Such whirlwind options planning is not unusual, says Bill Dillhoefer, director of business development for Net Worth Strategies, a firm that offers stock option software and consulting services for financial advisors. "Typically, an advisor will initially contact us when a client walks in the door, dumps some plan documents in his lap, and asks him to analyze his options portfolio and develop an exercise strategy," he says.
The Exercise Decision
Dillhoefer says that giving the standard rule-of-thumb advice to cut, run and diversify if options are well in the money grossly oversimplifies the decision-making process. "Stock options are unique investments with complicated tax features. Advising someone to exercise all of their options at once can be a bad move, because in many cases it makes more sense to exercise over a period of several years," he argues.
Holding stock options as long as possible often makes sense because they are an inexpensive, tax-efficient way to participate in the price movement of a stock, notes Michael Beriss, a senior financial advisor with American Express Financial Advisors in Bethesda, Md. And the longer they have until expiration, the more time value they have. "Nonqualified options have the greatest value if they are held unexercised for as long as possible," Beriss says. "That's why professional options traders usually exercise on the last possible day. They are also a great form of leverage. If the stock goes down, you haven't lost anything, and you haven't paid any interest charges."
At the same time, Beriss acknowledges that holding on to options for extended periods of time may conflict with a planner's diversification standards. "Deciding whether or not to exercise for diversification is a judgment call that has to be made by the client and the financial advisor," he says.
Therein lies the rub of options planning. While advising someone to exercise all their options and invest the profit in a diversified portfolio may seem like the right thing to do-and bring in more management fees or commissions almost immediately-options specialists say it is not always the best move from a tax or financial planning standpoint. But their experience shows that giving knowledgeable, well-thought-out advice has the potential for reward down the road, when clients eventually exercise their stock options and invest the profits.
Deciding when to exercise is probably the most critical decision option holders face. Michael Fitzhugh, a financial advisor and certified public accountant with Kochis Fitz in San Francisco, says recommending an exercise if stock tied up with an employer exceeds a certain percentage threshold is a common, yet oversimplified, approach.
"We look at the financial goal first," he says. "If someone has a lot of wealth in the form of stock options, and already has enough money set aside to meet financial goals, he may not need to exercise if he has faith in the stock and the company's future. On the other hand, if exercising someone's options is the bird-in-the hand that will make reaching financial goals a reality, it makes more sense to take the money off the table right away. The key question is whether or not someone would have a real problem if their options peter out."
Fitzhugh says that determining whether someone has too much money tied up in company stock or stock options is not an exact science. "An employee with another 20 years until retirement is in a better position to take the risk of a concentrated position than a 60-year old who is about to retire," he says.
He emphasizes that any opinion about how a company's stock will perform must come from the client. "We never take a point of view about whether or not a stock is going to go up, down or sideways," he says. "We have no insight about a company's prospects, and we make that clear from the beginning. That's not what the client is paying us for."
Beriss generally recommends that clients have no more than 10% to 25 % of their investments tied up in company stock, unless they have already met their core portfolio goals. "The question you need to ask is if the stock went down to zero, would the client still be able to retire as scheduled," he says. He also tries to quantify the risk of a concentrated position in stark terms. "Someone who owns 100,000 shares through stock options needs to be aware that every time the stock moves $1, his net worth increases or decreases by $100,000."