September 16, 2020 – One question I’ve gotten from readers a few times over the years is whether the participation in a so-called Employee Stock Purchase Plan (ESPP) is worthwhile.
A little bit of background: some corporations offer their employees to buy stocks of their company at a discount of up to 15%. There are some strings attached, though. For example, there are often minimum holding periods, anywhere between a few months and up to two years. The discount is also taxed as ordinary income, though the subsequent capital gains may qualify for treatment as long-term gains.
If you can liquidate the stocks right away and pocket the discount, then participating is likely a no-brainer. Take the money out of the ESPP and invest it in a low-cost index fund. It’s a nice boost to your contributions in your taxable account after you’ve maxed out all your other tax-advantaged options. 15% adjusted by your marginal income tax rate – federal and state. That would still be more than 10% for most people! Pretty sweet!
But what should you do if there’s a minimum holding period? During that time, part of your portfolio is now concentrated in one single corporation. The opposite of diversification. So, it’s a tradeoff: You get the discount but you also take on additional risk. Is it still worthwhile? This is an inherently quantitative question. Without putting hard numbers behind this we can talk about this until the cows come home. The only way to answer this question is through a quantitative exercise. And it turns out, the numbers look like it’s indeed worthwhile to participate in an ESPP, especially if you can get the full 15% discount, the maximum allowed under federal law.
Let’s take a closer look…
Tax treatment
Before we even get started with any computations, let’s first look at the tax issues associated with ESPPs. I’m not a tax guru, so I have to rely on some other experts on this one:
- Turbotax: Employee Stock Purchase Plans
- The Motley Fool: How to Get the Most From Your Employee Stock Purchase Plan
The ESPP Discount: What I gathered from the experts is that the discount your company offers you is always taxed as ordinary income. That’s consistent with my own past experience when I was still working and participated in the ESPP; the discount always showed up as ordinary income on the W-2 the same year I received the discount (not when I sold the stock). But I’ve also heard from others who found that the discount doesn’t show up on their tax documents until they actually sell the shares.
Dividends along the way: I got annual 1099-DIV statements. So, dividends were treated just like in any other equity investment. If you work for a non-REIT U.S. corporation and you satisfy all the minimum holding period requirements (“more than 60 days during the 121-day period starting 60 days prior to the ex-dividend date for common stocks”) then your dividends along the way should be qualified dividends and enjoy the lower rate on your federal return!
Capital gains: Gains will be considered “long-term” when you dispose of the shares at least 2 years after the “offer period” and at least 1 year after the exercise date. And “short-term” gains otherwise.
Side note: There’s a potential additional benefit in some ESPPs in that they would accumulate your contributions over a certain offer period window. But when you buy the shares at the end of that window you can do so at the lowest (daily closing) price observed during that window. That’s an additional discount on top of the 15%.
Efficient Frontiers with an ESPP
Let’s first check whether we should allocate any share of the portfolio at all to the ESPP. I propose we look efficient frontiers (EF) with and without the ESPP and check if and how the addition of an ESPP moves the EF and improves our risk vs. return tradeoff.
To set up an efficient frontier analysis, we need only a handful of inputs: expected returns and risk and correlation measures. Let’s start with a baseline portfolio with only a broad stocks index (S&P 500) and intermediate U.S. Treasury bonds (i.e., 10-years to maturity):
- Equity risk 15%, return 6.0%. 15% is the approximate long-term annualized risk of the S&P 500 (monthly data, annualized) and I assume a 6% nominal annualized return (i.e., about 2% inflation + 4% real return). A little bit more conservative than the very long-term average real return (about 6.7%), but we want to be cautious in light of the expensive CAPE ratio these days.
- Bond risk/return: 6.0% risk (realized risk over the last 10+ years) and 0.7% return (=current 10-year bond yield).
- Stock/Bond correlation: -0.30, roughly in line with the monthly correlation over the last 10+ years.
- I also assume that the risk-free, short-term government bond rate is 0.10%. It’s not needed for the baseline, but I always include the risk-free rate in my EF diagrams.
How about the stock return inputs? I assume that the company stock has an equity beta of 1.0, a correlation with the stock index of 0.6, and a correlation with the bond portfolio of -0.15. All these inputs vary quite substantially among the individual stocks you might find in the S&P 500. But you have to start somewhere. I will do some robustness analysis and confirm that changing these stock parameters will not change the results all that much. Only the ESPP discount really matters here!
If we believe in the CAPM model then a stock with a beta of 1 will have the same expected return as the index (and it’s “RiskFree + beta*(StockIndex-RiskFree” for all other betas in general). Let’s assume that the stock with the ESPP will also get a return boost of 5% annualized. Think about this as a 10% (net, after-tax) discount spread over a mandatory minimum holding period of 2 years. We can look at some other parameterizations later.
Also, notice that the four “risk variables”: beta, stock/index correlation, index risk, and stock risk are tied together through the formula:
Beta=Correlation*StockRisk/IndexRisk,…
thanks to basic statistics/econometrics in univariate regression models. So, we can pick only 3 of the parameters and the fourth is determined through the statistical identity above. In this case, the stock risk has to be 25% to be consistent with the other three parameters. Sorry about the math excursion but this is important stuff if want to do an Efficient Frontier analysis.
So, I plug that all into my Matlab program and then run some Efficient frontier analysis. I compute three different efficient frontiers:
- The baseline with only the stock index and bond index fund
- Add the ESPP stock but restrict the weight of the ESPP to 10% of the portfolio. Think of this as someone who has a $200k and is allowed to invest up to $10k a year in the ESPP. Since you’ll have 2 rolling years of ESPP contributions, you can’t go much above 10% weight.
- Add the ESPP stock without any constraints. Say, you’re a young employee, straight out of college, just starting out with your first corporate job. You can probably have a much higher ESPP weight then.
Let’s take a look at the efficient frontiers first, see the chart below. Adding the ESPP will move the EF quite substantially to the left, which is the desirable area, i.e., less risk/more return. For example, instead of a 100% stock portfolio with a 6% return and 15% risk (the end-point of the baseline EF), you could generate an excess 1.3% return for the same level of risk. Or, for a given expected return level of 6%, you can reduce the risk by about 3 percentage points. That’s a major improvement in the risk/return tradeoff.
Footnotes for the math geeks:
- I chopped off the EFs at the point where they’d bend backward again toward the 100% bond allocation. That part is not normally considered part of the EF because you go into the “inefficient portion of lowering returns while increasing risk.
- The efficient frontier is using the Matlab “quadprog” function. So you run a linear-quadratic optimization problem: minimize the variance w’∑w subject to the w’μ=target and the weight constraints (all weights between 0 and 1, all weights sum to 1 and, if applicable, additional weight constraints, like ESPP below 10%).
If you constrain the ESPP share to 10% you get less of a benefit. It means that the unconstrained EF wants to allocate significantly more than 10% of the portfolio to the ESPP. If you’re a young employee and you’ve maxed out all the tax-advantaged options, feel free to go crazy with the ESPP if you still have money left over!
Talking about allocations, we can also plot the portfolio weights as a function of the target expected return. Notice that the unconstrained frontier extends all the way to 11% expected return and 25% expected risk if you put 100% of your portfolio into the ESPP. The EF with the 10% constraint goes only up to about 6.5% expected return, so the allocation chart stops at that maximum expected return level when you hit the 10% ESPP, 90% equity index allocation.
There you have it! Despite the significantly higher risk in the individual stock (25% vs. the 15% index risk), the ESPP-advantaged investment should be in the portfolio along the efficient frontier.
Here’s another way to showcase the benefit you get from including the ESPP. Let’s start from a baseline of a 100% equity index investor (which was my own plan for much of my accumulation phase). With the inclusion of the ESPP, how much can we improve relative to the 100% equity index allocation with a 6% expected annual return and 15% risk? We can quantify that 2 different ways:
- Hold the expected return at 6%, by how much can I reduce the portfolio risk?
- Hold the risk target at 15%, by how much can I increase my expected return?
That’s what I do in the table below. And again, I display this for both the constrained ESPP (10% max) and the unconstrained weights:
- With a 6% return target, you can reduce the risk by about 1.4 and 3.0 percentage points, respectively. That’s about 10-20% less risk. Pretty good!
- With a 15% risk target, you can raise your expected returns by 0.46% and 1.28% p.a., respectively. That’s quite substantial!
Robustness analysis
Let’s play around with some of the parameters here and see how they will impact the results. I will change one parameter at a time and leave the other parameters unchanged:
1: Lower the ESPP alpha to 2% p.a.:
If we lower the ESPP alpha to only 2% p.a., there’s still a role for participating in the plan. The unconstrained efficient frontier still wants to go to more than 10% into the ESPP. As expected, if you constrain the ESPP to no more than 10% of the portfolio you diminish the benefit relative to the 5% alpha case. But even at 2% alpha, this might still be worthwhile!
2: Lower the ESPP alpha to 1% p.a.:
With only 1% alpha p.a., we’re now getting pretty close to zero benefits. I’d probably pass on that opportunity.
3: Increase the stock beta to 1.1
I set the ESPP alpha back to 5% and now play around with the company stock market beta. The weighted index beta across all stocks in the index is 1.0, by definition. But it can vary quite a bit. Raising the beta 1.1 (thus, the stock moves, on average, 1.1% for every 1.0% the index moves) will not make a major difference in the results, see the table below. Especially the 10%-constrained portfolios are almost identical.
4: Set company stock vs. bond correlation to 0:
The overall index has a nice negative correlation with the bond market. If we set the correlation between your ESPP stock and the bond market to zero (less diversification with the bond market), will that invalidate the
Not really. The results are almost the same for the return/risk targets of 6%/15%. You had small bond allocation to begin with at that point, so playing around with the bond correlation should not change the results much.
5: Lower the Stock vs. Index correlation to 0.5:
Playing around with the company stock vs. index correlation is not going to change the results much either; see below:
Caveats
As always, here are a few caveats to keep in mind:
More correlations: In the Efficient Frontier diagrams, I only factor in the correlations within the financial asset portfolio. Keep in mind that your human capital, i.e., earnings potential is also highly correlated with your company stock, just ask the former employees of Enron. When I was still working in corporate America I had a not-so-generous ESPP, so I never participated all that much in the ESPP. Yeah, there was a small benefit from the plan but I decided to never plow much money into this because I didn’t want to compound my risk of working in one of the most volatile industries with very little job security! If the ESPP benefit gets too small you’d better pass on it!
Transaction costs: Selling your shares in the ESPP might be significantly more expensive than the average commission you’ve become accustomed to in your discount online broker account. I’ve seen t-costs of $20 per transaction. It will likely not wipe out the entire benefit of the ESPP, but keep the t-costs in mind when planning the exit strategy. It might mean you’ll have to hold on to your ESPP lots a little bit longer to sell larger lots less frequently.
Compounding taxes: When you sell your ESPP shares to move the money to your preferred low-cost equity index fund, you have to pay for the capital gains. From a tax-minimization perspective, it’s always best to defer capital gains as long as possible. So going the ESPP route violates this principle and you might have a small tax drag from this.
Conclusions
An ESPP with a large enough discount will justify participation, despite the likely much higher risk in the individual stock. The results seem to be pretty robust even when playing around with the other stock parameters, like equity index beta, and correlations.
But the ESPP only makes sense until you reach the minimum holding period to reap the benefit of the discount! The individual stock without the return boost from the ESPP does not belong in your taxable portfolio! Too much uncompensated risk!
So it looks like the ESPP can be a good supplement to your taxable brokerage account. Instead of taking your net income and investing it in an (after-tax) index fund, first, funnel it through the ESPP and into the index fund after the minimum holding period. The 15% discount, probably 10% or more after taxes for most folks, is a nice boost for your retirement savings outside of your tax-advantaged accounts.
Talking about retirement accounts, one additional question I couldn’t tackle here today is whether the ESPP is actually so attractive that it beats your 401(k) contributions after maxing out the company match. That’s a topic for another post, hopefully, next week. So, stay tuned!
Hope you enjoyed today’s post! Looking forward to your comments and suggestions below!
Title Picture Credit: pixabay.com