Employee stock purchase plans explained

[MUSIC PLAYING] It's like a savings account on steroids. I think these are hidden gems in a crowded benefit landscape. What is an ESPP? An ESPP is an Employee Stock Purchase Plan. I saw it as a really easy and quick way to start investing. So you're buying it on sale, basically. When I sit down with new employees and I'm explaining the ESPP, they're like, no way! And I'm like, way! Your future self will absolutely thank you. [MUSIC PLAYING] It can be a valuable employee benefit, but not all employees who have access are taking advantage. Today, we're talking all things ESPP. Hi, I'm Ally Donnelly, and this is Fidelity's Money Unscripted. So, how do ESPPs work? What are the questions to ask before you jump in? And let's take a look at the potential return on investment. Fidelity's Emily Cervino is here, and she helps companies and their employees with their stock plans. I'm so glad you're here, Emily. Welcome. Well, thank you, I'm super excited to be here. And we're going to get to why in just a second, but I want to start with the basics. What is an ESPP? Well, we'll start with spelling that out. An ESPP is an Employee Stock Purchase Plan. And these are plans that are available to employees that allow them to purchase company stock, usually on favorable terms, usually on a discount, using payroll deductions. OK, so if my company offers an ESPP, why might I want to take advantage? Well, these plans are designed to deliver value to the employees. How so? So most plans offer a discount, and the discount is usually 15%. Discount on the stock price? Discount on the stock price. Right. So you're buying it on sale, basically. So most plans offer a 15% discount. And that discount can actually be even a little bit more or even possibly a lot more because most plans also have a pricing feature for them called a lookback. And a lookback compares two different prices and uses the lower price, which means plans that offer a 15% discount and a lookback when the stock price is appreciating, it can be quite a nice deal for employees. What else could be an advantage? Well, another thing that I really love about employee stock purchase plans is that they really are an easy way to save money, because these plans are funded through payroll deductions. So employees choose to have a little bit of their paycheck set aside to purchase the stock. And that, I think, is a really easy way to save money. Sure, it's not completely painless. You still have to be able to tolerate a little bit of reduction in your take-home pay. But I think it's so much easier to save money when it comes right out of your paycheck. Yeah, yeah. It's harder to spend it, then, right? You hit on payroll deductions there, but bring me through the mechanics of an ESPP and how it works. So, I work for Ally Donnelly Industries. Go. All right. So hopefully your company is a publicly traded company. Yes, it is. And for a publicly traded company, employees have an enrollment window when they can choose to sign up. So first of all, you need to know when your enrollment window is. And then you get to decide as an employee how much you want to contribute into your plan. An enrollment window for the stock purchase plan? That's right. Not benefits. No. It's definitely different than your general benefits enrollment window. So it is worth checking out when your enrollment window is because if you miss that window, you're going to have to sit on the sidelines for probably three or six months until the next window. Ah, OK. All right. So the enrollment window opens up, and then you decide how much of your pay you want to contribute into the plan. And these are post-tax deductions. So a little bit different than your 401(k) where you're contributing pre-tax dollars. And most plans allow you to contribute between 1% in 10% or maybe 1% in 15% of your pay. OK. So you can say I want to contribute, say, 7% of my pay. So your company will withhold 7% of your pay over a three- or a six-month period. And at the end, that is used to buy company stock. And I talked about company stock on favorable terms. Mm-hmm. So what does that really mean? So let me use some very basic numbers. OK. So let's say at the beginning of your purchase period, the stock is trading at $10 a share. And at the end of the period, the stock is trading at $12 a share. So if your plan has a 15% discount and a lookback, which is the most common plan design, then the company is going to compare $10 to $12. And the $12 price is higher than the $10 price. So we are going to look back to the $10 lower price and apply the discount there. So that means employees are paying 15% off of the $10 price-- so $8.50 on a day that the stock is trading at $12. So they give you the most advantageous number in that window? Not in the window. The beginning or the ending. Just two different prices, beginning or ending. Doesn't really matter what happens in between. Oh, OK. But they're going to give you the most advantageous between the beginning price and the ending price. So in that example, at $10 at the beginning, $12 at the end, we're going to use the $10 price, employees pay $8.50, stock is trading at $12. I'll do the math, that's a 41% return on investment. Ah. OK. Great. That is great. That's awesome. But we all know, stock prices don't always go up. Sure. So if the reverse was true, and the stock started at $12 a share, and then it declined to $10 a share at the end of your window, well, then we're going to ignore that $12 price at the beginning. We'll apply the discount to the end price, and so employees are still paying $8.50. Now the stock is worth $10 on that day, and that is a 17.6% return. OK. So not as great as when the stock price went up and you got a 41% return, but a 17.6% return is still a pretty generous return on an investment that's only available to employees. But it is important to note that employees can't generally sell their shares immediately on the day of purchase. OK. So we're calculating that ROI on the date of purchase, but it usually takes one, two, maybe three days for those employees to get the shares in their accounts and be able to sell them. Why does that matter? Well, it matters because stock prices are constantly moving. Oh, so it could still shift, then? It could still shift, yes. So if the stock price goes up even more, that's great. The return on investment by the time the employee receives the shares is even more. But if the stock price falls, then perhaps they'll realize a lesser return on investment. And it is even possible that if the stock price drops dramatically in those days, that employees could result with shares that are worth less than they paid for them. So there's always a little bit of risk when you hold company stock-- or any stock, in fact, but that built-in discount provides a little bit of a buffer for employees and a little bit of protection from the downside when there is periods of market volatility. Do they have to sell? Well, yeah. So most plans, 80% of the plans allow employees to sell right away. You don't have to sell. In fact, most employees don't, but 80% of plans, you could sell those shares as soon as you get them. So in the other 20% of plans, some companies do require employees to hold the shares, and that holding period is usually three, six, or 12 months. So there's definitely a little bit more risk involved there because then you're required to hold the shares. So if you had a financial emergency, you wouldn't be able to liquidate those shares to generate cash, and you're also subject to market volatility during that period. All right, so I know you are a big fan, but we also wanted to hear from everyday people who participate in their ESPP. So we went to the bio-pharmaceutical firm Vertex to get some perspective from employees. What I really like about it is-- it's not like it comes into my bank account and then goes out. I don't see that money. So if you can afford to have that money set aside and just know that you are saving and your future self will absolutely thank you. It's been very easy. It's a set-it-and-forget-it type of thing. When I sit down with new employees and I'm explaining the ESPP, they sit there and I can see it on their face and they're like, no way! And I'm like, way! This is a real thing. You should also go to the actual seminar. Don't trust me, but this is the crux of the overall program. I really saw it as kind of like a forced savings for myself. At the time I was relatively young, so I thought it was a great opportunity and a great benefit. You are very passionate about ESPPs. And that's great for your role in the company. But you also have a personal experience with ESPPs. So when I was quite young and starting out in my career, I had an opportunity to participate in an ESPP that turned out really well for me. And in fact, I've always thought I should have a plaque on the second story of my first home saying "This home made possible by an employee stock purchase plan." So I don't live in that house any longer, but I do rent it out to nine college students. Thoughts and prayers. Yes, indeed, indeed. So it serves as a real, tangible reminder to me of the financial foundation that I established through that ESPP that continues to benefit me and my family today. So I love the story about your house, that's amazing. But again, we want to hear from everyday people on how they're hoping to use their investment from an ESPP. Take a listen. I really keep it as an investment account for potentially another way to look at retirement. We've pretty much been saving up the ESPP proceeds as we go along and putting it towards the future. I actually just purchased my first home last month on my own and did that through selling stocks mostly from the ESPP program. It helped me pay for my wedding. It helped me pay for my engagement ring. Our honeymoon. The down payment on our first house. Saving for the boys' college, those types of things. You hear there are lots of plans for any potential extra money, but like you said earlier, we can lose money, too. That is true. Holding stock always involves some risk. But the plans that offer a 15% discount and a lookback, these are plans that are delivering a minimum of 17.6% on the date of purchase, and so that really helps to buffer some of the risk for employees. But yes, indeed, holding stock does involve risk. OK. What about taxes? Well, yeah-- I love that you're like, ugh. Yeah, taxes. They are a thing, they are a thing. Yeah. And we could spend all day talking about taxes. I imagine, you probably don't want to do that. But for most plans, US employees do not pay tax at the time that they purchase the shares. OK. But they pay tax in the year that they sell the shares. And the tax that they pay can be ordinary income, or it can be capital gains, depending on how long they've held the shares. OK. So it might sound a little bit trite, but it's always good to understand taxes, and if you have a tax advisor, talk to your tax advisor about that. OK. No surprises. OK. So as I'm listening to this, I'm like, yeah, I want to check out this ESPP. How likely is it that my company would have one of these plans? Great question. So first of all, these are generally plans for publicly traded companies. OK. So if you work for a publicly traded company, it's definitely worth checking into. So more than half of the S&P 500 offers an ESPP. They're most common in the technology sector and in life sciences. So there's a lot of employees who may have access to these plans and not realize it, and I think employees owe it to themselves to at least find out if their company has a plan. You say you might not know about it or understand it. How many employees on average-- I don't know what the numbers are, but take advantage of these plans. Well, here's a place where I think these plans are probably underutilized. And participation, about a third of eligible employees participate in these plans. And so I think that might be a little bit of an indication of underutilization because the plans can offer a tremendous amount of value for employees, and only a third of employees are taking advantage of that. So dig in there a little bit more. Why do you think that is? Well, part of it is certainly the fact that participating in a plan does require that the employee can tolerate the reduction of take-home pay, because you have to contribute some of your pay into the plan. So employees who really are struggling and potentially living close to paycheck to paycheck, even if you're able to contribute just 1% of your pay, at the end of the purchase period, you're going to receive shares that you can then sell to offset the reduction for future periods. So maybe this step-up strategy, maybe you start at 1%, and next period you increase to 2%, in the following period, 3%, to grow into it and have the liquidity from shares that you purchased previously to offset some of the reduction. Yeah. It's interesting. Some of the folks we talked to said they feel invested, more invested in their company when they have a little piece of it. It's one of my favorite benefits that Vertex has. Being able to both participate in a program like this with the financial benefit, but also be a small shareholder of the company I work for is a great feeling. The better the company does, the better the stock does. The better the stock does, you actually receive benefits from that. But really, at the end of the day, it's the work that drives me here, but that is just an amazing benefit to have. I'm now a little closer to what the company does and feeling a little bit more involved as an owner. They should feel more invested because they are. They are owners of the company, and quite frankly, that's why many companies offer these plans. They want employees to become owners and to feel like they're owners of the company. And that's because owners of the company take better care of the company. OK. So I've heard all of the facts. I want to participate. What are the questions I really should be asking before I jump in? All right, so these-- I like to think of it at the big three questions. So you figured out your company has an ESPP, so that's the first step. Then the next questions are, what's the discount? So the most common discount is a 15% discount. But we also see plans that offer a 10% discount or a 5%. Obviously, when it comes to discount, the greater the discount, the better. In some plans don't offer a discount, but they offer a match, and a match can be pretty attractive as well. So what's the discount or what's the match? OK. Now if there's a discount, you also want to know if there's a lookback. Now that lookback is what we talked about before, comparing two prices and using whatever's lower because a plan with a lookback is better than a plan without a lookback. OK. And then the third thing that I think is really important to know is, is there a sale restriction on those shares? So 20%, 1 out of 5 companies, has some sort of sale restriction. So if there's a sale restriction, employees really need to understand that and be willing to hold on to those shares for three, six, or 12 months, whatever their company requires. What if I leave the company? Oh, what if you leave the company? Well, so these are employee stock purchase plans, so if you leave the company, you don't get to participate in it anymore. OK, OK. But the shares that you purchased, well, those are yours. So when you purchase the shares and then you leave the company, you still own those shares if you haven't already sold them. And you could sell them or you can hold them. And so at Fidelity, these ESPPs, when you enroll in an ESPP, you get a full-service brokerage account. And the shares go into that account. So whether you've left the company or you're a current employee, you have a full-service brokerage account, and you can use that account to sell your shares and to invest in other products and diversify your portfolio. I don't have to take it out, so to speak? You don't have to take it out. And this is really important because we know a lot of ESPP participants, their ESPP is kind of their first toe, dipping their toe into the investing pool. In fact, about 40% of employees who participate in their plans haven't invested before outside of their retirement plans. So this is a great opportunity for those employees to really learn more about investing and understand what that account can do for them. To that end, some of the folks we talked to, this was their first step into investing beyond their retirement account. So we wanted to hear how it affected their thoughts or feelings on investing overall. I consider myself a novice. There's still a lot to learn, but that was absolutely the entryway into investing in other places. I was sitting on one IRA for the longest time not understanding what it was and what it meant. And as I joined Vertex and I saw it was part of a portfolio, I started to understand how it fit like a puzzle. I think that ESPP program has made me more confident in investing, and me being able to dip my toes in investing with ESPP has shown me opened up the world to those types of opportunities. I really think employees owe it to themselves to find out if they have an ESPP and what's involved in it. Your company may have told you about this during your onboarding when you're suffering from information overload. These really, I think, can be hidden gems in a crowded benefit landscape. And I really know and understand the value that these plans can offer to employees, and I just don't want employees to miss out on that. That's awesome. Emily Cervino, thank you so much. Well, thanks for having me. If you want more information on employee stock purchase plans, head to our website. It's Fidelity.com/MoneyUnscripted. Be sure to like, follow, and subscribe to the podcast, and we'll see you next time. It's your life. Get your money's worth. [MUSIC PLAYING] [Disclosures] Investing involves risk, including risk of loss. Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. The views and opinions expressed by the Fidelity speaker are his or her own as of the date of the recording and do not necessarily represent the views of Fidelity Investments or its affiliates. Any such views are subject to change at any time based on market or other conditions, and Fidelity disclaims any responsibility to update such views. 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