Asset Allocation with Restricted Stock

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This article first appeared in the September 2012 newsletter. Subscribe to get articles like this in your inbox.

When thinking about restricted stock units (RSUs) in a portfolio, most consider the tax and risk consequences of holding and selling restricted stock: should you elect to pay income tax when shares are granted rather than when they vest? How fast should you sell once they do vest? Should you use options to manage the risk of depreciation?

These are all important decisions, but they are already discussed at length elsewhere. Instead, let’s discuss how RSUs can affect your strategy for the rest of your portfolio.

Let’s say after careful consideration, you’ve decided on a 70% stock, 30% bond portfolio, but half of your savings is already in RSUs that you cannot sell. If you ignore your RSUs while managing your brokerage accounts, you essentially have two concurrent, but separate investment strategies. The risk profile of your overall portfolio is unfortunately largely dictated by your mix of RSUs vs brokerage accounts.

To manage both under one comprehensive strategy, you can adjust RSU balances by its risk attributes, tax liability, and vesting schedule to integrate it with an asset allocation framework.

Risk Attributes

First, determine which asset class is most similar to your restricted stock. For most, the appropriate asset class would be US stocks. If you use more narrow asset classes, it could be something like US value stocks or US small cap stocks. The asset class you select here would be most affected by your RSU balance.

Next, estimate how risky your stock is relative to that asset class. Smaller, growth companies tend to be more risky than larger, dividend-paying companies. An easy way to estimate this for public companies is by looking up the beta of your stock on Yahoo or Google Finance.

Tax Liability

Unless you specifically elected otherwise, income tax is due when shares vest. In this scenario, you can discount your unvested shares by your tax rate to estimate the after-tax value. For example, assuming a 40% total tax rate, your unvested (and untaxed) shares would count at 60%. If you did make the tax election, you should only discount for capital gains taxes.

Vesting Schedule

Similar to discounting future cashflows, you can discount shares by their vesting date. This accounts for the possibility that you are not with your current employer when shares are scheduled to vest. If we use a 25% discount rate for an example (you switch jobs every 4 years or so), shares due to vest in one year would count at 75%. Shares due to vest 2 years from now would count at roughly 56%, and so on. This calculation allows your shares to accrue smoothly to 100% as the vesting date approaches.

An Example

Let’s say you have $1mm in restricted stock (a small public company in the US) and you have $1mm in a brokerage account. And your target allocation for your overall portfolio is 35% US stocks, 35% non-US stocks, and 30% bonds. Let’s go through each adjustment:

  • Asset Class: US stocks
  • Risk Level (beta): 1.1x
  • Tax Rate: 40%
  • Vesting Schedule: all shares vest in 2 years
  • Vesting Discount: 25% per year

The adjusted balance of your RSUs would be $1mm * 1.1 * (1-40%) * (1-25%)^2 or about $371k. For asset allocation purposes, your portfolio now looks like one worth $1.37mm ($1mm + $371k). Next, let’s look at two approaches to including RSUs in an asset allocation strategy.

Approach 1: Perfect Substitution

Based on your target asset allocation, your US stock allocation should be $480k (35% of $1.37mm). Since you already hold $371k in US stocks in the form of restricted stock, you only need to hold the remaining amount ($109k) in your brokerage account. You can use the rest of your brokerage account to hit your targets for other asset classes.

The downside of this approach is that most of your US stock allocation is now taken up by a single stock. Since that stock is not a perfect proxy for the whole asset class, we would be giving up some diversification benefits by doing this. And what if your RSU balance were much higher? Should you reduce US stock holdings in your brokerage account to zero? Probably not.

Approach 2: Balanced Substitution

A second approach attempts to balance the need to account for restricted stock for asset allocation purposes and the diversification benefits of holding a US stock fund even with a concentrated holding in a single US stock.

Unlike the first approach, as your RSU balance increases, you no longer reduce your US stock allocation 1:1. Instead, you start to reduce similar asset classes as well to preserve some balance in your portfolio. For an employee of a US company, you would reduce allocations in your brokerage accounts in the following order:

  1. US stocks
  2. Non-US stocks
  3. Other risky assets, such as real estate and commodities
  4. And eventually, even bonds, since they are more risky than cash

This approach satisfies multiple requirements in managing RSUs:

  • Your overall portfolio is guided by your target allocation, since this approach does not ignore your RSUs
  • Diversification is largely preserved, since an asset class would not be solely represented by a concentrated holding in a single stock
  • The effect of RSUs is adjusted for risk, tax and vesting factors in a smooth, quantifiable way

Still have questions on how to incorporate RSUs into your asset allocation strategy? Feel free to contact me to discuss the details.

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