Introduction

Performance Stock Units (PSUs) are a common component of executive compensation packages, aligning employee incentives with company performance. While they can be a lucrative form of compensation during one's career, managing PSUs effectively in retirement is crucial to mitigating risk and achieving financial security. This whitepaper explores strategies for diversifying PSUs in retirement to ensure a balanced and sustainable financial portfolio.

Understanding PSUs and PSAs

What Are PSUs and PSAs?

Performance stocks focus on the performance of your company as measured by specific business goals during a set period.⁶

These grants can be in the form of Performance Stock Awards (PSAs), but they are most commonly in the form of Performance Stock Units (PSUs). A PSU is a promise from your employer to award you shares at the vesting date (which is the date when you get full ownership of the shares) and after the performance has been certified. A PSA, on the other hand, is granted in advance of the vesting date. However, like PSUs, PSAs are not delivered to you until they vest and the performance has been certified.¹⁰

Both PSAs and PSUs vest—or deliver the shares—upon your company meeting predetermined performance goals. Vesting is dependent on meeting goals within a defined timeframe.¹⁰

If your company meets the goals established at the outset of the performance period, you will receive the target number of shares specified in the initial agreement. If your company far exceeds the target, you might be awarded a greater number of shares. This sliding scale method means you will not be certain of the number of shares you'll receive until the performance period ends and the shares vest. Participants also can receive fewer shares than the target amount—or even no shares.¹⁰

After the vesting date and once the performance has been certified, your company will release shares of stock to you. Then you can sell the shares or hold them as part of your investment portfolio.¹⁰

How Performance Stock is Taxed

Taxes Upon Delivery

When your shares vest, they are assigned a Fair Market Value (FMV) and taxed as ordinary income. Your employer should report this value on Form W-2 or other relevant tax documents, and it will be subject to income tax.⁶

In most cases, your employer will withhold income taxes. Your employer will either hold back cash or stocks depending on the rules of your company's plan.⁶

Taxes Upon Selling

When you sell your shares, you may incur a capital gain or loss, depending on whether the value of the stock increased or decreased. You will be subject to capital gains tax if your stocks increase in value, which is calculated by the appreciation over the market price of the shares on the vesting date.⁶

• Short-Term Capital Gains: If you sell your stock within one year of receiving your shares, they are taxed at your income tax rate.⁶
• Long-Term Capital Gains: If you sell your shares more than one year after you receive them, they are taxed at a lower rate, typically reserved for long-term capital gains.⁶

Special Tax Consideration for PSAs

PSAs allow you to use the 83(b) election to report the stock award as income in the year shares are granted rather than when they vest. This election enables you to pay all the ordinary income tax upfront, so you won't be taxed again until you sell the shares. The election must be made within 30 days of the grant.¹⁰

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The Importance of Diversification

Concentration Risk

Many retirees face significant exposure to a single company's stock due to years of accumulated PSUs. This lack of diversification can create substantial financial risk, particularly if the company's performance declines post-retirement.

Liquidity Needs

Retirees often need to convert assets into cash to fund living expenses. Holding a concentrated position in PSUs can limit liquidity and expose retirees to market timing risks.

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Strategies for Diversifying PSUs in Retirement

1. Gradual Liquidation

One approach to diversifying PSUs is systematically selling shares over time. This strategy reduces exposure to a single stock while potentially minimizing the impact of short-term market volatility.

• Tax Considerations: By selling shares gradually, retirees can manage their taxable income to avoid higher tax brackets and take advantage of long-term capital gains rates.
• Market Conditions: Spreading sales across market cycles can reduce the risk of selling during a downturn.

2. Direct Indexing

Direct indexing involves purchasing individual securities that replicate the performance of an index, allowing retirees to diversify their holdings while retaining greater control over tax-loss harvesting and customization.

• Advantages: Enables tax-efficient diversification and potential for personalized investment strategies.
• Advanced Option: Combine direct indexing with long-short strategies to hedge risks and enhance returns by taking offsetting positions in correlated securities.

3. Exchange Funds

Exchange funds allow investors to contribute shares of a single stock in exchange for a diversified portfolio of stocks. This strategy is particularly effective for high-net-worth individuals with concentrated positions in PSUs.

• Advantages: Maintains equity exposure while significantly reducing single-stock risk.
• Considerations: Exchange funds often require a minimum investment and have a lock-up period.

4. Donor-Advised Funds (DAFs)

Retirees can donate appreciated PSUs to a DAF to achieve philanthropic goals while reaping tax benefits.

• Tax Benefits: Avoids capital gains tax on the donated shares and provides an immediate charitable deduction.
• Impact: Allows retirees to diversify their portfolio while supporting causes they care about.

5. Options and Derivatives

For retirees comfortable with advanced strategies, options and derivatives can hedge against downside risk.

• Covered Calls: Generate income by selling call options on PSUs, allowing retirees to earn premiums while potentially capping upside potential.
• Protective Puts: Purchase put options to limit potential losses.
• No-Cost Collars: Combine covered calls and protective puts to create a "collar" that limits both upside and downside, often implemented at no net cost.

6. Estate Planning Tools

Incorporating estate planning tools can further enhance financial security and tax efficiency while ensuring wealth transfer to future generations.

• Grantor Retained Annuity Trusts (GRATs): Transfer wealth while minimizing gift tax by placing PSUs into a GRAT and receiving annuity payments.
• Intentionally Defective Grantor Trusts (IDGTs): Use an IDGT to transfer PSUs outside the taxable estate while leveraging valuation discounts.
• Annual Gifting: Gift up to the annual exclusion amount ($19,000 per recipient in 2025) to family members, reducing taxable estates.
• Charitable Remainder Trusts (CRTs): Convert PSUs into a stream of income while supporting charitable causes and deferring taxes.

7. Direct Reinvestment into Diversified Portfolios

After selling PSUs, retirees can reinvest proceeds into a diversified mix of equities, fixed income, and alternative investments aligned with their risk tolerance and retirement goals.

• Model Portfolios: Use model portfolios to ensure proper asset allocation.
• Managed Accounts: Engage a financial advisor to oversee the transition and ensure alignment with long-term objectives.

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Case Study: Diversifying PSUs in Action

Background:

Jane Doe, a retired executive, accumulated $10 million in PSUs from her employer. At retirement, the shares represented 80% of her total investment portfolio.

Actions Taken:

1. Gradual Liquidation: Sold 10% of her PSU holdings annually over five years, managing taxable income and avoiding market timing.
2. Exchange Fund: Contributed $2.5 million worth of PSUs to an exchange fund, achieving immediate diversification.
3. Direct Indexing: Transitioned $3 million of proceeds into a direct indexing strategy, leveraging tax-loss harvesting to offset gains.
4. Advanced Hedging: Utilized covered calls and no-cost collars to generate income and protect against market volatility.
5. Philanthropy: Donated $2 million in appreciated shares to a DAF, funding charitable initiatives while realizing tax savings.
6. Estate Planning: Established a GRAT to transfer $1 million of PSUs to her heirs while minimizing gift tax liability.
7. Reinvestment: Reinvested proceeds from PSU sales into a balanced portfolio of index funds, bonds, and alternative assets.

Outcome:

Jane’s portfolio is now diversified, with no single stock representing more than 10% of her total holdings. This reduced her financial risk while providing steady income to support her retirement lifestyle.

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Conclusion

PSUs can represent a significant source of wealth, but their concentration risk necessitates a proactive approach to diversification in retirement. By leveraging strategies such as gradual liquidation, direct indexing, exchange funds, charitable giving, estate planning tools, and advanced financial instruments like options and collars, retirees can mitigate risks, optimize tax outcomes, and ensure a stable financial future. Partnering with a financial advisor is essential to tailoring these strategies to individual goals and circumstances.

About the Author

Brad Morgan is a CERTIFIED FINANCIAL PLANNER™ specializing in executive compensation and retirement planning. With a focus on helping retirees manage complex financial portfolios, Brad assists clients in achieving long-term financial security and peace of mind.