Employee benefit packages often include programs that encourage ownership of company shares through discounted share purchase programs (ESPP), restricted stock grants and/or employee stock option programs. Companies look to motivate employees to hold shares of the company with the idea that they will benefit by taking actions that are aligned with shareholder interests. From an employee perspective, these programs can have a positive impact on the employee’s retirement plan, but they need to be managed carefully. Why? These incentive programs can materially affect the individual’s allocation risk and they have tax implications. In addition, a number of studies have shown that behavior biases may be causing employees to make non-optimal decisions. Let’s look at the issues and methods to mitigate those risks.

Allocation Risk

Modern Portfolio Theory is based on the idea that firm specific risk is not rewarded. Firm specific risk can be substantially reduced by holding a reasonable number of companies in the portfolio. In “Modern Portfolio Theory and Investment Analysis”, Edwin J. Elton and Martin J. Gruber assert that 80% of firm specific risk could be diversified with 20 stocks. Although there has been recent debate over the precise number based on increased correlations between stocks, the basic principle remains the same. As a general rule, I’d like to see less than 5% held in any individual stock. For employee shares purchased at a discount with substantial tax consequences for selling, a 10% limit may be appropriate.

Tax Implications

Company shares purchased at a discount in a taxable account pose an added challenge. If we could buy and hold the shares for a long period of time, we could defer tax liability. On the other hand, if you are able to defer up to 15% of your salary (up to an annual cap of $25,000 for US ESPP programs), it is likely that one would end up holding a disproportionate amount of shares in a single stock. What’s the solution? For those companies that offer a generous discount to fair value (say 15%), purchasing shares with the intent to divest shares over time to stay under a preset 5% total allocation may be a reasonable approach. Generally, we would also look to use tax loss harvesting to attempt to match gains from employee shares with other assets held. This type of tax planning takes work. We have to consider factors such as short and long term gains as well as any ordinary income component that will be realized when shares vest and/or are sold.

Behavior Factors

According to findings by Vanguard Research published in “How America Saves 2014” , 15% of defined contribution plans offer company stock as an option in their plans. They also found that 9% of participants held concentrated positions of more than 20% in the company’s stock. This analysis is focused on defined contribution plans such as 401Ks and does not count any ESPP shares and/or restricted stock or options vested and held. As such, it may substantially underestimate the problem. What explains why employees are holding too much company stock and how can this be corrected?

Familarity and Overconfidence. Gur Huberman, author of “Familiarity Breeds Investment” argued that people invest in what is familiar to them. In addition, Overconfidence bias is an emotional bias where investors overestimate their own judgements. Investors in their company stock may feel that they have access to knowledge or information about the company that gives them insight as to the company’s prospects.

Status Quo. Status Quo refers to the behavioral bias where people feel more comfortable in leaving things as they are. Once an employee joins a share purchase program and begins to accumulate shares, the Status Quo bias may explain why they have an excess allocation to the company stock. In order to stay within rational limits (say 5% allocation), the employee would need to take action to monitor and make dispositions for any shares which exceed some preset limit.

Loyalty Effects. Employees may hold on to their shares out of loyalty to the company. Companies encourage employees to hold shares for a variety of reasons including alignment of shareholder interests or as a defense to a hostile takeover.

Managing Behavior Bias – What Can You Do To Manage it?

The first step is to be aware of the potential biases.   Seek information from outside sources and be aware of the biases listed above.   Ask yourself the following questions:

• Am I overestimating the future prospects for the company?
• What are outside analysts saying?
• Has the company experienced strong recent performance? Am I over-weighting those results?
• Am I holding shares out of loyalty?

Identify an allocation and divestiture plan for your company shares. Set a maximum allocation to company shares and divest excess shares over time. Develop a plan for proactively managing the tax consequences. For example, estimate how much company stock you will be purchasing, how many restricted or option grants will vest and what this will do to your allocations.