By: AnnaMarie Mock, CFP®
Leonardo DaVinci wisely said, "Study the science of art. Study the art of science. Realize that everything connects to everything else."
Financial planning integrates art and science through a dynamic process. The art is subjective and experienced while exploring goals and aspirations and making decisions. The science is objective and visible in the tools to develop projections analysis.
Financial planning is an art that takes a scientific approach.
The Scientific Method Applied to Financial Planning
Although I am not a scientist, I use the scientific method regularly. The scientific method is an open-ended process to pose questions and determine a viable approach to success. It's all about a repeatable process that leads to a set of guidelines and actionable steps. A successful financial plan is no different. We may try a new planning technique, observe whether it works, and then adopt or reject it based on the client's response.
Everyone's path to success is unique. Therefore, we must approach every financial plan as if we are conducting an experiment, either validating or abandoning a particular option. Following this process will reduce uncertainty and increase your odds of successfully achieving your long-term goals.
How do we use the scientific method in a practical financial planning setting? We will use evaluating equity compensation as an example of the process.
Example: Evaluating Equity Compensation
Step 1: Observation - A significant part of my net worth is concentrated in vested & unvested non-qualified stock options (NQSOs) available to me through my employer equity compensation plan.
Step 2: Question & Research - How can I maximize the value of my options and reduce my risk exposure?
The research element is essential. It's challenging to make an educated decision or recommendation without all the facts.
Features of equity plan: The elements of the equity compensation plan dictate how the awards are treated. Some standard terms to know are grant date (issuance date), strike price (price to purchase the shares), and vesting (date you have the right to acquire or exercise the options). The vesting schedule determines the timeline & amount of shares the employee will receive in the future. Graded vesting refers to incremental ownership over time; a four-year vesting schedule (25% vesting per year) is most common; however, the vesting schedule can range from monthly, quarterly, or annually with set vesting percentages. The vesting schedule and the type of compensation play a role in taxation.
Type of equity compensation: The stock option or grant awarded can have different nuances for planning purposes – SARs, RSUs, ISOs, and NQSOs. For example, NQSOs give employees the right to buy company shares at a preset price (strike price) when the options vest, also known as exercising. This requires planning because of the out-of-pocket cost of purchasing the shares.
Research industry insights: Comparing your company to the broader industry is not always an indication of what's ahead, but it can gauge trends that may impact your business and, ultimately, the stock price.
Taxation of Benefits: Tax planning is crucial to saving money in the short-term and building wealth over the long term. You want to focus on what you keep, not what you make. All types of employer stock options come with some sort of tax liability, whether when it vests, exercised, or sold, but there are strategies to implement, like using the liquidity of one grant to pay for the cost of the next award. The objective is to minimize any tax or cost surprises.
Identify and quantify your goals: Formulate a vision in your mind about what you want to accomplish and put those thoughts on paper to map out how you want your life to look. Your goals should be ambitious but also attainable to motivate without causing stress. Defining a purpose for equity compensation involves a shift in perspective regarding money and work, prioritizing what is most important. Being mindful of the tradeoffs allows adjustments to expectations or behaviors to maintain progress in your action plan.
Step 3: Hypothesis - If I create an actionable plan for my stock options working in tandem with my overall financial plan, I will be able to build wealth and fund my goals while considering the tax implications.
Step 4: Predications – I can sell my vested stock now to fund my short-term goals, invest the rest in a diversified portfolio to minimize the risk concentration, and pay for the cost of exercising my other options. Based on my vesting schedule, I can plan on exercising and selling a portion every year, barring the price remaining above the strike price without generating a surprise tax bill, all while being intentional with the stock proceeds.
Step 5: Analysis – This is the culmination of all the other steps and stresses the importance of researching to test your predictions and provide the best outcome. In the case of the NQSOs, we predict we can sell and exercise this year, but we need to calculate to see if that is feasible.
You should only exercise NQSOs when the exercise price (current price per share) exceeds the strike price, also referred to in the money. The total value generated is what is paid at the time of exercising. When NQSOs are exercised in the money, the difference between the exercise and strike prices is taxed as ordinary income. If the exercise price is below the strike price, the option is considered out of the money. You can wait for the price to surpass the strike price or expire at this juncture. The FMV at exercise becomes the cost basis, which is pertinent when calculating the taxable gain at the sale as well. The timing and FMV at the sale will dictate the amount of taxes.
Step 6: Monitor - After the initial run-through of the process, monitoring is one of the most critical steps. If the analysis is consistent with the prediction, it gets incorporated into the recommendations for your plan. Changes in circumstances and goals (the art), over time, almost guarantee that the advice for today may not be the same in the future. Your plan needs to pivot as your life evolves; in this step, we take note of what went well, denote any problems or opportunities that arose, and modify the plan as needed.
We can help you evaluate and take the guesswork out of your employer's stock options and create a process to smooth cash flow and taxes while coordinating your overall financial plan.
AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.