All Your Eggs In One Basket?
29 October 2007 Jason Butler APFS, CFP, IMC
Over the course of a career, a CEO can hold several company share options, prompting a need for a financial strategy. Jason Butler from Bloomsbury Financial Planning explains to CEO the best way to manage these funds.
Academic studies have shown that investors who hold individual equities are not compensated for the additional risks they are exposed to compared with investing in the stock market as a whole. Logic therefore dictates that one should avoid holding individual shares at all costs.
CEOs naturally need to have demonstrable faith in the company they lead, which inevitably means building up a significant shareholding in the employing company, whether through share incentives, options or bonus schemes. Many CEOs will work for several companies throughout their career, consequently amassing concentrated positions in those organisations. These holdings can be divided into two pots: current and historic.
Current shares relate to holdings in the company for which the CEO is working today. In a way these are the least risky individual shares to hold, because no one knows a company like the CEO. That being said, how many times has a well run and profitable company seen its shares underperform the market due to negative sentiment or reduced market liquidity?
Historic shares relate to holdings in companies for which the CEO no longer works. These are potentially even more risky because the CEO no longer has intimate knowledge of the company and its business, even if he or she maintains contacts at the company.
For this reason the CEO should look to divest him or herself of shares in historic companies as soon as is practicable. Notwithstanding the investment case for doing so, the CEO is not constrained by the listing rules governing the terms of personal dealing.
Given that few managers consistently beat the market, after costs and risks are taken into account, the CEO should, assuming that continued equity exposure is appropriate, re-invest the proceeds into a diversified portfolio of low-cost index funds which give broad exposure to all the main asset classes, including the stock market as a whole.
Taxation, however, is an added complication in relation to shares arising from incentives, options or approved share schemes. Depending on the basis the shares were purchased or awarded they will be subject to either income or capital gains tax treatment. It is beyond the scope of this article to give a detailed commentary on the tax aspects of share schemes for senior executives, other than to say that in simple terms, shares acquired under a statutory scheme will generally be subject to capital gains tax, whereas those arising from a non-statutory scheme will generally be subject to income tax and National Insurance. There are several statutory share schemes and it is common for executives to be offered a combination of these, together with non-statutory scheme shares or options.
Where the disposal of shares is subject to income tax, earnings are usually qualified for pension purposes. This can be useful if other taxable income is below £460,000 (perhaps the CEO is in between jobs) and the value of existing pension benefits is below the lifetime limit of currently £1.6m. At present tax relief is given on pension contributions at the investor’s highest rate, thus negating any income tax arising on the share disposal.
Where the disposal of shares is subject to capital gains tax, and assuming the company is listed, it will usually qualify for business asset taper relief if the individual is also an employee of the company. This means that after two years only 25% of the gain would be subject to tax, an effective rate of 10%. However, recent changes in capital gains tax mean that from 6 April 2008 the tax would rise to 18% regardless of how long the asset had been held. It would seem that disposal before the rules change would be advisable.
Where the disposal of shares in a listed company, which are subject to capital gains tax, arises when the individual is no longer an employee, then the gain will be subject to apportionment between the much more generous business asset and non-business asset taper relief.
Depending on how long the shares have been held as a non-business asset, the overall tax will rise. From April 2008, and the application of the new single flat rate of 18%, it is likely that the majority of individuals in this situation will be worse off. Clearly an analysis of the current tax treatment would be advisable.
Although tax is an important consideration, it should not be the primary factor when making investment decisions. The most tax efficient investment is one which produces no dividends and only capital losses. Notwithstanding the possibly complex tax treatment, our experience is that some CEOs find it hard to dispose of shares in companies in which they have worked, particularly where they still have strong links with the organisation or where the share price has been higher than the current price.
If it isn't a good time to dispose of the shares, perhaps because of a possible price-rise, it is still possible to trigger the current favourable capital gains tax treatment by selling the shares to a pension scheme. As long as there are sufficient funds in the pension, or new contributions could be made to provide such funds (for which tax relief will also be given at one's highest rate), the scheme can buy the shares providing it has the option to 'self-invest'. Then, when the price reaches the target level, the shares could be sold and re-invested into a fully diversified portfolio.
With changes to capital gains tax on the horizon, now is a good time to review those collections of share holdings with a view to diversifying into a proper investment portfolio and avoid having all one’s investment eggs in one basket.