Company stock in 401(k) plans — the good, the bad and the risky

The rewards of company stock holdings in a retirement savings plan must be balanced with significant risks that span the organization, from HR, legal, risk management and compensation to executives and employees.

In brief

• Excessive holdings in company stock in some 401(k) plans are raising alarm bells for employers and their employees.
• Risks include investment under-diversification for employees and litigation for employers.
• Employee financial education about the risks is critical.

Many US employers, particularly large companies, continue to allow their employees to invest balances in a 401(k) plan in the company’s stock. It’s a risky investment, as heavy concentrations of company stock in such plans pose substantial risks to employees and employers alike.

Limited holdings in company stock may offer rewards to the employee and employer

An employee may be attracted to the idea of investing in their employer. They might believe that the company is a sound investment — and they may be in a good position to make such a judgment. Upon receiving a distribution from the plan, the employee could potentially qualify for a tax advantage on any portion of the distribution consisting of shares of company stock. Also, their heirs could receive a tax break upon inheriting the company stock.

There might be benefits for an employer as well. Using company stock instead of cash to make matching contributions to plan accounts is less costly, thanks to tax breaks. Also, many employers believe that encouraging employees to become part owners in the company can motivate them to work harder toward the company’s success.

The risks can’t be ignored

The risks of concentrated holdings in company stock in 401(k) plans must be weighed against any potential rewards of employee ownership. Employers and employees need to be aware of these risks and be able to take well-informed actions to mitigate them.

Investing too heavily in company stock can cause an employee’s retirement assets to be insufficiently diversified. No matter how financially viable an employee believes their employer is, having too many retirement eggs in one basket exposes the employee’s assets to unnecessary risk. The importance of diversifying a retirement portfolio — investing in a significant variety of assets, as well as both among and within different asset classes — cannot be overstated. Diversification reduces the risk that a loss on any one asset — such as the stock of any one particular company — could have on an entire portfolio.

The appropriate amount of company stock for an employee should be based on their particular financial circumstances. So, how might an employee decide? One approach taken by financial planners is to run a retirement projection showing the employer stock value dropping to zero. If the retirement goal can still be reached under that projection, the employee may be willing to take on the business risk of a higher company stock allocation. More often, the projection would lead to diversification of some, most or possibly all the company stock position due to the risk. Research has shown that returns on the majority of company stocks have lagged behind the returns of broad stock market averages. In a study published in 2004, Lisa K. Meulbroek, Ph.D., Fritz B. Burns Professor of Financial Economics, estimated that a large position in company stock over an extended period is effectively worth less than 50 cents on the dollar after factoring in the costs of inadequate diversification.

An employee’s current and future wellbeing is significantly linked to the wellbeing of the company they work for. There’s the compensation that the employee receives from the company, including pay, insurance and other benefits. A weighty investment in company stock makes the employee even more dependent on the company’s business success.

For employers, there is fiduciary risk. For some companies in recent years, declines in the value of company stock held in 401(k) accounts have led to litigation. Employers whose plan has a heavy concentration in company stock may face legal action when the company’s business results and stock value head south. This is especially true when employee and employer contributions are automatically invested in company stock.

A 2006 federal law eased some of the risks

With the enactment of the Pension Protection Act (PPA) of 2006, plan participants gained new diversification rights. For example, under the PPA, if any of an employee’s own contributions are invested in company stock, the employee has the right to move these balances into other plan investments at any time. Also, an employee with three years of service or more under their plan must generally be allowed to diversify employer contributions that are invested in company stock.

Employers are further addressing risks through plan design changes

Employee education is key

Employers should offer employees financial education around the risks of having too much of their 401(k) account invested in their employer’s stock.

Too many employees lack comprehension of the risks. For example, plan participants surveyed by the Boston Research Group in 2002 were keenly aware of what happened to Enron employees’ retirement savings after the company’s bankruptcy. Only half of the respondents, however, said that their own company stock posed the same or less risk than a money market fund. Also, in a 2007 survey conducted by Benartzi, Thaler, Utkus, and Sunstein, only a third of respondents who owned company stock realized that the stock was riskier than “a diversified fund with many different stocks.”

Getting in front of employees to help them understand the risks of owning company stock is a critical component of financial education. Support and guidance from trained financial professionals lead to employees who are informed and engaged in their financial lives.

EY Personal Finance provides a suite of financial wellness programs that help your employees improve their financial wellbeing and feel more confident about their money matters. By offering one-on-one financial planning and online resources and tools, we help your employees identify their financial needs and goals and take informed action to improve their financial security. To date, we have served more than 250 organizations and five million employees across the US. Talk with us about how we can provide financial education, guidance and counseling to your employees.