This blog post is from Jeffrey Thomas, a Dallas-based financial advisor with Raymond James Financial Services.
Imagine Bob and Mary, a married couple in their 50s. Mary is a long time stay-at-home mom to their two children, now teenagers. Bob is a senior executive for a major public company, with a significant amount of net worth tied up in stock options and company stock. The couple has other substantial assets, including a very nice home, substantial 401(k) and other company benefits, nice automobiles, and country club membership.
Last month, the couple decided to get divorced. A quick review of their financial holdings would suggest that that Mary will end up with a substantial interest in the non-ERISA company stock holdings and other equity-oriented positions. The parties begin discussing how to divide their assets over the course of the next few months, but no adjustments to the holdings is made to protect against an unexpected event. The company for which Bob works unexpectedly takes a downturn and in two months time, one half of his net worth is wiped out. Even though the company dividends are not guaranteed, the previously very healthy dividend has been eliminated. The parties suddenly have to re-adjust their negotiations.
This isn’t an unusual scenario, yet there are many folks out there like Bob and Mary, who failed to consider the risks to their wealth as a result of the change in the family dynamic. Ignoring possible portfolio preservation opportunities can cause adverse family wealth consequences, which can prolong negotiations and increase the costs to the parties.
Individuals face many constraints in addressing the risks of equity holdings – especially concentrated stock positions. Taxes, contractual limitations, legal requirements, employer mandates and a variety of psychological barriers all complicate the process. In addition to long-term careers with one company, an individual may have a concentrated equity position because:
(1) there has been a generational ownership within a family;
(2) a prior sale of a company for stock in different public company; or
(3) The individual has a buy-and-hold mentality in a stock that appreciated above expectations.
People may not want to sell their positions as a way to maintain a portfolio, because they have an aversion to paying capital gains taxes. Additionally, the employee/owner of the stock may have a robust knowledge of the company fundamentals that leads to him/her having confidence in positive future performance. In our example above, Bob’s employer had been paying a very healthy (and seemingly “safe”) dividend, and giving that up may reduce the income stream available to a shareholder. Also, many senior employees would prefer to avoid regulatory filing and disclosure requirements when selling their employer’s publically owned stock.
A fundamental premise to sound financial planning is that people save money to fund a future liability: namely, retirement. The longer an individual waits before drawing down on a portfolio for financial support, the more risk he or she may assume.
Immediately, upon reaching the decision to get divorced, Bob and Mary’s investment purpose in the couple’s portfolio became an individual purpose and not a joint purpose. Bob would continue to have a salary from his employer to support him for many years. His time frame for long term investing was not impacted. Mary suddenly had a vastly different interest in the portfolio and had an immediate need for preserving the principle and generating income. Her time frame for using the portfolio to support her lifestyle became different than Bob’s. This difference needs to be considered when negotiations commence in a divorce or collaborative law marital separation.
Broadly diversified equity portfolios are subject to sudden and large negative movements. Recent examples of macro risks include: Global Credit Crisis; Real Estate Bubble; Technology/Telecom Crash; Terrorism; Sovereign Debt Risk; etc. The Dow Jones Industrial Average (an unmanaged index of 30 actively traded stocks) declined over 50% in less than 6 months at the end of 2008 thru the first 3 months of 2009.
The more concentrated the equity component, the riskier it becomes to fail to make modifications. The average long term return for the broad U.S. equity market is approximately 10%, with a potential one year decline of 22% and a potential upside of 42% within a 95% confidence level.
However, a single stock may experience a much wider distribution of returns in any given year. A decline of 90%, or an upside price appreciation of 110% within the same 95% confidence level may be experienced in any given year with any single stock. When preserving wealth and generating income becomes a priority, an investor needs to seriously consider the impact on how a 90% decline in stock value will impact their livelihood.
Once one of the parties acknowledges that the risk associated with maintaining the existing portfolio is inconsistent with his/her new investment objectives, deciding on an acceptable modification becomes his or her next decision.
Note: Space and regulatory limitations prohibit presenting the potential solutions to the parties’ dilemma here. To read the full article, including solutions, please request it be mailed to you by the author, at the website linked in his bio info at the top of this page.