Convincing clients to let go of huge holdings

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A time-honored idiom warns against putting all your eggs in one basket, and the reason is evident to every adviser: such a portfolio is vulnerable to being cracked or broken if a single stock slips.

Even the heartbreaking stories of investors who lost most of their wealth after Enron and Lehman Brothers collapsed can’t convince some clients to sell.
“Without question, clients with concentrated portfolios underestimate the risks of owning a large position in one stock,” says Paul Bennett, a managing director of United Capital, a financial life management firm in Great Falls, Virginia. “Clients should consider diversifying away from any position that goes north of 5% to 10% of their overall portfolio.”

How can advisers raise awareness of the possible perils? One approach is to use scare tactics. “When discussing the downside risk of a concentrated position,” says Lucas Bucl, a principal at KHC Wealth Management in Overland Park, Kansas, “we often will cite examples where a large loss of value has occurred with another stock. Some common ones are Enron, WorldCom, Sprint, AIG, Lehman Brothers or Chipotle.”

“Clients should consider diversifying away from any position that goes north of 5% to 10% of their overall portfolio,” says Paul Bennett of United Capital.

Large concentrated positions can occur if a client accumulates shares of the publicly held firm for which he or she works. Bennett notes that company stock holdings may result from stock options, performance shares, restricted stock units or participation in an employee stock purchase plan. “There could be an allocation to company shares within a 401(k) or deferred compensation plan,” he adds.
“In all of these cases, overconfidence bias can occur: clients feel they have a knowledge advantage because they work for the company,” Bennett says.” Unfortunately, this is usually not the case. The lack of diversification can (and often does) wreak havoc on retirement planning.”

Other sources of concentrated portfolios can lead to what Bennett terms endowment bias. “A client may have inherited a large position in one company from a parent or other relative who had diligently invested for decades,” he says. “These clients may not want to sell the stock because they believe that would be going against the wishes of their benefactor. Even thinking about selling stock that Uncle Bill willed to them can produce feelings of guilt.”

To overcome such insistence on standing pat, planners can point out the dangers. “What I’ve found to be most effective,” Bennett says, “is providing examples of other (unnamed) clients who did not diversify and were forced to modify their retirement planning. That meant working longer, having a lower income or other trade-offs.”

Another option, Bennett goes on, “is to dynamically show clients what-if scenarios on the screen. The client provides forecast numbers (good and bad) for the price of the concentrated position to see how volatility impacts their overall planning. This exercise can be a reality check for many.”

Persuading the client that a concentrated position is risky may be only part of the adviser’s task. They may feel their career success is linked to holding their centerpiece securities.

“Many of our executive clients have explicit or implicit holding requirements for company stock, which can be an impediment to managing the overall exposure,” Bucl says. “Often, these clients must get management approval to sell positions. A request to sell can be seen in a negative light, implying that the person selling may not be 100% behind management’s initiatives. We prepare our clients for these sometimes uncomfortable conversations by helping them explain the strategy and reasoning for wanting to reduce their stock position.”

“Many of our executive clients have explicit or implicit holding requirements for company stock, which can be an impediment to managing the overall exposure,” says Lucas Bucl of KHC Wealth Management.

As Bucl explains, the process for selling company shares may involve a formal request, which goes through the firm’s HR department to the company’s general counsel or even to the CFO for approval or denial. “For example,” he says, “I have a client who is an executive at a public company. There are no specific holding requirements for him, but the corporate culture looks down upon selling its stock. It wasn’t until the stock had moved up and a few key executives sold some shares before my client was even willing to entertain the idea of requesting permission to sell.” The executive was still very reluctant to raise the subject, as he was up for a promotion.

“We helped him focus on some important goals that he planned to fund with the stock sale proceeds,” Bucl says. “The money would be used primarily for college costs and cleaning up debt. We coached him so that he could explain how the proceeds would be used in his financial plan, when he was asked by a superior. As a result, he got the green light to sell the stock and still received the promotion a few months later.”

If the client (and perhaps the employer) agrees, planners can initiate tactics to move money from the single stock position. “In most cases, selling periodically or making charitable donations make the most sense,” says Adam Fuller, a principal at Homrich Berg, a wealth management firm in Atlanta. Selling appreciated shares in a taxable account may generate tax bills, but the low tax rates on long-term gains and the possibility of offsetting capital losses may keep that pain manageable.
Donating appreciated shares will avoid taxes. “Low-basis concentrated stock is a wonderful asset to use to fund charitable gifts,” Fuller says. “In the right situation, using a large gift to a donor-advised fund or a private foundation to create a pool for future gifts can be an excellent strategy if the client is charitably inclined. It is amazing how many clients are surprised when we explain this option; as planners we often forget that what is common knowledge to us is a great insight to families.”

After learning of the benefits, many clients with concentrated positions start donating stock instead of cash, according to Fuller. “One client, for example, has a very high annual income and tithes seriously,” he says, “resulting in substantial annual donations to his church. He had no idea that he could donate stock instead of cash; he was sitting on some legacy stock positions from his old employer that he did not want to sell due to taxes. Those shares could be used to fund the DAF.”

Fuller adds that one way to deal with concentrated positions is to remind clients that acquiring wealth and preserving or maintaining wealth are two different skill sets.

UBS financial advisor Eric Bickler, who ranks number 27 on On Wall Street’s list, has built a successful practice serving current and former corporate executives.
January 14
1 Min Read

“We stress the idea that acquiring significant wealth is often the result of concentrating effort in a single firm,” he says. “Preserving that wealth is an equally important but different task. As we tell those clients, you won the race by being concentrated, but you keep the trophy by being diversified. There is no reason to keep using a high risk strategy of a large concentrated position once you have already won.”

Reducing the risk in a client’s concentrated portfolio can go beyond selling shares or donating them to charity. In selected situations, other methods may be useful:

•Exchange funds. The client contributes shares from the concentrated position in return for a portion of a diversified stock portfolio. “We have recommended exchange funds in cases when a client didn’t have a charitable intent, wanted to diversify, but didn’t want to incur taxes now,” says Adam Fuller of Homrich Berg in Atlanta. “After being in the fund for seven years, this client receives a proportional distribution of the stocks in the fund.”

The key here is how well the shares in the fund perform. “Stocks that sounded good seven years ago, when the exchange fund was built, might not be so good today,” Fuller says.

•Protective option collars. The client purchases a put option on the stock in the concentrated position, limiting the downside risk, and sells a call option to help fund the hedge. “This strategy is generally more effective for shorter periods of time,” says Lucas Bucl at KHC Wealth Management in Overland Park, Kansas, “rather than a permanent risk management strategy.”

•Prepaid variable share forwards. The client enters into a contract to sell a variable number of shares in the future in exchange for cash today, typically 70% to 90% of the current value. “This diversification strategy defers taxes and establishes a floor (and ceiling) on the stock price,” Fuller says. “We have not had a client establish a variable forward in a number of years due to the high cost and uncertainty over tax regulations.” According to Fuller, the investment minimums for such strategies may be $500,000 and up.

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