Going forward, restricted stock won't be quite so restricted
anymore.
Microsoft Corp.'s decision to stop issuing its employees stock options -- and instead give them
restricted stock -- could be a defining moment in how millions of Americans
are compensated.
The move casts a spotlight on restricted stock, a form of pay that until
now has been used chiefly to reward only top executives. But stock options
are under attack in the postbubble era, and many employers are looking for
other ways to reward workers. Even before Microsoft's move, other companies
were exploring similar changes, and a number could soon follow suit.
DaimlerChrysler AG recently said
it is looking into alternatives to stock options as a means of compensating
executives.
Just as stock options were emblematic of the outsize gains of the 1990s,
the movement toward restricted stock partly reflects expectations for more
modest market returns down the road. The "restricted" in restricted stock
refers to the fact that employees can't sell the shares until a certain
amount of time passes, often three or four years, and that employees may
have to forfeit the shares if they leave. Unless a company becomes
insolvent, restricted stock usually retains some value. But the upside
isn't as lucrative, either. Employees generally get fewer shares, and thus
will make less money if the company's stock price soars.
Still, with stocks unlikely to duplicate their 1990s magic, employees
"are much better off with restricted stock," says Matt Ward, chief
executive officer of WestWard Pay Strategies, a compensation consulting
firm in San Francisco. "It's much less risky."
Here's a look at how restricted stock works and what it's likely to mean
for your pocketbook:
What is restricted stock?
The term refers to shares issued to employees that can be sold only in
the future. Typically, employees forfeit their shares if they leave the
company before the stock vests. At some companies, an employee forfeits the
shares if certain financial targets aren't met.
Microsoft is using a mix of both approaches. The software maker's top
600 employees will receive a variant of restricted stock that is tied to
the company's performance. Rank-and-file employees, on the other hand, will
receive grants tied to how long they remain with the company.
If my employer switches from stock options to restricted stock,
will I receive the same number of shares?
Not likely. There is no set standard, but companies typically provide
one share of restricted stock in place of three or four stock options.
Because restricted stock consists of actual shares, rather than the right
to buy future ones, and thus is less risky, employers nearly always give
workers fewer shares than they would if they were granting stock
options.
If I get restricted stock, how long before I can sell my
shares?
You can't sell them until they vest. The most common arrangement is for
a portion of the shares to vest each year for three or four years. At
Microsoft, one-fifth of the shares will vest each year for five years. Once
the shares vest, you can hold them indefinitely.
How is restricted stock different from stock options?
With restricted stock, you receive actual shares of stock. You also
typically receive any dividend payments from those shares, even before the
stock has vested. That means employees will get a regular check each
quarter with dividend income.
Stock options, on the other hand, give you the right to buy a set number
of shares at a preset price at some point in the future. The exercise price
of the options is generally the stock's price at the date of issue. If the
share price drops below the exercise price, stock options have no current
value.
Restricted stock can put money in your pocket even if share prices fall.
Say, for instance, you were given 1,000 shares of restricted stock at $20 a
share. If the stock price falls to $15 after four years, you still have
1,000 shares valued at $15,000.
If I don't receive restricted stock today, am I likely to get it in
the future?
More than 60% of companies surveyed by Mercer Human Resource Consulting
in April said they were either introducing restricted stock or expanding
their use of it.
But fewer employees are likely to get restricted stock than got stock
options, which made millionaires of everyone from top executives to
secretaries at companies such as Microsoft when stock prices were soaring.
"The typical company went down [the pay scale to employees earning]
$60,000" when issuing stock options, says Ira Kay, head of the
compensation-consulting practice at Watson Wyatt Worldwide. "With
restricted stock, it might go down to people who earn $80,000 or
$100,000."
How is restricted stock taxed?
Restricted stock generally isn't taxed until the stock vests. Then, the
value of the stock is treated as ordinary income. So, if you have $15,000
of restricted stock vesting this year, it is treated on your tax return as
if you earned that amount in additional salary. The price at the time of
the grant doesn't matter.
If these shares pay dividends, those payments are taxed as ordinary
income until the shares vest. After that, they usually qualify for the 15%
dividend tax rate in the new tax law. If you hold your shares after
vesting, any increase in price will be taxed as capital gains when you
sell.
There is another option, however, that slices your tax bill in certain
circumstances. Under Internal Revenue Service rules, you can elect to pay
the tax at the time the shares are issued instead of when they vest. Any
increase in the stock's value is then generally taxed at the lower
capital-gains rate.
But you have to make this so-called 83(b) election within 30 days of the
time you receive the shares. "If you really think there's substantial
upside potential and you are comfortable you are going to vest, then it
might make sense," says Martin Nissenbaum, national director of personal
income-tax planning at Ernst & Young LLP.
There are also significant drawbacks with that approach. You'll have to
come up with cash to pay the taxes even though you can't sell the shares to
cover your tax bill. Worse yet, if you forfeit the stock, say, you change
jobs, you can't get a refund. The result? You'll have paid the IRS for
income you never received.
Is restricted stock a better deal for employees than stock
options?
That depends. The big plus with restricted stock is that it still has
value even if the company's share price falls. By contrast, roughly half of
all outstanding stock options were underwater at the end of 2002, according
to a study by Brian Hall of Harvard Business School and Thomas Knox of the
University of Chicago. While more options are in the money today, even in
bull markets roughly one-third of options are underwater, the study
found.
But the upside isn't nearly as lucrative as with stock options. Let's
say, for instance, you get 3,000 shares of restricted stock valued at $20 a
share. If the price rises to $50 over five years, those shares would be
valued at $150,000. Suppose, on the other hand, you receive 10,000 stock
options with an exercise price of $20. When the stock reaches $50, the
options will be valued at $300,000.
Is restricted stock a pay cut in disguise?
It could be. Because awards of restricted stock are booked by companies
as a charge to earnings, employers have an incentive to issue fewer of
them. Stock options traditionally haven't been recognized as an expense,
though some companies are beginning to do so.
Bottom line: Companies are probably going to be handing out less equity
compensation, whether it comes in the form of options or restricted stock.
"There is going to be a trend toward smaller grants and smaller
participation," says Mr. Kay of Watson Wyatt. "We are already seeing some
evidence of that."
