Many firms that seek to increase employee motivation and tenure are able to do so by rewarding their workers with shares of company stock.This method of compensation can benefit both employees and employers in many respects; employees can get an extra measure of compensation that takes them beyond their regular paychecks, while employers can allow the open market to shoulder at least a portion of the cost.
Many firms encourage their employees to purchase stock inside their 401(k) or other qualified plans as well. 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 was created in an effort to create secure retirement for American workers. When Congress introduced this act in the early seventies, 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 the 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 their “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% with another 2010 publication giving a percentage of 9.2. 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 from repeating itself. Among the provisions of this act were stipulations prohibiting employers from restricting employees from selling their shares inside a qualified plan.
The National centre for Employee Ownership published a Statistical Profile of Employee Ownership on its website in February of 2012 showing that there are still about 800 401(k) plans and nearly 11,000 ESOP plans that invest either mostly or exclusively in company stock. Although the economic turbulence of the past several years has curtailed the purchase of company shares inside retirement plans, this practice has clearly continued.
Methods of Stock Purchase
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 directly with company shares.
Advantages of Purchasing Company Stock in Qualified Plans
Employers encourage the purchase of company stock in their retirement plans for several reasons. As mentioned in the introduction, 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 to doing this for employees are often overshadowed by one of the most fundamental rules of asset allocation.
When You Don’t Diversify
Any competent financial planner will tell his or her 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 being seriously overweighted with this holding in their portfolios.
The employees at Enron, Worldcom, United Airlines and other firms that went bankrupt learned the consequences of this the hard way. Workers who invest in company stock 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 portfolios.
It can certainly be tempting to load up on company shares in many cases, especially if the company is doing well and the stock has outperformed the market over time. But factors such as governmental regulation, market forces and economic conditions can drastically alter the solvency of a company in some cases. An employee who has half of his or her liquid assets tied up in a company that goes bankrupt may have to work another five or 10 years to make up for this loss.
Jody works in sales for XYZ Corporation. She makes $100,000 a year and contributes the maximum amount to her 401(k). ABC Corporation will match up to 50% of her 401(k) plan contributions with company stock. After 20 years at the company, she has accumulated nearly $250,000 worth of shares in the company and is starting to think about retirement.
The economy heads into a deep recession, however, and the stock price plummets by 80% in one year. Then ABC is unexpectedly forced to declare bankruptcy due to serious problems with its line of products. Jody will only have the remaining balance in her 401(k) plan plus whatever other savings that she has accumulated to live on during retirement.
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 stock, 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 his or her risk tolerance and investment objectives and provide insight as to how much company stock he or she should own, if any.
Companies that genuinely care about the welfare of their employees will often have resources available on this matter as well. For more information on this topic, consult your HR department or financial advisor.