G. A. Finch queries Jason D. Garcia, a vice president in the Wealth Strategies Group of Northern Trust based in Chicago.
FINCH: Jason, first of all, I want to thank you for coming in and telling me and my partners and my associates about all the interesting things you and your company are doing. I know the readers of Your Executive Life Blog would also benefit from hearing about some of the things you and your company do. Your title is “Wealth Strategist.” We all know what wealth is and what strategy means. How does that translate as a job description and function for you?
GARCIA: Thank you G.A. The role of the Wealth Strategist at the Northern Trust Company is part business development and part relationship management. We are charged with the responsibility of identifying prospective new clients for the bank, in the arena of investment management, commercial and personal banking, trust administration, philanthropic & legacy planning and comprehensive financial planning.
The Wealth Strategist will engage a prospective client in a holistic wealth management conversation, identifying the needs important to that individual or family—and then bring to bear the top intellectual capital from the bank to meet those needs, (i.e., portfolio managers, trust administrators, financial planners, private bankers, etc.).
The Wealth Strategist will also act as the client’s Relationship Manager or central contact as the client gets acclimated with their new team, ensuring that all of the client’s needs are met. That, in a nutshell, is the role of the Wealth Strategist.
FINCH: You have briefed me about Northern Trust’s Executive Officer Initiative by which you provide information to executives on ways to preserve and maximize their compensation, benefits, and investments. Tell us about concentrated stock position strategies.
GARCIA: One of the concerns that Executive Officers have, from a number of different sectors and industries, is their exposure to risk, per the concentration of company stock they accumulate throughout the course of their careers. Due to some rules and regulations, they are limited as to the action they may take with their stock throughout their tenure at the company. As they prepare for retirement, there are also tax and dividend income replacement concerns that they will face as they endeavor to unwind their concentrated positions.
The Northern Trust presents tools and solutions such as Net Unrealized Appreciation, 10b5-1 Strategies, Tax Advantage Equity and Zero Premium Collars to help remedy some of these issues.
FINCH: What should an executive know about zero premium collars?
GARCIA: The Zero Premium Collar is for the individual that has a large quantity of a single stock. The individual does not want to sell the position but he or she would like to minimize the downside risk, without any cash outlay. A zero premium collar is essentially a contract between one individual and a counterparty (typically a broker-dealer) that established both a “floor” and a “ceiling” price on the individual’s stock. The contract guarantees that the value of the stock will remain somewhere in between that “floor” and “ceiling” price.
The mechanics of the zero premium collar may be further explained as follows. You would purchase a put option—which gives you the right to sell the stock at a certain “floor” price. This effectively limits the amount of money you can lose, establishing the “floor” price, otherwise known as the “put strike price.” You can offset the cost of the put option by selling a call option, which gives the counterparty the right to buy your stock at a “ceiling” price. So, your potential upside gain for your stock would be limited to this “ceiling” price, otherwise known as the “call strike price.” Since you buy and sell the put and call contracts simultaneously, there is no premium to be paid.
Zero premium collars generally involve European-style options, which means the counterparty cannot exercise the options before the contract matures. However, you can terminate the contract at your discretion. We can help you determine the most appropriate “floor” and “ceiling” targets based on the volatility of the stock.
The bottom-line benefits of using a zero premium collar are:
- You limit your downside risk;
- You maintain market value appreciation up to a certain level;
- You are not required to make an initial cash outlay;
- You retain your voting rights during the contract term;
- Your taxes are deferred until the contract is settled;
- You can borrow against the position
Consulting with your financial planner and tax advisor is the best course to determine whether or not a zero-premium collar strategy is best for you. At the Northern Trust, we execute these reviews often.
FINCH: What about Net Unrealized Appreciation?
GARCIA: Net Unrealized Appreciation or NUA is another useful financial tool. If you participate in a 401(k), ESOP, or other qualified retirement plan that lets you invest in your employer’s stock, you need to know about net unrealized appreciation–a simple tax deferral opportunity with an unfortunate complicated name.
When you receive a distribution from your employer’s retirement plan, the distribution is generally taxable to you at ordinary income tax rates. A common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA. However, when you ultimately receive distributions from the IRA, they’ll also be taxed at ordinary income tax rates. But if your distribution includes employer stock (or other employer securities), you may have another option. That is, you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA). You won’t be taxed on the NUA until you sell the stock. What’s more, the NUA will be taxed at long-term capital gains rates–typically much lower than ordinary income tax rates. This strategy can often result in significant tax savings.
So, the mechanics of NUA operate as follows:
A distribution of employer stock consists of two parts: (1) the cost basis (that is, the value of the
stock when it was contributed to, or purchased by, your plan) and (2) any increase in value over the
cost basis until the date the stock is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA.
For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA. How does the NUA tax strategy work?
At the time you receive a lump-sum distribution that includes employer stock, you’ll pay ordinary income tax only on the cost basis in the employer securities. You won’t pay any tax on the NUA until you sell the securities. At that time the NUA is taxed at long-term capital gain rates, no matter how long you’ve held the securities outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain, depending on how long you’ve held the stock outside the plan.
At the end of the day, the following are the advantages of electing NUA:
- Your distribution of NUA will be taxed at long-term capital gains rates, rather than ordinary income tax rates.
- Your distribution won’t be subject to the required minimum distribution rules that would apply if you rolled the distribution over to an IRA. You need never sell the stock if you don’t want to.
- The NUA portion of your distribution will never be subject to the 10% early distribution penalty tax.
Consulting with your financial planner and tax advisor is the best course to determine whether or not NUA is best for you. Again, at the Northern Trust, we execute these reviews often.
FINCH: Could you give our readers a primer on 10B5-1 strategy?
GARCIA: G.A., as you well know, determining the best time to purchase and sell stock to take full advantage of the market is never simple. Company blackout periods and insider trading restrictions can make it even more difficult for corporate executives to manage their liquidity and find an opportunity to increase (or reduce) their single-stock exposure.
By way of background, we know that insider / executives have historically experienced difficulty in trading their company stocks due to blackout periods established by their own companies. In October 2000, the SEC created 10b5-1, which dramatically expanded the time period during which such trading could occur. As long as an insider / executive established a trading plan while not in possession of material inside information, future trading can occur at any time, even during blackout periods.
A 10b5-1 trading plan allows for the purchase and sale of stock at a predetermined time and price. Once established, the plan remains in effect even during times when you are aware of material, nonpublic information that might have influenced your trading decision. It’s important to note that a properly executed 10b5-1 trading plan becomes a documented affirmative defense against allegations of insider trading.
It’s also important to note that company executives remain subject to legal compliance. So, establishing a 10b5-1 plan does not relieve them from compliance of their company’s insider trading policies. It is recommended that any corporate executive considering this trading plan engage legal counsel like your law firm, G. A. – as well as investment professionals experienced in 10b5-1 trading plans like my team at Northern Trust. Ultimately, the trading plan should also be approved by the executive’s company counsel.
FINCH: What can you tell us about tax advantaged equity?
GARCIA: We all know that taxes can significantly reduce investor returns. Indeed, taxes can represent the single largest cost of investing for taxable investors. Tax considerations are especially important for investors who:
- Have or are about to experience the sale of a business;
- Have or are about to sell a significant concentration of company stock or;
- Are tax sensitive.
Fortunately, portfolios can be effectively managed to preserve wealth through a tax advantaged equity (TAE) strategy.
The mechanics of TAE operate as follows. It combines an equity benchmark exposure with a proprietary active tax management process. Within a separately managed account, we approximate the risk and return characteristics of a particular benchmark, (e.g., S&P 500). We then proactively harvest losses in a manner customized to your individual tax and investment goals. This approach can help protect the returns obtained through a traditional active manager by:
- Realizing losses in specific securities that have decreased in value and
- Limiting the turnover in securities that have increased in value.
In addition to managing risk to meet client specifications, we also consider the impact of security sales and resulting tax implications that may affect the portfolio. This tax-efficient solution can be used alone or in combination with a core investing approach or other satellite strategies such as single-stock exposure management; active fixed income; and hedge fund, private equity or a manager-of-managers programs.
At the end of the day, employing an effective TAE strategy can field the following benefits:
- Provide pre-tax returns similar to a benchmark (minimizing tracking error);
- Deliver after-tax, value added returns through active management (particularly loss harvesting);
- Provide customized management in a separate account vehicle;
- Reflect specific stock or sector limits based on social screens or other concentrated positions.
FINCH: Do you have any other wealth strategy observations you would like to share with executives and professionals?
GARCIA: There are a plethora of strategies that one may employ, all based on time horizon, risk tolerance, income needs, philanthropic & legacy planning and overall estate planning. Wealth strategy solutions can be as unique as the individual client. The best course of action for any executive, professional or anyone who has questions as to what options are available to them—in the wealth management arena—is to meet with his current wealth advisor to explore ideas based on his needs. We at Northern Trust are certainly available to provide this kind of advice.
I appreciate your interviewing me on these wealth preservation and enhancement strategies.
LEGAL, INVESTMENT AND TAX NOTICE: THIS INFORMATION IS NOT INTENDED TO BE AND SHOULD NOT BE TREATED AS LEGAL ADVICE, INVESTMENT ADVICE OR TAX ADVICE. READERS, INCLUDING PROFESSIONALS, SHOULD UNDER NO CIRCUMSTANCES RELY UPON THIS INFORMATION AS A SUBSTITUTE FOR THEIR OWN RESEARCH OR FOR OBTAINING SPECIFIC LEGAL OR TAX ADVICE FROM THEIR OWN COUNSEL. THIS POST DOES NOT ESTABLISH AN ATTORNEY-CLIENT RELATIONSHIP AND DOES NOT CONSTITUTE AN ENDORSEMENT.