Having just come out of my first complete Employee Share Purchase Plan (ESPP)1 “cycle,” I’m somewhat disappointed at how naive I was going in.2 I was so excitemented to buy into a very profitable, guaranteed investment, that I failed to analyze the steps in detail. Doing so would have helped me have more realistic expectations, as well as allowed me to maximize my profit. Hopefully this will help others in my position fifteen months ago make more informed investment decisions.3
At first glance, my company’s ESPP seemed almost too good to be true. The high-level process goes like this:
- Near the end of the preceding year, commit to participate and select an initial contribution amount ranging from 1%-25% of your income.
- Adjust your contribution level as desired throughout the year.
- Contributions cutoff when the total amount contributed reaches a set maximum (e.g., $6,827 in my case in 2008).
- The financial institution buys company stock with the contributed money at a 15% discount from the current share price or the share price at the beginning of the year, whichever is lower.
As far as I could tell, if I sold the stock right after it was purchase, I would walk away with at least a 15% return on my investment – greatly exceeding any guaranteed return investments (perhap all of the non-guaranteed ones, too). Sure, there could be some variation between the time the stock is purchased and the time my sale goes through, but it would likely be minor.
A good start
Everything proceeded according to plan through step 3. I enrolled, set my contribution level and adjusted it as needed – all through an easy online interface. I didn’t even have to worry about the maximum value, as my contributions were automatically suspended once I reached it.
The first wrinkle
Starting from the stock purchase, however, I began to notice wrinkles in the process – or in my understanding of the process, at least. A few days into the new year I went online to sell my stock and reap the 15% profit. Oddly, however, I saw there was still a good amount of money leftover in the ESPP fund (i.e., money that wasn’t used to buy stock). $2,377.20 – or almost 35% – to be exact.
Needless to say, I was disappointed. I didn’t want to make 15% on 65% of what I invested and 0% on the rest. That’s less than a 10% net return overall. Yes, it’s better than any other guaranteed investement I know of, but still.
I investigated despite my disenchantment and found the dollar amount isn’t the only investment limitation in my company’s ESPP; there’s also a share limit. In this case, the limit was 95 – and it apparently took only 65% of the dollar maximum buy 95 shares.
(As an aside, I have a difficult time understanding these limitations. Would something go horribly wrong if employees were allowed to invest (even ten times) more? And why the extra limitation (i.e., the share limit) when prices go down? Wouldn’t the company want more investment when prices are on the decline?)
Another thing I didn’t expect was how long the whole process would take. I intended to sell the stock (at full price) “as soon as” I bought it (at a discounted price), but it apprently takes a couple of days for the transactions to “clear.” When it was all said and done, six days passed from the time the company bought the shares to the time the sale finalized.
I must admit I contributed to that delay some. I entered a lower limit on my order, and it took the stock about a day to surpass the limit and trigger the sale. Share transactions weren’t the only delays, however. It also took about six days for the leftover money in my ESPP account to be transferred to my “core” (or individual) account – i.e., to work its way out of the system to where I could use it.
And then, when I thought everything was settled, my withdraw attempt was thwarted by a delay of “7-10 business days” to confirm my bank account details. (Granted, I could have set this up ahead of time. I also won’t have this delay in the future since the account link will already be setup.)
Taxes and fees
Of course, my company isn’t the only entity wishing to limit my profit; the financial agency and the government both want in on the action, too. Fidelity charged a fee to perform the stock share, and then the government took slices for federal income tax, medicare and social security:
|Fidelity sale fee||$10.95|
|Federal Income Tax||$196.41|
|Social Security Tax||$48.71|
Here’s one way at looking at the overall cash flow:
|($4,449.80)||$2,377.20||95 share purchase|
|$5,224.97||$7,602.17||95 share sale|
|($10.95)||$7,591.22||Fidelity fee for sale|
|($196.41)||$7,394.81||federal income tax|
|($48.71)||$7,346.10||social security tax|
Subtracting off the initial investment leaves a $507.71 net profit, which corresponds to a (
$507.71 / $6827 =) 7.4% net return – just under half of what I naively expected. Of course, some other investments would be charged at the same tax rates, so it’s worth knowing the return before taxes: (
$764.22 / $6827 =) 11.2%.
Even without changes in my company’s ESPP plan (or the country’s tax schedules), there are still some things I could do next time to increase my return.
The shorter my money sits in the ESPP account before the stock purchase, the better. The regulations state I must contribute between 1% and 25% of my paycheck throughout the year in order to participate, but contributions can still be delayed within this rubric.
For example, if my paycheck is $5,000 each month and the maximum yearly ESPP contribution is $7,500, a “fully delayed” contribution schedule would be as follows:
|Month||Contribution %||Contribution $||Total Contribution|
The schedule should always end up being a certain number of months at 1%, one month at an intermediate level, and then the remainder of the year at 25%. Of course, your salary could change mid-year, which would throw everything off. Also, if your company limit is high enough (or your salary low enough), you might pay 25% the whole time and not reach the maximum. On the flip side, if your company limit is low enough (or your salary high enough), you might reach the maximum without ever having to contribute 25% (or even above 1%).
Using the current share price and my investment balance, I can always calculate how many shares I could afford right then. If that number starts getting close to my limit, then it may be a good idea to drop my contribution rate back down to 1%. I might not reach the maximum contribution level, but if the money isn’t going to be used to buy stock, it’s better off somewhere else (where it will earn interest).
I have to be careful here, though, as it would be possible to paint myself into a corner – particularly if I was employing the delayed contribution schedule I described above. If the share price jumps high enough at the end of the year, I may not be able to get enough funds invested to buy a full 95 shares due to the 25% limit. It’s probably wise, then, to keep a buffer. For example, if the share limit was 100, the share price had been sitting at around $50 for nine months, and I already had contributed $6,000, I would feel comfortable dropping my contribution level down to the minimum. After all, the share price would have to jump more than $10 for me not to get the maximum investment – something greatly inconsistent with the price behavior so far that year.
Despite all of the unexpected twists and missed opportunities, the ESPP still turned out to be the best place to put my cash – given I was looking for a guaranteed return over one year. I didn’t see any CDs or high interest online savings accounts in 2008 that surpassed 4% APY,4 and the highest rate I was paying on an a debt was 5.00% on my mortgage. These couldn’t hold a candle to the 11.2% and 7.4% returns (respectively) on the ESPP.5
2 Hansen, Brandon. “Stock Purchase Plans vs Extra Mortgage Payments.” OmniNerd_, 28 August 2007. Accessed January 2009 from [http://www.omninerd.com/articles/Stock_Purchase_Plans_vs_Extra_Mortgage_PaymentsPayments]. Thanks to OmniNerd, my nativity is recorded for the world to see!
3 I’m not a professional consultant or anything of the sort. If you happen to lose money following my advice, I will sue you. So now we’re even.
5 The savings account return is taxable, so it should be compared to the pre-tax ESPP return (11.2%). Avoiding mortgage interest, on the other hand, is not taxable, so it is compared to the after-tax ESPP return (7.4%). The mortgage interest comparison is even a little more complicated than that, as mortgage interest sometimes qualifies as a tax writeoff. Thus, although making extra payments on your home allows you to pay much less interest in the long run, you also pay less interest in the short term. Granted, the change is likely to be small, but it’s possible that slight writeoff reduction it could slip you into a higher tax bracket.
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