Mar
13
2024
What is a Glide Path?

Guide to Glide Paths for 401(k)

By | invest, Investing, Preparing for Retirement | Comments Off on Guide to Glide Paths for 401(k)

Asset managers use a “glide path” to determine how the asset allocation of a target-date retirement fund will change based on the number of years until the fund’s target date. Each target-date fund has its own glide path, though they typically begin with a more aggressive allocation that gets more conservative over time.

The idea behind most target date fund glide paths is that investors with a longer-term time horizon should have a higher percentage of their portfolio in riskier assets, like stocks, since they have time to recover from short-term volatility. As their retirement date approaches (or once they’ve started retirement), investors likely will benefit from a more conservative portfolio that protects the assets they’ve already accumulated.

What Is a Glide Path?

The glide path is the formula that asset managers choose when they put together a target-date mutual fund that determines how and when that portfolio will adjust its asset allocation over time.

Target-date funds (and their glide paths) are common investment choices in 401(k) accounts, as well as in other types or retirement accounts, such as a Roth or traditional IRA set up through a brokerage account.

A key component to saving for retirement is having a suitable mix of investments that allow for portfolio diversification. Early on, most glide paths focus on stocks that typically offer the greatest potential to grow in value over time and then shift to bonds and other fixed-income investments according to the investor’s risk tolerance to manage volatile price swings as they grow older.

Understanding Glide Path

The glide paths within target-date funds aim to create a set-it-and-forget-it investing option for retirement savers, who may get diversification based on their time horizon within a single fund. Investors who are younger and have 20 to 30 years until retirement typically need to maximize their portfolio growth, which requires a much higher allocation toward stocks.

By comparison, someone who is nearing retirement or has already retired, may need to scale back on their portfolio risk. Glide path investing automatically reallocates the latter investor’s portfolio toward bonds which are typically lower risk investments with lower returns compared to stocks but provide portfolio stability. That also generally means that younger investors in a target-date fund will typically have higher 401(k) returns than older investors.

Types of Glide Paths for Retirement Investing

There are different glide path strategies depending on an investor’s risk tolerance and when they plan to retire. Typically, target-date funds have a declining glide path, although the rate at which it declines (and the investments within its allocation vary depending on the fund).

Declining Glide Path

A declining glide path reduces the amount of risk that a target-date fund takes over time. In general, it makes sense for retirees or those approaching retirement to reduce their investment risk with a more conservative portfolio as they age. A decreasing glide path is the more common approach used. It involves a higher equity risk allocation that steadily declines as retirement approaches.

Static Glide Path

Some target-date funds may have a static glide path during some years. During this time, the investment mix would remain at a set allocation, such as 60% stocks and 40% bonds. Managers maintaining portfolios that have a static glide path rebalance them regularly to maintain this allocation.

Rising Glide Path

Some specialists believe that the glide path should begin to rise again once an investor reaches retirement age, taking on more risk over time. This argument takes the position that increasing risk in a retiree’s portfolio could reduce volatility in the early stages of retirement when the portfolio is at risk of losing the most wealth in the event of a stock market decline.

An increasing glide path may be an option to consider for retirees with pension benefits or higher withdrawal rates or those who are working in retirement. If a retiree understands the risk involved and is comfortable taking it on, this strategy might make sense, however, generally speaking, the rising glide path is the least utilized method for retirement planning.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Choosing the Right Glide Path

If you’re saving for retirement in a 401(k), there may only be one target-date option available to you based on your target-retirement age. However, if you have choices within your 401(k) or you’re choosing a target-date fund within an individual retirement account or another investment vehicle, you’ll want to look for a target-date fund with a strategy that aligns with your investment view.

One rule of thumb uses the “rule of 100,” which subtracts the investor’s age from 100 to determine the percentage of your portfolio that should be in stocks. However, some managers use glide paths that decline more or less quickly than that.

Some target-date funds also incorporate alternative assets, such as private equity or real estate, in addition to traditional stocks and bonds.

”To” or “Through” Retirement

When glide paths reach retirement date, they can take one of two approaches, either a “To” or “Through” approach. A “To” retirement glide path is a target-date fund strategy that reaches its most conservative asset allocation when retirement starts. This strategy generally holds lower exposure to risk assets during the working phase and at the target retirement date. This means, at retirement, it reduces exposure to riskier assets, like equities, and moves into more conservative assets, like bonds.

“Through” glide paths tend to maintain a higher allocation toward riskier assets as investors accumulate savings at their target retirement date and years into retirement. This means exposure to equities in retirement tends to be higher, at least in the first few years of retirement.

In choosing which path is best suited to you, you must determine your risk tolerance and how aggressive or conservative you are able to be. This includes deciding how much exposure to equities you can afford to have. Decreasing exposure to stocks means investors may not have to worry as much about a portfolio that fluctuates in value, whereas an increased exposure to equities may mean a portfolio with more volatility that could have potential for greater gains over time.

The Takeaway

Glide paths are formulas that investment managers create to determine the level of risk in a target-date fund. The idea is that a portfolio automatically adjusts itself based on risk tolerance that changes as the investor ages, allowing for a more hands-off approach.

Glide paths are common investment choices in retirement accounts such as 401(k)s and IRAs. As you’re determining your retirement savings strategy, carefully consider whether they may make sense for you.

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FAQ

What does glide path approach mean?

A glide path refers to a formula that asset managers use to determine the allocation mix of assets in a target-date retirement portfolio and how it changes over time. A target-date retirement portfolio tends to become more conservative as the investor ages, but there are multiple glide paths to take account to a retiree’s risk tolerance.

What is a retirement glide path?

A retirement glide path is the approach within a target-date fund that includes a diversified portfolio of stocks and bonds. Retirement glide paths typically start out with a more aggressive mix of investments and get more conservative over time.

Which type of mutual fund follows a glide path?

Target-date retirement funds are the most common type of mutual fund that follows a glide path. However managers may also use glide paths for other time-focused, long-term investments, such as 529 retirement accounts.

What is an example of a glide path?

Here is one example of a glide path: Say an investor plans to retire in 2050 and buys a target-date 2050 fund. If the investor is using a declining glide path strategy, it will automatically reduce the amount of risk that the target-date fund takes over time. So, for instance, the target-date fund might have 70% stocks and 30% bonds at the beginning, but over time, the amount allocated to stocks will steadily decline, and the amount allocated to bonds will steadily increase —making the portfolio more conservative as the investor approaches retirement.

What are the benefits of a glide path?

Benefits of a glide path may include making investing easier because the process of changing asset allocation is automatic, and allowing for an essentially hands-off approach since glide paths are professionally managed. However, there are drawbacks to consider as well, including possibly higher management fees for some target-date funds.

Photo credit: iStock/akinbostanci

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Mar
12
2024

What Is 401(k) Plan Benchmarking?

By | Growing Wealth, invest, Investing, Preparing for Retirement | Comments Off on What Is 401(k) Plan Benchmarking?

Benchmarking a 401(k) retirement plan refers to how a company assesses their plan’s design, fees, and services to ensure they meet industry and ERISA (Employee Retirement Income Security Act) standards.

Benchmarking 401(k) plans is important for a few reasons. First, the company offering the plan needs to be confident that they are acting in the best interests of employees who participate in the 401(k) plan. And because acting in the best interests of plan participants is part of an employer’s fiduciary duty, benchmarking can help reduce an employer’s liability if fiduciary standards aren’t met.

If a company’s plan isn’t meeting industry benchmarks, it may be wise for an employer to change plan providers. Learn more about how benchmarking works and why it’s important.

How 401(k) Benchmarking Works

While a 401(k) is a convenient and popular way for participants to invest for retirement, the company offering the plan has many responsibilities to make sure that its plan is competitive. That is where 401(k) benchmarking comes into play.

An annual checkup is typically performed whereby a company assesses its plan’s design, evaluates fees, and reviews all the services offered by the plan provider. The 401(k) plan benchmarking process helps ensure that the retirement plan reduces the risk of violating ERISA rules. For the firm, a yearly review can help reduce an employer’s liability and it can save the firm money.

ERISA, the Employee Retirement Income Security Act, requires that the plan sponsor verifies that the 401(k) plan has reasonable fees. ERISA is a federal law that mandates minimum standards that retirement plans must meet. It helps protect plan participants and beneficiaries.

The Importance of 401(k) Plan Benchmarking

It is important that an employer keep its 401(k) plan up to today’s standards. Making sure the plan is optimal compared to industry averages is a key piece of retirement benchmarking. It’s also imperative that your employees have a quality plan to help them save and invest for retirement. Most retirement plan sponsors conduct some form of benchmarking planning, and making that a regular event — such as annually — is important so that the employer continuously complies with ERISA guidelines.

Employers have a fiduciary responsibility to ensure that fees are reasonable for services provided. ERISA also states that the primary responsibility of the plan fiduciaries is to act in the best interest of their plan participants. 401(k) benchmarking facilitates the due diligence process and reduces a firm’s liability.

How to Benchmark Your 401(k) Plan: 3 Steps

So, as an employer, how exactly do you go about benchmarking 401(k) plans? There are three key steps that plan sponsors should take so that their liability is reduced, and the employees get the best service for their money. Moreover, 401(k) benchmarking can help improve your service provider to make your plan better.

1. Assess Your 401(k) Plan Design

It’s hard to know if your retirement plan’s design is optimal. Two gauges used to figure its quality are plan asset growth and the average account balance. If workers are continuously contributing and investments are performing adequately compared to market indexes, then those are signs that the plan is well designed.

Benchmarking can also help assess if a Roth 401(k) feature should be added. Another plan feature might be to adjust the company matching contribution or vesting schedule. Optimizing these pieces of the plan can help retain workers while meeting ERISA requirements.

2. Evaluate Your 401(k) Plan Fees

A 401(k) plan has investment, administrative, and transaction fees. Benchmarking 401k plan fees helps ensure total costs are reasonable. It can be useful to take an “all-in” approach when assessing plan fees. That method can better compare service providers since different providers might have different terms for various fees. But simply selecting the cheapest plan does not account for the quality and depth of services a plan renders. Additional benchmarking is needed to gauge a retirement plan’s quality. Here are the three primary types of 401(k) plan fees to assess:

•   Administrative: Fees related to customer service, recordkeeping, and any legal services.

•   Investment: Amounts charged to plan participants and expenses related to investment funds.

•   Transaction: Fees involved with money movements such as loans, withdrawals, and advisory costs.

3. Evaluate Your 401(k) Provider’s Services

There are many variables to analyze when it comes to 401(k) benchmarking of services. A lot can depend on what your employees prefer. Reviewing the sponsor’s service model, technology, and execution of duties is important.

Also, think about it from the point of view of the plan participants: Is there good customer service available? What about the quality of investment guidance? Evaluating services is a key piece of 401(k) plan benchmarking. A solid service offering helps employees make the most out of investing in a 401(k) account.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Investing for Retirement With SoFi

Investing for retirement is more important than ever as individuals live longer and pension plans are becoming a relic of the past. With today’s technology, and clear rules outlined by ERISA, it can be easier for workers to take advantage of high-quality 401(k) plans to help them save and invest for the long term.

For the company offering the plan, establishing a retirement benchmarking process is crucial to keeping pace with the best 401(k) plans. Reviewing a plan’s design, costs, and services helps workers have confidence that their employer is working in their best interests. Benchmarking can also protect employers.

If your company already has a 401(k) plan that you contribute to as an employee, you might also consider other individual retirement accounts to open. You can learn more about various options available, such as IRAs. There are different types of IRAs, including traditional and Roth IRAs. You may want to explore them to see which might be best to help you reach your retirement savings goals.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


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FAQ

How often should a 401(k) be benchmarked?

It’s considered a best practice to benchmark a 401(k) annually to make sure the plan complies with ERISA guidelines. Making sure that the plan’s fees are reasonable and acting in the best interests of plan participants is part of an employer’s fiduciary duty. Benchmarking facilitates the due diligence process and reduces an employer’s liability if fiduciary standards aren’t met.

How do I benchmark my 401(k) fees?

To benchmark your 401(k) fees, take an “all-in” approach by calculating the service provider fees plus the investment expenses for the plan. This helps you compare your plan’s fees to fees charged by other service providers. In addition, assess the plan’s quality by looking at administrative fees (fees related to customer service and recordkeeping, for instance), investment fees (expenses related to investment funds and amounts charged to participants in the plan), and transaction fees (fees related to moving money, such as withdrawals or loans).

Photo credit: iStock/MicroStockHub

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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Mar
08
2024

What Is a Stock Market Crash?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is a Stock Market Crash?

The specter of a stock market crash weighs on the mind of many investors. After all, stock market crashes have played a substantial role in the United States during the 20th and 21st centuries. But knowing what is a stock market crash as well as the history and effects of stock market crashes can help investors weather the storm when the next one occurs.

What Happens When the Stock Market Crashes?

A stock market crash occurs when broad-based stock indices like the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite experience double-digit declines over a single or several days. This means that the stocks of a wide range of companies sell off rapidly, generally because of investor panic and macroeconomic factors rather than company-specific fundamentals.

While no specific percentage decline defines a stock market crash, investors generally know one is occurring while it’s happening.

💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

What Causes the Market to Crash?

Stock market crashes are usually unexpected and occur without warning. Often, crashes are caused by investor dynamics; when stocks start to sell off, investors’ fear takes over and causes them to panic sell shares en masse.

Though stock market crashes are usually unexpected, there are often signs that one could be on the horizon because a stock market bubble is inflating. A bubble occurs when stock prices rise quickly during a bull market, outpacing the value of the underlying companies. The bubble forms as investors buy certain stocks, driving prices up. Other investors may see the stocks doing well and jump on board, further raising prices and initiating a self-sustaining growth cycle.

The stock price growth continues until some unexpected event makes investors wary of stocks. This unexpected event causes investors to unload shares as quickly as possible, with the herd mentality of panic selling resulting in a stock market crash.

Catastrophic events such as economic crises, natural disasters, pandemics, and wars can also trigger stock market crashes. During these events, investors sell off risky assets like stocks for relatively safe investments like bonds.

Stock markets can also experience flash crashes, where the stock market plummets and rebounds within minutes. Computer trading algorithms can make these crashes worse by automatically reacting and selling stocks to head off losses. For example, on May 6, 2010, the Dow Jones Industrial Average fell 1,000 points in 10 minutes but recovered 70% of its losses by the end of the day.

Recommended: What Is the Average Stock Market Return?

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Examples of Past Stock Market Crashes

There have been several crashes in the stock market history, the most recent being the crash associated with the coronavirus pandemic in early 2020. The following are some of the most well-known crashes during the past 100 years.

Stock Market Crash of 1929

The most devastating stock market crash in the history of the United States occurred in October 1929. The crash occurred following a period of relative prosperity during the Roaring Twenties, when new investors poured money into the stock market.

The crash began on Thursday, October 24, when the Dow Jones Industrial Average declined about 11%, followed by a 13% decline on Monday, October 28, and a 12% drop on Tuesday, October 29. These losses started a downward trend that would continue until 1932, ushering in the Great Depression.

Black Monday Crash of 1987

On Monday, October 19, 1987, the Dow Jones Industrial Average plummeted nearly 23% in a single day. Known as Black Monday, this selloff occurred for various reasons, including the rise of computerized trading that made it easier for panicked investors to offload stocks quickly, and stock markets around the world crashed.

Dotcom Crash of 2000

The Dotcom crash between 2000 and 2002 occurred as investors started to pull money away from internet-based companies. The Nasdaq Composite index declined about 77% from March 2000 to October 2002.

In the mid to late 1990s, the internet was widely available to consumers worldwide. Investors turned their eyes to internet-based companies, leading to rampant speculation as they snapped up stocks of newly public internet companies. Eventually, startups that enthusiastic investors had fueled began to run out of money as they failed to turn a profit. The bubble eventually burst.

Recommended: Lessons From the Dotcom Bubble

Financial Crisis of 2008

The stock market crash of 2008 was fueled by rising housing prices, which came on the heels of the dot-com crash recovery. At the time, banks were issuing more and more subprime mortgages, which financial institutions would bundle and sell as mortgage-backed securities.

As the Federal Reserve increased interest rates, homeowners, who often had been given mortgages they couldn’t afford, began to default on their loans. The defaults had a ripple effect throughout the economy. The value of mortgage-backed securities plummeted, causing major financial institutions to fail or approach the brink of failure. This financial crisis spilled over into the stock market, and the S&P 500 fell nearly 60% from a peak in October 2007 to a low in March 2009.

Coronavirus Crash of 2020

As the coronavirus pandemic swept the United States in February 2020, the government responded with stay-at-home orders that shut down businesses and curtailed travel. The U.S. economy entered a recession, and the stock market plunged. The S&P 500 fell 30% into bear market territory in just one month, including a one day decline of 12% on March 16, 2020.

What Are the Effects of a Crash?

Stock market crashes can lead to bear markets, when the market falls by 20% or more from a previous peak. If the crash leads to an extended period of economic decline, the economy may enter a recession.

A market crash could lead to a recession because companies rely heavily on stocks as a way to grow. Falling stock prices curtail a company’s ability to grow, which can have all sorts of ramifications. Companies that aren’t able to earn as much as they need may lay off workers. Workers without jobs aren’t able to spend as much. As consumers start spending less, corporate profits begin to shrink. This pattern can lead to a cycle of overall economic contraction.

A recession is usually declared when U.S. gross domestic product, or GDP, shrinks for two consecutive quarters. There may be other criteria for declaring a recession, such as a decline in economic activity reflected in real incomes, employment, production, and sales.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Preventing Stock Market Crashes

Major stock exchanges like the New York Stock Exchange (NYSE) have instituted circuit breaker measures to protect against crashes. These measures halt trading after markets drop a certain percentage to curb panic selling and prevent the markets from going into a freefall.

The NYSE’s circuit breakers kick in when three different thresholds are met. A drop of 7% or 13% in the S&P 500 shuts down trading for 15 minutes when the drop occurs between 9 am and 3:25 pm. A market decline of 20% during the day will shut down trading for the rest of the day.

Suppose a crash does occur, and it threatens to weaken the economy. In that case, the federal government may step in to ease the situation through monetary and fiscal policy stimulus measures. Monetary policy stimulus is a set of tools the Federal Reserve can use to stimulate economic growth, such as lowering interest rates. Fiscal stimulus is generally infusions of cash through direct spending or tax policy.

Investment Tips During a Market Crash

A stock market crash can be alarming, especially when it comes to an investor’s portfolio. Here are some investment tips to consider for navigating a market downturn.

Don’t Panic and Focus on the Long-Term

It will help if you remain calm when the stock market is plummeting. That’s often easier said than done, especially when your portfolio’s value declines by more than 10% in a short period. It’s tempting to join the panic selling, to make sure stock losses are minimized.

But remember, investing is a long game. In general, making decisions based on something happening now when your investing time horizon might be 30 years, may not be the best choice. If you don’t need access to your money right away, it may be better to hold on to your investments and give them time to recover.

Diversify Your Portfolio

Stocks and the stock market get most of the media’s attention, especially when the stock market is crashing, but there are other potential ways to help you realize your financial goals. Other assets like bonds, commodities, or emerging market stocks may be attractive investment opportunities to consider during a crash.

Consider Buying The Dip

While it depends on an individual’s specific situation and risk tolerance, a stock market crash might present opportunities to purchase stocks at a lower, more attractive share price that some investors may want to consider.

The Takeaway

The stock market tends to recover following a stock market crash; it took the S&P 500 six months to recover the losses experienced during the coronavirus crash. So any rash moves investors make during a stock market crash may prevent them from seeing gains in the long term.

A stock market crash can be scary, causing you to panic and fret over your savings and investments. But often, with investing, the best advice is not to make rash decisions. Even during a stock market crash, there may still be some opportunities and strategies to help build wealth over time.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


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FAQ

When was the last market crash?

The last stock market crash was in 2020, at the onset of the coronavirus pandemic, when business shut down and the stock market plunged. The S&P 500 fell 30% in just one month. Within six months, however, the S&P 500 had recovered its losses.

What goes up when the stock market crashes?

Bonds generally tend to go up when the stock market crashes, although not always. Government bonds such as U.S. Treasuries typically do best during a market crash, though again, there are no guarantees.

Do stocks recover after a crash?

Historically, the stock market has recovered after a crash, although it’s impossible to say how long a recovery might take. Some stock market recoveries have taken a year or less, some have taken much longer.

Photo credit: iStock/Prostock-Studio

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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Mar
08
2024
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Stock Buyback: What It Means & Why It Happens

By | Growing Wealth, invest, Investing, Terminology | No Comments

One of the most popular ways a company can use its cash is through a stock buyback. Over the past five years, according to S&P Dow Jones Indices, big companies have spent more than $3.9 trillion repurchasing their own shares to boost shareholder value. Because of this significant activity, investors need to know the basics of stock buybacks and how they work to feel confident in making investment decisions.

What Is A Stock Buyback?

A stock buyback, also known as a share repurchase, is when a company buys a portion of its previously issued stock, reducing the total number of outstanding shares on the market. Because there are fewer total shares on the market after the buyback, each share owned by investors represents a greater portion of company ownership.

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*Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

How Do Companies Buy Back Stock?

Companies can repurchase stock from investors through the open market or a tender offer.

Open market

A company may buy back shares on the open market at the current market price, just like a regular investor would. These stock purchases are conducted with the company’s brokers.

Tender offers

A company may also buy back shares through a tender offer. One type of tender offer, the fixed-price offer, occurs when a company proposes buying back shares from investors at a fixed price on a specific date. This process usually values the shares at a higher price than the current price per share on the open market, providing an extra benefit to shareholders who agree to sell back the shares.

Another type of tender offer, the dutch auction offer, will specify to investors the number of shares the company hopes to repurchase and a price range. Shareholders can then counter with their own proposals, which would include the number of shares they’re willing to give up and the price they’re asking. When the company has all of the shareholders’ offers, it decides the right mix to buy to keep its costs as low as possible.

Why Do Companies Buy Back Stock?

Stock buybacks are one of several things a company can do with the cash it has in its coffers, including paying the money out to shareholders as a dividend, reinvesting in business operations, acquiring another company, and paying off debt. There are several reasons why a company chooses to buy back its stock rather than some of these other options.

1. Increases Stock Value

One of the most common reasons a company might conduct a share buyback is to increase the value of the stock, especially if the company considers its shares undervalued. By reducing the supply of shares on the market, the stock price will theoretically go up as long as the demand for the stock remains the same. The rising stock price benefits existing shareholders.

Recommended: Understanding Capital Appreciation on Investments

2. Puts Money Into Shareholders’ Hands

A company’s stock buyback program can be used as an alternative to dividend payments to return cash to shareholders, specifically those investors who choose to sell back their shares to the company. With dividend payments, companies usually pay them regularly to all shareholders, so investors may not like it if a company reduces or suspends a dividend. Stock buybacks, in contrast, are conducted on a more flexible basis that may benefit the company because investors do not rely on the payments.

3. Takes advantage of tax benefits

Many investors prefer that companies use excess cash to repurchase stock rather than pay out dividends because buybacks have fewer direct tax implications. With dividends, investors must pay taxes on the payout. But with stock buybacks, investors benefit from rising share prices but do not have to pay a tax on this benefit until they sell the stocks. And even when they sell the stock, they usually pay a lower capital gains tax rate.

4. Offsets dilution from stock options

Companies will often offer employee stock options as a part of compensation packages to their employees. When these employees exercise their stock, the number of shares outstanding increases. To maintain an ideal number of outstanding shares after employees exercise their options, a company may buy back shares from the market.

5. Improves financial ratios

Another way stock buybacks attract more investors is by making the company’s financial ratios look much more attractive. Because the repurchases decrease assets on the balance sheet and reduce the number of outstanding shares, it can make financial ratios like earnings per share (EPS), the price-to-earnings ratio (PE Ratio), and return on equity (ROE) look more attractive to investors.

What Happens to Repurchased Stock?

When a company repurchases stock, the shares will either be listed as treasury stock or the shares will be retired.

Treasury stocks are the shares repurchased by the issuing company, reducing the number of outstanding shares on the open market. The treasury stock remains on its balance sheet, though it reduces the total shareholder equity. Shares that are listed as treasury stock are no longer included in EPS calculations, do not receive dividends, and are not part of the shareholder voting process. However, the treasury stock is still considered issued and, therefore, can be reissued by the company through stock dividends, employee compensation, or capital raising.

In contrast, retired shares are canceled and cannot be reissued by the company.


💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

The Pros and Cons of a Stock Buyback for Investors

When a company announces a stock buyback, investors may wonder what it means for their investment. Stock buybacks have pros and cons worth considering depending on the company’s underlying reasoning for the share repurchase and the investor’s goal.

Pros of a Stock Buyback

Tender offer premium

Investors who accept the company’s tender offer could have an opportunity to sell the stock at a greater value than the market price.

Increased total return

Investors who hold onto the stock after a buyback will likely see a higher share price since fewer outstanding shares are on the market. Plus, each share now represents a more significant portion of company ownership, which may mean an investor will see higher dividend payments over time. A higher stock price and increased dividend boosts an investor’s total return on investment.

Tax benefits

As mentioned above, a stock buyback might also mean a lower overall tax burden for an investor, depending on how long the investor owned the stock. Money earned through a stock market buyback is taxed at the capital gains tax rate. If the company issued a dividend instead of buying back shares, the dividends would be taxed as regular income, typically at a higher rate.

Recommended: Investment Tax Rules Every Investor Should Know

Cons of a Stock Buyback

Cash could be spent elsewhere

As mentioned above, when companies have cash, they can either reinvest in business operations, acquire a company, pay down debt, pay out a dividend, or buy back stock. Engaging in a share repurchase can starve the business of money needed in other areas, such as research and development or investment into new products and facilities. This hurts investors by boosting share price in the short term at the expense of the company’s long-term prospects.

Poorly timed

Companies may sometimes perform a stock buyback when their stocks are overvalued. Like regular investors, companies want to buy the stock when the shares are valued at an attractive price. If the company buys at a high stock price, it could be a bad investment when the company could have spent the money elsewhere.

Benefits executives, not shareholders

Stock buybacks might also be a convenient tactic to benefit company executives, who are often compensated by way of stock options. Also, some executives earn bonuses for increasing key financial ratios like earnings per share, so buying back stock to improve those ratios potentially benefits insiders and not all shareholders.

The Takeaway

Like almost everything else to do with the stock market, the benefits and drawbacks of stock buybacks aren’t exactly straightforward. Investors need to ask themselves a few questions when analyzing the share repurchases of a company, like “why is the company conducting the buyback?” and “does the company have a history of delivering good returns?” Answering these questions can help investors decide whether a stock buyback is the best thing for a company.

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FAQ

Is a stock buyback positive or negative?

Stock buybacks have advantages and disadvantages for investors and companies. For instance, buybacks may increase the stock value and increase dividend payments to shareholders over time. However, stock buybacks may not be the best way for a company to spend its money in the long-term, and they may potentially benefit company executives more than shareholders.

When should a company do a stock buyback?

A company may do a stock buyback when it has the cash available and wants to increase the value of the stock, improve financial ratios, consolidate ownership, or drive demand for the stock.

Do I lose my shares in a buyback?

You won’t lose your shares in a buyback unless you want to sell them. The way a buyback works is that a company buys back stock from any investors who want to sell it. But you are under no obligation to sell your stock back to the company — it’s up to you whether to keep your stock or sell it back.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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