Too True to Be Good

Putting stock in an employer has merit. Owning too much is risky.
Ellen BenoitAugust 1, 1997

By now, most workers have heard a barrage of reasons to invest retirement nest eggs in stock rather than Treasury securities and money markets. But sound advice about investing for growth has triggered at least one risky consequence: excessive 401(k) concentration in stock issued by employers.

“We are seeing incredible demand for the opportunity to invest as much as possible in employer stock where the employer is doing well in the market. With large-cap companies, the past couple of years have been excellent,” says Pam Scott, principal with the Kwasha Lipton Group of Coopers & Lybrand. “The investment education that companies have done should not be discredited simply because employees are investing in employer securities. The issue is really, are the employees doing well through those investments? It will be interesting to ask that question in a time of poor market performance.”

At such a time, however, it may be too late to correct a problem that cries out for attention today. The most important lesson that shrewd investors have learned in the past 50 years is the value of diversification as a way to improve returns and control risk. A prudent rule of thumb, say experts, caps investment in any one stock at about 5 percent of a portfolio. If that investment hits the skids, it’s not a wipeout.

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Schlumberger Ltd. has faced this conflict head on. The giant ($9 billion) oil-field-services company doesn’t permit employees to invest more than 5 percent of their company-managed retirement assets in any single security. “I think prudence in investment is a good idea,” says CFO Arthur Lindenauer, “and if the only retirement assets an employee has are in a 401 (k), I don’t think there’s any difference.”

A warning not to put too many eggs in one basket sounds embarrassingly obvious, but an awful lot of participants in defined contribution plans are ignoring it.

In a survey last fall, the Institute of Management and Administration (IOMA) reported that a whopping 42 percent of assets in defined contribution plans of 246 large companies were sitting in employer stock. Most recently, in a survey of 500 companies by IOMA and consulting firm RogersCasey & Associates, 70 percent of the employers expressed concern about the concentration of company stock in their employees’ 401(k) plans.

While it’s standard practice for employers to make matching contributions to 401(k) plans in the form of stock, IOMA editor Sean Hanna estimates those matches account for just half of the total company stock in these plans. That means that plan participants are choosing to buy their employers’ stock, despite the fact that plan sponsors have stepped up efforts to provide investment education, especially since the adoption of rule 404C in 1992. Given that diversification is the basic lesson in managing investment risk, questions arise about the effectiveness of employee education programs–and even whether the very notion of self-directed plans is fundamentally flawed. Do plan participants need to be saved from themselves?

This is not a question to be shunted aside. Although current laws appear to restrict an employer’s liability for impoverished retirees, who’s to say how laws will change in a few years, when half of all voters belong to the American Association of Retired Persons (AARP)?

A rude surprise probably awaits plan participants who have never experienced a prolonged market downturn. “The existence of 401(k) plans and the bull market have coincided, so most people in these plans are not familiar with downturns, except maybe for a brief period in 1987. It’s unclear what their reaction will be if we have not just a quick downward bump, but a sustained decline for a couple of years,” says David Certner, the AARP’s senior coordinator for economic issues.

Bankruptcies at Color Tile and Carter Hawley Hale provide cautionary tales. When the stocks collapsed, many employees lost their jobs, along with much of their retirement savings. These two cases, among others, convinced Sen. Barbara Boxer (D­Calif.) to take aim at companies that require 401(k) plan participants to hold more than 10 percent of their assets in company stock or holdings.

The fate of Boxer’s proposed bill is uncertain, but the fact that it does not address employer matches likely diminishes the potential impact. These matching contributions account for half of the stock in 401(k) plans. Many plans require that matching funds remain in company stock, sometimes until the employee is ready to retire.

At the predominant matching rate of 50 percent, company stock will account for around one-third of plan assets even if the employee does not buy any independently. “In plans like that, it would be helpful to allow employees to take the money out of the company stock account and invest it in other alternatives within a short period of time,” says Barbara Ann Uberti, a vice president at Wilmington Trust Co., which serves as trustee for about 500 qualified plans with more than $20 billion in assets.

Uberti adds, however, that she would not recommend prohibiting matches in stock, and she does not see the need for further regulating self-directed plans, which in any case are not covered by the Boxer bill. In those plans, she says, “we need more attention given to diversification in company education materials, to highlight the risk of concentrating retirement assets in a single stock, especially when that stock is not only a source of retirement security but also employment security.”


Repeated studies underscore the importance of diversifying. “A single common stock has about three times the risk of a portfolio with approximately 12 stocks, and is far riskier than the market as a whole,” says William Howard, a certified financial planner and president of William Howard & Co. Financial Advisors Inc. in Memphis. “Yes, there’s a chance for a bigger return, but the whole concept behind retirement planning is that you want to preserve purchasing power,” he says. “Why take a risk you’re not getting compensated for if you don’t have to?”

Howard recommends employee education programs include not only the benefits of diversification, but also how to calculate returns, how markets behave over long periods of time, and the impact of inflation. He says employees should also learn to monitor their allocations and make adjustments when needed, and he urges plan sponsors to offer a broad range of investment options, to include assets that will behave differently during the same economic period.

Basic financial literacy gets high priority at International Paper, in Purchase, N.Y. Besides a quarterly newsletter and routine employee briefings, IP is revamping its education program to close the gap in employee knowledge about investing. One important goal is “to come up with a method by which we can measure quantitatively the success of our education efforts,” says Robert Hunkeler, vice president of investments. “We want to actually measure investment aptitude over time.”

How? Says Hunkeler: “We might ask questions such as, Do you understand the difference between pretax and aftertax contributions and the economic impact of that difference? The difference between withdrawal and loans and the economic impact there? Do you have a sense of the expected rates of return on various investments and what is the riskiness of some of these investments?”

The challenge for corporate financial executives is to manage the tension between the benefits of keeping company stock in friendly employee hands and the obligation to avoid putting employee assets at undue risk. “One of the things we’ve seen is that everybody has a tough time trying to include company stock in education, because it creates so many conflicts,” says IOMA’s Hanna. “A lot of managers are wary of addressing the issue, so it gets short shrift. It’s hard for a company to say, ‘We have a very good company and good stock, but don’t buy too much of it.’ So you have five or six core options, and then company stock gets segregated.”

No one disputes the value of prudence, but some proponents of company stock say too much is made of the 401(k) as the sole source of savings. “We think you need to look at the employer stock issue in the broader retirement context,” says Neil Grossman, vice president, legal and regulatory affairs, for the Association of Private Pension and Welfare Plans. “In larger companies, the ESOP or other defined contribution plans invested in employer stock are likely to be supplemental to Social Security benefits, a defined benefit plan, and maybe even a 401(k) plan that allows some investment diversity.” Indeed, according to the Employee Benefit Research Institute, 50 percent of 401(k) plan participants are also covered by defined benefit plans. Still, counters the AARP’s Certner, “The fact that they have other resources is great, but I don’t think that undermines the notion that you want prudence and diversification in any of your retirement plans.”

Some argue that the riskiness of company stock is exaggerated. Says David Wray, president of the Profit Sharing/401(k) Council of America, a nonprofit association of plan sponsors: “If you look at the system from an historical perspective, you see a self-selection process. Where it makes sense and is likely to be successful you see ownership in plans,” usually in publicly traded companies with more than 5,000 employees. Conversely, in companies smaller than that, fewer than 5 percent have company stock in their 401(k) plans.

“The key,” continues Wray, “is that companies need the ability to determine when it makes sense and to make rational market-type decisions. How can you say to the thousands of retired employees from a company that invested most of its plan assets in company stock, ‘Only 10 percent of your money should have been invested in company stock and you should have half of what you’ve received’? I don’t want to say that over the years no employees have ever had losses, but overall, what we’ve seen is that the use of company stock in defined contribution plans has been extraordinarily effective.”


Wray also thinks reformers overlook the substantial benefits of company stock. Diversification is an excellent risk management tool, he says, but it’s expensive. “The two principal expenses in a plan are management fees and commissions and transaction costs. In company stock plans, there is almost no turnover, so transaction costs are low, whereas in mutual funds, they can be significant. And there are no management fees,” he explains. He cites an IOMA study that calculated that the private pension system saves $900 million a year in management fees through the use of company stock. “If the stock performs exactly like the S&P 500, you’re going to do better than a fund that’s paying even small fees,” he concludes. On the contrary, says William Howard, “Diversification reduces risk and doesn’t impede return potential. I’d rather trade off paying costs for a portfolio that will let me sleep at night.”

The debate continues. For the time being at least, it looks like self-directed plans will stay that way. “We try to educate,” says International Paper’s Hunkeler, “but ultimately it is a 401(k) plan, and employees have the final decision about how to invest the money. In the most flexible of programs, employees can own large amounts of company stock. Who’s to say that’s right or wrong for any individual employee or investor? The 401 (k) is not the limiting factor.”