ESPP Power: Market Turbulence Of 2020 Showcases The Unique Benefits Of Employee Stock Purchase Plans
07 July 2020
Despite the torrent of market turbulence and volatile stock prices, many participants in employee stock purchase plans (ESPPs) have seen good returns in 2020. In fact, the stock-price volatility of 2020 provides a great example of why ESPPs are such a good deal. According to data from Fidelity Investments, employees with purchases in tax-qualified Section 423 ESPPs at the stock-price lows in March and April saw gains of over 40% by mid-June, after the market rebound. Read on for this rare good-news story of the current economic cycle.
Unique Benefits Of ESPPs
While there are various kinds of ESPPs, the most common type is known as a Section 423 plan, named after the part of the tax code that provides rules for it and the favorable taxation of the purchase discount. ESPPs with a purchase discount function a lot like stock options: employees get to buy company stock at less than the stock's market price. The features of these ESPPs include:
- after-tax contribution from your pay
- a set offering period when payroll deductions occur
- set purchase dates that use the accumulated deductions
- typically a discount on the stock-purchase price
With stock options, the exercise (purchase) price is the market price at the time of grant regardless of whether the stock price has fallen or risen since grant. Options can therefore be "underwater" if the exercise price is higher than the current stock price. By contrast, ESPP participation can never be underwater, as any discount comes off whatever the stock price is.
In fact, ESPPs with a discount and a lookback provision can even be a good deal even in a down market because you get the discount off either the start-date price or the purchase-date price, whichever is lower. Even if you do not have a lookback, you still get a discount off the market price on the purchase date.
Example: Your company uses a 15% discount with a six-month lookback.
- The offering date price is $10.
- The stock market price on the purchase date is $8.
- Your purchase price is $6.80 (85% of $8, not 85% of 10).
- In the price-drop example, your initial gain is 17.64% ($1.20 spread at purchase divided by $6.80 purchase price), before any change in the stock price after purchase
Data Shows Big Gains For Employees With Purchases In Down Markets
If the stock price then bounces back up after the purchase, ESPP participation can become very profitable. According to data from Fidelity Investments, employees at companies with ESPP purchases during the stock-price lows of March and April experienced meaningful gains of over 40% in the market rebound as of mid-June.
Of the Section 423 ESPPs that Fidelity Stock Plan Services manages for companies of varying sizes and industries, 48% of them had purchase dates for employees in March or April 2020, during the big stock-market decline. Fidelity looked at Section 423 plans with a 15% purchase price discount, both with or without a lookback, and quarterly or semiannual purchases that occurred in those months (i.e. purchase date every 3 or 6 months during the ESPP offering).
Fidelity found that, of those with lookback features, 32% of the companies used the offering-date stock price for the purchase-price calculation (i.e. stock price was still higher on purchase date), while 68% used for the calculation the lower price on the purchase date. Return on investment (ROI) for these employees in Section 423 ESPPs:
- All but two companies had positive ROI for employees as of June 17. At three companies, the price declined from the purchase-date stock price but positive ROI was still generated for employees based on discounted purchase price.
- At almost 96% of the companies, the positive ROI for employees in the ESPPs spans from 10%+ to 100%+ as of June 17 for those that held their companies’ shares.
With most ESPPs, you can withdraw from an offering or decrease your salary contribution percentage. Once the impact of Covid-19 hit the economy, it may have been tempting for employees to pull out of their ESPPs and use the money for immediate needs. However, Fidelity's data shows the wisdom of sticking with your ESPP, which can be an effective and disciplined form of investing at regular intervals, similar to dollar-cost averaging.
"Democratizing" Wealth Accumulation
For Emily Cervino, Head of Thought Leadership at Fidelity Stock Plan Services, Fidelity's 2020 ESPP data tells a very encouraging story about the significant wealth-building potential ESPPs present for employees at all levels. ESPPs can provide employees with some insulation from stock-market volatility when they have certain design features, she explained to me. “Thanks to the ESPP discounts and the market recovery, most of our [plan] participants have had impressive gains in their March and April purchases,” she added. “For many companies, the ESPP has been a bright spot in an otherwise difficult time.”
Another special aspect of ESPPs is that eligibility is usually companywide for employees at all levels. By contrast, at many public companies stock options and restricted stock units are granted only to certain employees and executives. Under the IRS rules for Section 423 ESPP plans, companies can exclude workers only for very specific reasons, such as being employed for less than two years. With broad-based participation, ESPPs can thus perhaps even play a small rule in reducing income inequality, including the racial wealth gap.
In Emily's words, ESPPs can therefore play a role in "democratizing wealth accumulation." These plans are not about executive compensation, she emphasized, as ESPPs provide the same financial benefit “from the very top to the very bottom of the organization.” Plus, as the coronavirus pandemic reveals the wisdom of stockpiling emergency savings, it is crucial to note that ESPPs can help employees build savings faster—whether by selling the shares to bank the cash proceeds or holding shares that keep going up in price.
Webinar: Financial Planning For Equity Comp During The Pandemic
The impacts of Covid-19 have been a wild ride. After a steep swings in the markets, financial planning continues to be tested by ongoing volatility, economic uncertainty, corporate layoffs, and indefinite employment furloughs. It is more important than ever for financial advisors to re-evaluate planning approaches.
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