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Dear Prudence

Offering company stock in employee 401(k)s may not always be wise. Just ask Lucent.
Russ Banham, CFO Magazine
December 1, 2001

Vinny Agro was only 21 years old when he first started working at the old New York Telephone in 1970 as an equipment deliverer. In the 31 years since the now­application sales consultant hired on, the division in which he works has morphed several times — it was acquired by AT&T in 1984, spun off as Lucent Technologies in the mid-1990s, and sold this year to Denver-based Expanets Inc. In 1999, Agro and his wife, Camille, examined his 401(k) retirement plan and felt like Croesus — after three decades of continual investment, the value of the account, entirely in Lucent stock, was $800,000. As of November, the Agros were shocked to learn that the value of their 401(k) account had plunged to $58,000. "It seems to have disappeared overnight," says Agro.

In response, the Agros have joined a class-action suit against Lucent that alleges the company had information on its increasingly perilous financial condition and did not inform employees and retirees who had invested their 401(k) retirement proceeds in Lucent stock. Says Camille Agro: "Lucent didn't protect its employees."

The suit pits thousands of employees, former employees, and retirees against the telecommunications equipment manufacturer. The charge: by not restricting or eliminating the company's stock in the plaintiffs' 401(k) plans, Lucent officials cost the plaintiffs millions of dollars as the stock price fell from $37 a share to less than its current $6 a share. "We allege that Lucent breached its fiduciary duties of loyalty, prudence, and prudent diversification [of retiree] assets by failing to disclose to plan participants and beneficiaries information indicating that Lucent stock was not a prudent stock," says Lynn Sarko, managing partner at the Seattle-based law firm Keller Rohrback, a lead counsel in the suit.

The landmark case represents the first time a large employer (lacking any complications such as M&A or fraud) has been sued because its own stock is alleged to be an imprudent investment option in a 401(k) plan. The lawsuit challenges presumed interpretations governing 401(k) plans, particularly Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA), making employees responsible for the investment choices they make in a 401(k), and limiting the employer's fiduciary obligations to merely providing a diversified range of investment options. In the Lucent case, plaintiffs will argue that one of those options — the Lucent stock fund — should have been eliminated, or at least limited, as a choice, since the company allegedly knew it was destined for trouble.

"Certain company officials knew the forecast of sales revenue growth they were providing to the market and the public was materially false," says Sarko. "A prudent financial adviser would have recognized that a company issuing forecasts that could not possibly be met would fail at some point in the future, and it would be imprudent as a fiduciary to continue to allow hundreds of millions of dollars in retirement fund assets to be invested in this house of cards."

While Sarko would not reveal whether current CFO Frank D'Amelio or former CFOs Deborah Hopkins and Donald Peterson were among the "certain company officials" implicated, it's clear the case will have far-reaching effects on finance departments. "If you're a CFO thinking this cannot happen to you, you're wrong," says Michael Weddell, a consultant with Watson Wyatt Worldwide, a Washington, D.C.-based consulting firm. "This could conceivably happen to anyone with a company stock in its plan. While at some point the company stock may have been prudent [as an investment option], if it ceases to be prudent and you had someone in your organization at a senior level with facts indicating it was no longer prudent, you need to worry."

The issue is a particularly sticky one for CFOs, as it creates a conflict between their fiduciary responsibility to plan participants and their responsibility to other shareholders. After all, restricting stock that was once an investment option is a strong signal of management doubts about the company, and could hurt the stock even more.

Where's the Loyalty?
Lucent Technologies has had more than its share of difficulties. More than 29,000 workers have lost their jobs at the Murray Hill, New Jerseyy-based company with $21.3 billion in revenues last year. For them, the precipitous decline in the company's stock value has been one half of a double whammy, since much of their retirement nest eggs were invested in the stock. Sarko asserts that Lucent was aware of the high volume of stock in the employees' retirement accounts and failed to safeguard it. "Under ERISA, a plan sponsor must have utmost loyalty to the plan participants — they're protecting your money, like a bank," he explains.

Lucent spokeswoman Michelle Davidson insists that the company has demonstrated such loyalty. "The allegations of fraud have no basis in the facts or in the law," she says. "We are confident that we have met all of the 404(c) requirements." Davidson adds that Lucent does not require its employees to invest their 401(k) contributions in Lucent stock, and, in fact, presents 16 different funds across three different asset classes from which to choose. "We also take great measures to ensure that employees have multiple opportunities to learn about diversifying their retirement portfolios," asserts Davidson.


She insists that Lucent "will prevail" in the courts, but other companies are taking steps to prevent the issue from getting that far. Last year, for example, now-bankrupt Federal-Mogul determined its stock had ceased to be a prudent buy and took a series of actions that eliminated it as a 401(k) investment option. "Our stock was very volatile, had certainly declined in value, and had become a distraction for employees," says Jim Fisher, a spokesman for the Southfield, Michigan-based automobile-parts supplier with $6 billion in 2000 revenues. "We wanted to alleviate the distracting and disconcerting feelings they were having."

Consequently, employees were given the opportunity to take their matching stock contribution and immediately transfer it to one of the other six core funds in the 401(k) plan, says Richard Stewart, Federal-Mogul manager of pension and capital-accumulation plans. "Previously, they had to keep the matching contribution as Federal-Mogul stock for a period of time," he explains. "Then, this past July, we stopped matching their contributions with our stock altogether, changing it to cash. Shortly thereafter, we said their contributions would no longer be eligible for investment in our stock, period. The stock was just too volatile."

Don't Let Employees Down
It's unclear how many other companies have taken similar actions. What is clear is that many companies are now waiting for the courts to clarify whether or not their fiduciary duties require dissemination of wide-ranging company data (including competitive information) to plan participants if they have invested some of their retirement assets in company stock.

Central to the decision, of course, is how the courts will interpret certain ERISA laws. Under ERISA 401(k), for example, an employer can establish a partnership wealth-accumulation strategy for employees as long as this retirement fund is diversified — a mix of low-to-higher-risk investments, including company stock. And under ERISA 404(c), the 401(k) plan sponsor is not responsible for the investment decisions an employee makes. "The idea is for the employee to have control," explains Paul Strella, an attorney in the Washington Resource Group, the legal resource unit of William M. Mercer Inc. "The plan sponsor presents the investment options — a mutual fund, a bond fund, a money-market fund, company stock, and so on — and says, 'Here they are, here are the various prospectuses. It's your money; you make the decisions.' "

While Weddell agrees this is the substance of 404(c), there are some uncertain elements within it. "The legal question seems to be: If a plan sponsor chooses several different funds as options in a 401(k), and one of those funds is next to worthless, should the plan sponsor have known better than to offer that fund?" he says. "If Lucent knew its stock was in trouble, as alleged, and didn't say anything, the [plaintiffs] may have a case. ERISA does not exempt prudence."

Strella is not so sure. "Is it the plan sponsor's obligation to go out and check every single investment in the world?" he asks. "Is that even possible? Perhaps [the plaintiffs] are arguing that a fiduciary has an even higher disclosure standard than exists under Securities and Exchange Commission regulations. But nothing in ERISA says that. I just don't see the black-letter law that Lucent has violated."

Others agree that ERISA is open to interpretation. "The key question seems to be what is 'prudent' in terms of a company's ethical and fiduciary responsibility," says Carl Weinberg, principal at Unifi Network, a New York-based human resources consulting firm. "If the fiduciary has knowledge that any one of the funds in a plan may go south, does it have a responsibility to do something? If it does [do something], it may be construed as making an investment decision for the plan participant, which 404(c) explicitly prohibits it from doing."

But Patrick McGurn, vice president of Institutional Shareholder Services, a Rockville, Maryland-based investor-advocate and proxy-advisory service, says any company that acts as a plan sponsor "is supposed to owe undivided allegiance to the beneficiaries of the plan. To the extent you let anything influence your decision-making other than the long-term interests of those beneficiaries, you are in clear violation of your fiduciary requirements. That is not even a tough legal question," he argues. "If you're worried about the company as opposed to the plan participants, whether it is a defined-benefit or defined-contribution 401(k) plan, you're in violation of the law."

Yet wouldn't a heightened responsibility to provide plan participants with inside information on the company and its stock potentially incite a widespread sell-off, not to mention scrutiny from the Securities and Exchange Commission? Sarko demurs: "I've been on panels with members of Wall Street who say, 'How can you expect a company to stop its employees from investing in its stock when that would send a signal to regular investors that the company is in trouble?' To that I respond, 'If you want to prevent this conflict of interest, of being torn by this, then don't put yourself in that position.' " In short, don't offer company stock.

Lucent maintains that it shares the same information on the company's performance with investors that it does with employees, via press releases, daily electronic internal publications, and special call-in numbers for employees to access stock analyst conference calls. Basically, it offers the market and the public essentially what every other large company offers. "Lucent makes every effort to keep our employees fully and clearly informed," says Davidson, adding that the company also distributes newsletters on investing to employees and has sponsored financial seminars on the subject.


The company also did nothing wrong, she adds, with respect to letting employees buy as much company stock as they wanted, a decision only they can make under ERISA guidelines. Lucent did what other companies do: it presented a laundry list of investment options to give employees as much investment latitude as possible. It's now up to the courts to decide who's right and who's wrong.

Can't Buy Me Diversification
What can companies do while waiting for the threshold case to be decided? No one believes eliminating company stock from either defined-benefit or defined-contribution plans has much merit, due to the many reasons for having such stock in plans in the first place — including employee incentive and pride of ownership.

In defined-benefit plans, amounts are already limited to 10 percent of holdings, and some experts advocate extending such limits to defined-contribution plans. "The best policy is to have a plan that doesn't encourage people to amass so much company stock that they're completely undiversified," says McGurn, who also warns against giving employees incentives to buy, such as stock discounts.

Federated Department Stores Inc., for example, limits investment by employees in its own stock to 50 percent of the plan's assets. "We want to protect them from overinvesting in the company," says James Tobin, operating vice president, retirement plans, at the Cincinnati-based retail chain with $18.4 billion in 2000 revenues. "We also implemented a plan a couple years ago that included a matching contribution in company stock, but the minute it was made, the employee could move it into another fund in the plan. We didn't want to lock them into an investment they could not move out of quickly."

Others advocate arming employees with sophisticated financial software that would tell them when they had ventured into undiversified and risky investment terrain. "Overloading on company stock should be a personal decision," says Charlene Parsons, vice president of Global Rewards, the compensation benefits program administrator within E-business solutions company Unisys Corp. ($6.89 billion in 2000 revenues). "But they should not make these investments without understanding the potential risks," she adds.

Parsons is currently working with three vendors — Fidelity, Morningstar, and Financial Engines — on asset-modeling tools that help employees analyze their entire retirement portfolio, integrated with their personal brokerage accounts. Says Unisys CFO Janet Brutschea Haugen, "Our overall strategy is geared to employee wealth accumulation. And we are providing the tools necessary for employees to easily model where they are in terms of building a nest egg. [They can tell] if they are making decisions that are too risky or too conservative, and if they're saving at the rate of speed to accomplish their objectives."

Federated Department Stores also has installed the personal investment tools sold by Financial Engines. "The software models projections and recommendations on where employees should be investing their money based on their financial needs and retirement objectives," Tobin says. It should be noted that Lucent is moving to provide similar tools to its employees in the near future, says Davidson.

Such tools, though, cannot be used in a vacuum, says Sarko, who recommends that companies hire independent investment firms to review which funds are prudent and which are not. "The decision as to whether or not a company stock should remain an investment option needs to be in the hands of someone truly independent," he says. "Company officials and executives should have nothing to do with this decision." But Weddell of Watson Wyatt argues that even an independent adviser is subject to a conflict of interest. "Many third-party advisers are owned by larger insurance brokerages and consulting firms that may have other business with that client," he says.

Ultimately, says one CFO of a Fortune 100 company who asked for anonymity, companies should have a commonsense approach to 401(k) investments. "There is really no rule of thumb when it comes to selecting investment options in a 401(k), except that it must be looked at in conjunction with a pension plan," he says. "I believe a good test would be to examine all the investment choices and ask, If one of these were to lose its value in a single week, would the rest of the assets, assuming they retained their value, provide enough of a benefit that the retiree could retire in reasonable fashion?" If not, then the plan may be too risky, he notes.

On the Front Burner
One unfortunate offshoot of the Lucent case is that companies considering offering their own stock in employee retirement plans may now be discouraged. "Employers don't have to offer company stock, you know, and the fact is that very few do — perhaps a couple thousand of the 400,000 companies we track with 401(k) plans," says David Wray, president of the Profit Sharing/401(k)Council, a Chicago-based nonprofit association of 401(k) and profit-sharing sponsors. "Companies have been very cautious about this, and are more so now. The business purpose of a 401(k) is a good bond with the employee," he adds, "not to make them mad at you."

If the plaintiffs win their case, will that mark the end of company stock in 401(k) retirement plans? McGurn doesn't think so. "You'll see greater use of restrictions by companies governing the level of exposure individual employees can take, the use of more sophisticated financial tools assessing prudent diversification, and a marked increase in employee education," he says. "These will be voluntary at first, and, if not widespread, may be mandated."


For finance chiefs, what seemed to be a back-burner issue is now aflame. "This case makes it clear that if you have your own company stock in a 401(k) plan and there is any indication that it is headed for trouble, you cannot ignore the potential impact on plan participants," says Watson Wyatt's Weddell. "This is a threat that must be taken seriously. That said, this case has a long way to go, and there is no guarantee the plaintiffs will prevail."

Russ Banham is a contributing editor at CFO.

Borrowing Privileges
Companies Ease Loan Repayment for Laid-Off Workers

The topic of 401(k) plan balances may be a sore subject these days, but at least a handful of companies, including Lucent Technologies, are easing some of the pain for laid-off workers who have loans outstanding on their accounts.

Typically, 401(k) plan rules require that employees pay up these loans within 90 days of leaving or face steep income and penalty taxes on the withdrawal. Lucent, however, amended its plan last spring to allow former workers to continue paying loans according to their original schedules through coupons or electronic funds transfer. "We did this to offer more flexibility to people whose positions have been eliminated or who have taken early retirement," says spokeswoman Michelle Davidson, noting the payments are made directly to Fidelity Investments, the plan administrator.

It's not an entirely new idea — AT&T instituted a similar measure last year, and it has been standard practice at Ford Motor Co. for many years. But experts say more companies are now considering the idea, given the recent rash of layoffs.

"This is certainly something we've been hearing about among our members," says James Delaplane, vice president for retirement policy at the American Benefits Council. Indeed, "it's a way for companies to say, 'We don't want to hurt you any more than we have to,' " says Karen Field, senior manager at KPMG LLP's compensation and benefits practice in Washington, D.C.

The main cost to employers that extend 401(k) loan terms is the administrative burden. Revising the plans to accommodate such a measure is "not trivial" and often requires board approval, according to Field. For companies that manage their own plans, or whose administrator won't handle payments outside the normal payroll deductions, there is also the hassle of collecting checks and keeping track of payment schedules. However, there are few cash costs, and minimal employer liability, since the borrowing is against an employee's own funds.

Some employers are also exploring the idea of stepping in with the necessary funds, though, says Field, with so-called make-up loans, where the employer effectively pays off the 401(k) loan and receives the money back with interest over time from the employee.

Fifty-eight percent of plans, accounting for 82 percent of participants, offer loans, according to research on 1999 401(k) plan data by the Employee Benefits Research Institute. Fewer than 20 percent of participants had loans outstanding at the end of that year. —Alix Nyberg

Combination Punch
The Benefits of Offering a Pension Plan and a 401(k)

Companies that offer traditional defined-benefit plans tend to offer better 401(k) plans, too, according to a recent survey by William M. Mercer Inc. The reason? Better financial discipline.

Employers that have both defined-benefit and defined-contribution (DC) plans, says Laurel Cochennet, a Mercer retirement consultant who helped write the study, "tend to carry over a certain degree of perspective and finance influence" from their defined-benefit plans to their 401(k)s or other employee savings plan. That influence, according to the study, contributes to DC plans that are more generous, offer quicker vesting policies, and are more communicative with their participants.

For example, 45 percent of companies with both types of plans offer immediate vesting on the employer's matching contribution, compared with only 27 percent with just DC plans. In addition, some 34 percent of companies with both plans target communications to participants who don't diversify, compared with only 18 percent of DC-plan-only companies. And 66 percent of companies with both plans have a formal investment policy in place, compared with just 45 percent of those with a solo DC plan.

The study also looked at the differences among plans when either the finance department or the human-resources department had more influence. When finance is in charge, the study found that DC plans were more likely to have a nonmatching company contribution, a discretionary company contribution, and employer-paid plan fees. Moreover, when finance exerts its influence, says Cochennet, the plans typically have "performance standards in place and [administrators] are more likely to intervene if things aren't being done properly."

The study was based on interviews with 252 defined-contribution sponsors, 58 percent of which also offered defined-benefit plans. The plans had total assets of $125 billion and averaged 8,100 employees per plan. —Lori Calabro

Double Rewards

Differences in features between companies that offer only a DC plan versus a DC/DB combo.
Source: William M. Mercer Inc.


Plan DesignBoth DB and DC PlansDC Plans Only
Eligibility: no age requirement51%30%
Eligibility: upon hire or within three months50%28%
Immediate vesting on the employer match45%27%
Immediate vesting on the profit-sharing contribution43%11%
Matching contribution automatically invested in company stock26%11%
Communication
Use interactive computer programs 48%38%
Use benefit fairs52% 31%
Provide individual counseling for terminating employees58%39%
Target communications to participants who don't diversify34%18%
Target communications to employees approaching retirement32%22%
Measure the effectiveness of communication materials 57%43%
Plan Management and Administration
Have a record-keeping service contract69%50%
Current challenge: underperforming assets 25%37%
Current challenge: compliance issues8%17%
Performance-monitoring report provided by vendor35%54%
ADP: not highly compensated5%5%
ADP: highly compensated6%6%
Investments
Have a formal investment policy66%45%
Offer a stable value fund70% 57%
Offer an indexed domestic equity fund73%62%
Offer an actively managed large-cap core domestic equity fund27%16%
Offer an actively managed mid-cap domestic equity fund38%51%
Offer company stock for employee-directed assets43%24%
Employee direction allowed for company matching contribution71%89%





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