefer not pull equity out of their home sooner. That equity may then be utilized in a number of different ways. One approach is to move to a less expensive home making any excess equity available. If staying in the home a Reverse Mortgage is another approach.

Reverse Mortgage

A Reverse Mortgage is a loan only available to senior home owners that uses a portion of your home equity as collateral. Funds can be received in a lump sum, monthly, or as a line of credit. It is called ‘reverse’ because you do not make monthly payments and overtime the equity in your home decreases based on the equity used and associated interest due. The loan balance generally does not need to be repaid until the last surviving homeowner moves or dies. The estate then has approximately 6 months to repay the balance.

The FHA offers a Home Equity Conversion Mortgage (HECM) which is a reverse mortgage guaranteed by the Federal Government. These reverse mortgages tend to have the lowest interest rates but have a maximum loan size. With the exception of the offerings of some credit unions, private reverse mortgages may have a higher limit and lower upfront and monthly fees but typically charge a higher interest rate.

Reverse Mortgage and Retirement Planning

If we view home equity as just another investment asset we might consider different priorities for when and how to use it in a retirement plan. An article in the February Issue of the Journal for Financial Planning, "Reversing the Conventional Wisdom:  Using Home Equity to Supplement Retirement Income,"   is a technical paper examining this issue. Barry H. Sacks, J.D, Ph.D and Stephen R. Sacks, Ph.D did a 30 year comparison of the use of a reverse mortgage

1) As a last resort

2) Used first, before the investment portfolio

3)  With a a coordinated strategy using both investment portfolio assets and a reverse mortgage home equity credit line.

   

They found that using the reverse mortgage last had the poorest results. The coordinated strategy provides the highest retirement plan confidence levels, and a higher net worth of the remaining estate twice as often.

These findings make a lot of sense. Consider substituting a CD for that home equity. By using the CD first we leave more of the higher earning investment portfolio to grow over a longer period. However it also seems that we have increased risk by using ‘safe’ assets first. As long as there are a sufficient amount of other safe assets (i.e, emergency funds, a cash allocation in the portfolio, etc), then using the ‘excess’ safe assets is reasonable.

However many of my clients would have no interest in pulling equity out of their home immediately upon retirement. Many are still paying mortgages and have a goal of paying it off as quickly as possible.

This leads to another clever use of the reverse mortgage equity line of credit. Harold Evensky (Evensky & Katz Wealth Management, www.evensky.com, ) has recently proposed the use of this line of credit as a source of emergency funds. These funds could be utilized for a sudden emergency need for cash. They could also be used to live on instead of portfolio withdrawals in a year of negative investment performance. The funds could then be repaid in good years, restoring the original equity.

The reverse mortgage line of credit works exactly like a regular Home Equity Line of Credit (HELOC), with the exception that it does not result in a required stream of loan payments. The danger of this open ended approach is that a person might erode their home equity over time unnecessarily, without paying down the balance in the good times.

Conclusion

The Reverse Mortgage is another powerful tool in the retirement income planning tool box. As with the other options available, it is not always the best approach. It should only be used when it is appropriate for an individual’s particular situation. There should be careful planning to determine the most optimal timing and method.

Achieving and Keeping a Secure Retirement!!! Part 3

This is the third and final posting that summarizes the presentation I gave with Bob Finke at the Scotts Valley Financial Planning Clinic on February 4, 2012.

Retirement Spending and Withdrawal Goals

Retirement spending is typically funded by social security, employer pensions/retirement accounts and your own savings. The amount you need to withdrawal from your investment portfolio is the amount of your retirement spending that is not covered by passive income streams outside of your portfolio.

The typical goals for retirement withdrawals are

• Maximize withdrawals, especially in early retirement
• Eliminate the possibility of running out of money
• Avoid undesired reductions or freezes of withdrawals
• Maintain purchasing power

There are many different approaches that can provide a secure retirement. The ones discussed here all assume that your investment portfolio is invested with an appropriate asset allocation that is rebalanced once or twice a year

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Bucket Methods

One popular method is the Bucket Method. This involves separating short and long term funds into separate accounts. Funds are moved periodically from longer term to short term buckets. This method provides the benefit of feeling more in control but may require more work to manage multiple buckets.

The simplest bucket approach is with 2 buckets: one holds cash for 1 or more years. The other is a fully diversified portfolio for longer term funding, that may also contain a cash allocation

With a 3 bucket approach the first bucket is the same, a second bucket holds low risk/return assets to be used in 5 – 10 years, and the third bucket holds higher risk/return assets for longer term.

I have heard of methods with up to 5 buckets. If you like the bucket approach you should pick that one that will work best for you.

Single Asset Allocation Methods

Another approach is to have a single diversified asset allocation for the whole retirement portfolio. This would include a cash allocation that would 1 or more years of spending. Cash is withdrawn directly for current year spending, and is replenished when you rebalance to the target asset allocation.

Safe Withdrawal Amount

Once you have selected how you will organize and manage your retirement portfolio you still need to determine how much is safe to withdraw. First you need to do a cash flow and retirement plan to determine how much you will need to withdraw. Divide this amount by your portfolio value to get your Withdrawal Rate. The typical default safe withdrawal rate is 4%. Some of the methods discussed below may allow it to be somewhat higher safely. If your rate is higher than that you need to go back to the drawing board and find a way to reduce your spending!

Note that we are talking about the Initial Withdrawal Rate. Over the course of your retirement that rate will increase, and can do so safely. So if you are already well into retirement the current safe withdrawal rate needs to be determined with additional analysis.

Safe Withdrawal Strategies

The approaches discussed here assume a 2 Bucket approach in which the current year’s spending is withdrawn at the beginning of the year and held in a separate cash account. The single investment portfolio is invested with an appropriate asset allocation that is rebalanced once or twice a year.

Lifestyle Policy Method

This is also called the Inflation Adjustment Strategy, After the initial year the annual withdrawn amount is increased by inflation (CPI) each year. There is not adjustment for performance or portfolio value

Here is an example:

•  $500,000 portfolio
•  $20,000 initial withdrawal amount
• 4% initial withdrawal rate
• 3% inflation
• $20,600 2nd year withdrawal amount
• $21,218  3rd year withdrawal amount
• $21,855  4th year withdrawal amount

 

Endowment Strategy

This approach was developed by Thornburg Investment Management based on work by William Reichenstein. Annual withdrawals are inflation and performance adjusted which keep the overall portfolio on a sustainable path.

The Annual Withdrawal Amount is calculated each year as the sum of:

• 90% of previous year’s withdrawal amount
• 10% of the start of year portfolio value, times the initial withdrawal rate
• Actual annual inflation (using CPI), times the sum of the previous two parts

This calculation gives a moderate boost after good years and a moderate reduction in the annual increase after a year of poor performance. The overall effect is to allow a 25% - 35% increase in your withdrawal rate while still being sustainable and secure.

Guardrails Strategy

This approach was developed by Jonathan T. Guyton, CFP® and William J. Klinger. It establishes a set of decision rules for portfolio management and withdrawals. Annual withdrawals are inflation and performance adjusted as with the Endowment Strategy.

Decision Rules Summary

Condition	Action
Prior Year’s Return is Negative	Apply Withdrawal (W/D) Rule   - No increase if W/D rate > initial W/D Rate
Current W/D Rate more than 20% Above Initial W/D Rate	Apply Capital Preservation Rule  - Reduce W/D rate by 10%
Current W/D Rate more than 20% Below Initial W/D Rate	Apply Prosperity Rule  - Increase W/D rate by 10%
Current Withdrawal (W/D) Rate is within 20% of Initial W/D Rate	Apply Inflation Rule   - Increase by Inflation (CPI)
Annually	Apply Portfolio Management Rule  - Rebalance. Use W/D funding order

These rules act as financial ‘guard rails’ to prevent portfolio depletion. Analysis indicates a 30% - 43% increase in your withdrawal rate while still being sustainable and secure.

Here are the Decision Rules in detail:

Withdrawal Rule

• No increase in withdrawal following a year when portfolio total return is negative and withdrawal rate would be greater than initial withdrawal rate
• There is no ‘make—up’ for a missed increase.

 

Capital Preservation Rule

• If withdrawal rate is 20% greater than initial withdrawal rate
• Current year withdrawal rate is reduced by 10%, and then other rules applied
• Decreased withdrawal is basis for next year’s withdrawal
• Rule expires 15 years before life expectancy

 

Prosperity Rule

• If withdrawal rate is 20% below the initial withdrawal rate
• Current year withdrawal is increased by 10%, and then other rules applied
• Increased withdrawal is basis for next year’s withdrawal

 

Inflation Rule

• If withdrawal rate is within 20% of initial withdrawal rate, and
• Unless withdrawal rule prevents it
• Then increase previous year’s withdrawal by inflation (CPI)

 

Portfolio Management Rule

• Asset classes with positive return and above target allocation have the excess sold
• Withdrawals are funded in following order 
•  Overweight equities
•   Cash
•  Fixed Income
• Equities in order of highest performance
•  If Equities have negative return, no withdrawal from equities if cash and fixed-income can fund the withdrawal

Achieving and Keeping a Secure Retirement!!! Part 2

Last time I summarized the first part of a presentation I gave with Bob Finke at the Scotts Valley Financial Planning Clinic. The second part related to actions to take in retirement will be partially covered in this posting, and completed in the next posting.

What does Retirement Mean?

What does retirement mean to you? Does it mean not working? If so what, exactly, are you going to do with your time? It is a good idea to consider this deeply. Most people expect to stay active in retirement. However unless you understand your interests and have a strategy for following them you may find yourself disoriented, disconnected and uncertain what to do.

Many people opt for partial retirement, working part time. For some this is necessary to have a secure retirement. For others it is a way to stay active and continue doing what they love at a more relaxed pace. Whatever the reason, partial retirement will delay the use of your nest egg and increase the security of your retirement.

Inflation & COLA

Inflation is a major obstacle to a secure retirement, as it was to savings before retirement. As the cost of living rises, the purchasing power of your savings decreases. This is why for most people keeping their savings in cash will actually reduce their security as inflation decreases the real value of those savings. An appropriately diverse portfolio targeted to your personal risk profile is one way to make sure your nest egg grows faster than inflation

Passive Income Streams

Passive income streams that last for life great enhances your retirement security as there is little chance of it ending during your lifetime. Passive means income that is provided without your active involvement in management or production.

Some passive income streams do not increase with inflation. So although the income will continue for life inflation will erode its value. Other types of income include a Cost of Living Adjustment (COLA) which allows them to partially or fully keep up with inflation.

You should also consider whether an income stream can be inherited. Understanding the estate planning characteristics of an income stream is important, whether or not leaving an inheritance is important to you

Here are a few passive income streams and their characteristics:

Type	Inflation	Inheritance
Social Security	COLA	Cannot be inherited directly. Survivor benefit for the spouse.
Other Government Pension	Varies. CalPERS and CalSTRS both of annual COLA up to a max and purchasing power protections	Cannot be inherited except through spousal survivor benefits if selected.
Private Pension	Varies. Typically does not have COLA	Cannot be inherited except through spousal survivor benefits if selected.
Annuity	Typically only if a COLA rider is purchased	Varies by product and annuitization selection
Stock Dividends	Increase as company value increases	Can be inherited
Real Estate	Increases as property value increases	Can be inherited

Account Type Strategies

You should consider the tax characteristics of your various investment accounts.

·         Roth accounts have tax free earnings. Assuming you follow the rules there is no tax due on withdrawals

·         IRA, 401(k) and 403(b) accounts have tax deferred earnings. The full value of withdrawals is taxed as ordinary income at your standard rate

·         Taxable accounts are taxed at ordinary income or capital gains rates as income is earned and recognized each year.

In a taxable account Qualified Dividends (QD) and Long Term Capital Gains (LTCG) on the sale of securities held for more than one year are currently taxed at maximum of 15% (0% if you are in the 10% or 15% tax bracket). Note current law has the QD and LTCG rate maximum increasing to 20% in 2013 (10% in the 15% tax bracket).

By optimizing the type of account in which you hold different types of assets you can pay less tax on your earnings overall:

·         Roth and Tax Deferred Accounts: Hold bonds, REIT’s and tax inefficient stocks

·         Roth Accounts: Hold highly appreciating assets and aggressive stocks

·         Taxable Accounts: Hold stocks with qualified capital gains and dividends as well as tax managed funds

Note that this is secondary to maintaining your asset allocation. So you will probably not be able to fully optimize your portfolio. Do whatever you can without subverting your asset allocation.

Next Time: Part 3: Safe Withdrawal Strategies