Beware Of Company Stock In Qualified Plans

Many firms that seek to increase their workers' motivation and tenure do so by rewarding them with shares of company stock. They also encourage their employees to hold this stock inside their 401(k) or other qualified plans. But while this strategy does have a few advantages, it can also pose some substantial risks to employees, and these risks are not always explained adequately.

The ERISA Loophole

The Employee Retirement Income Security Act of 1974, which led to the creation of 401(k)s, was created in an effort to safeguard American workers' retirement funds. When Congress introduced this legislation in the early 1970s, most major corporations and employers in America were all for it – on one condition. They told Congress that if they were not allowed to put their own stock in a company plan, then they would not offer any of the qualified plans created by the Act in any capacity! Needless to say, Congress quickly caved to their demands and allowed a loophole that permitted the purchase of "qualifying employer securities" inside an "eligible individual account" in qualified plans. This provision allows employers to push (or at least offer) their own stock to their employees while maintaining the fiduciary status that requires them to put their employees' financial interests before their own.

The Enron Factor

The Employee Benefit Research Institute (EBRI) published a brief in January of 2002 that showed that the total allocation of 401(k) plan assets in company stock had remained steady at just under 20% for the previous five years. Its March 2008 publication stated, however, that by 2006 this percentage had dropped by almost half to about 11%. The first drop was due largely to the financial meltdowns of Enron and Worldcom, where billions of dollars of assets in the employee pension plans were lost as a result of the company stock becoming worthless within a matter of weeks. Needless to say, this fiasco quickly led to widespread criticism from both the media and securities regulators about the asset allocation practices that were encouraged by both companies. The Pension Protection Act of 2006 was one of several pieces of legislation designed to prevent this sort of problem: Among its provisions were stipulations prohibiting employers from restricting employees from selling their shares inside a qualified plan.

According to the National Center for Employee Ownership, as of 2018, there are 6,416 Employee Stock Ownership Plans (ESOPs) and 1,164 KSOPs (a combination ESOP-401(k) plan) that invest either mostly or exclusively in company stock. In addition, there are 4,468 ESOP-like plans, which are "substantially invested (at least 20%) in employer stock." All told, this comes to a total of more than 10,000 plans with 14 million participants. Although the economic turbulence of the past several years has curtailed the purchase of company shares inside retirement plans, the practice has clearly continued.

Purchasing Company Stock: The Pros

401(k) plans and ESOPs are the two most common types of qualified plans in which company shares can be found. ESOPs are popular with closely held businesses that use the plan as a means of transferring ownership (for this reason, the use of company stock in an ESOP plan is somewhat more understandable). Some employers strongly encourage their workers to invest all of their contributions into company shares, while others will either refuse to match any contributions that are not used to buy company stock or else match employee contributions with company shares.

Employers encourage the purchase of company stock in retirement plans for several reasons. They can benefit from improved employee motivation and longevity by aligning their employees' financial interests with the company. They can also shore up their power base among the shareholders at large by placing more shares in the hands of workers who are likely to support at least the majority of the decisions made by the board of directors. Perhaps most importantly, they can also save money by making their matching contributions in the form of company shares instead of cash.

Employees can benefit by making tax-deductible purchases of company stock in their plans without having to enroll in a separate plan of any kind, such as an employee stock purchase plan or stock option plan. But the advantages of doing this for employees are often overshadowed by one of the most fundamental rules of asset allocation.

Purchasing Company Stock: The Cons

Any competent financial planner will tell clients to avoid putting most or all of their eggs into one basket. Employees who funnel most or all of their retirement plan contributions into company stock can end up with their portfolios seriously overweighted. They need to realistically consider the possibility that their employers could go bankrupt at some point, and then assess the impact that this would have on their investment and retirement funds. An employee who has half of their liquid assets tied up in a company that goes bankrupt may have to work another five or 10 years, at least, to make up for this loss. The employees at Enron and Worldcom learned this the hard way.

But a company doesn't have to actually go under. Even a plummet in its shares can smash a retirement nest egg. For example, say a longtime employee of XYZ Corporation has accumulated $350,000 in their 401(k), $250,000 worth of it in the company stock. They are thinking about retiring in a year or so. The economy heads into a deep recession, however, and the XYZ shares depreciate by 80% in one year, so they're now only worth $50,000. The 401(k), now worth $150,000, has lost over half its value – and just about at the time the employee was getting ready to cash it in.

The Bottom Line

Although there are some very real reasons why purchasing at least some company stock inside a retirement plan can be a good idea, employees should always start by obtaining some unbiased research on their company, such as a detailed report from a third-party analyst. A series of meetings with a qualified financial planner can also help an employee to determine their risk tolerance and investment objectives and provide insight as to how much company stock they should own, if any. Companies that genuinely care about the welfare of their employees will often have resources available on this matter as well.

If the shares come as a company match or another sort of gift, great. But even the offer of incentives to buy the stock shouldn't tempt employees to overweight their portfolios with it. Workers owe employers their time, brains, and effort – but not the obligation to put their retirement years at risk.