Solving the problem of
employer stock in 401(k)s
» A Potential Solution
Employees in the United States expect to receive some
type of retirement plan and, today, the 401(k) is the
retirement plan most commonly offered to American workers.
As part of the set of rules that govern 401(k) plans, the
Employee Retirement Income Security Act of 1974 (ERISA)
encourages employers to include their own stock as
investments in these plans by exempting those investments
from, among other things, ERISA's diversification
requirements. This exemption and the fact that stock
contributions do not require a cash outlay from plan
sponsors encourage employers trying to maximize the
benefits they can provide to their employees at the lowest
cost to make pension contributions in shares of company
stock. (There are additional advantages and disadvantages
in the use of company stock in an ESOP, and those are
beyond the scope of this article.)
401(k) investments in employer stock are significant.
According to the Investment Company Institute (ICI), by the
end of 2003, 401(k) plans held $1.9 trillion in assets
covering 42 million workers nationwide. About half offered
company stock as an option, and about 10% of participants
invested their retirement accounts almost exclusively in
company stock. At the time, about 16% of all 401(k) funds
were invested in company stock (equating to about $300
billion covering 2 million participants).
Laws encouraging retirement investments in company stock
often leave employees with their retirement security
resting on the fortunes of a single investment. No
professional investment advisor would counsel clients to
invest in only one security (and an equity security at
that), and even the most daring investors would never keep
all of their money tied up in one security for 20 to 30
years—particularly if their employment income and other
benefits also were tied up in the same underlying company.
That type of approach violates the most basic principles of
diversification fundamental to any sound investment
strategy (also known by the maxim that one should not put
all of one's eggs in one basket).
The dangers inherent in 401(k) investments in company
stock have been demonstrated recently and repeatedly
through the demise of a number of publicly traded companies
and the multibillion-dollar collapse in the value of 401(k)
accounts invested in employer stock. Of course, the
specific causes of the corporate failures of the early 21st
century were unusual, and actions have been taken to
protect those who suffered directly from the recent
scandals. New laws such as Sarbanes-Oxley are designed to
prevent those particular types of scandals from occurring
again.
Changes in the law designed to prevent the repeat of
past sins, however, cannot guarantee that corporations will
not fail in the future. Over any given period of time, some
publicly traded companies will fail. The cause of any
particular corporate failure is really irrelevant. For
employees, what matters is that, over any given 20- to
30-year period (the period during which employees are
saving for their retirement), a significant number of
publicly traded companies will fail, and workers in those
firms who choose to invest in employer stock will see their
retirement savings wiped out in the process.
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A Potential Solution
Any practical solution to the dangers posed by pension
investments in employer stock must preserve the benefits
and incentives that encourage employers to maximize the
amount they may contribute to employee retirement funds.
Equity securities consistently have outperformed other
types of investments over any lengthy period of time. Laws
that discourage employees from maximizing their investment
returns make no sense. At the same time, however, the
solution also must resolve the real dangers posed by the
resulting lack of diversification that is not only
permitted, but also encouraged by existing pension laws.
The diversification problem already has been dealt with
in the nonpension world. Most individual investors do not
have sufficient funds to build an adequately diversified
portfolio. Savvy investors deal with this problem by
investing in pooled funds (index funds, mutual funds,
etc.). These funds permit individual investors to invest
limited assets quickly and efficiently in one investment
that, while offering them the ease of one-stop shopping and
minimal investment requirements, provides them with the
benefits of large portfolio diversification. If any one
asset in a mutual fund fails (as they do from time to
time), the value of the overall investment is not destroyed
because these funds maintain diversified portfolios.
Applying these same principles to 401(k) funds makes
sense for all of the same reasons—particularly for those
employers with publicly traded securities. Permitting large
employers to pool their employer stock accounts into one
larger pool (or multiple pools) would alleviate some of the
risks posed by the current lack of diversification now
mandated by current pension rules.
Employers still would be able to maximize the amount that
they could contribute and take advantage of the tax
benefits available under current law while, at the same
time, alleviating risks their employees face due to the
complete lack of diversification.
Currently, the law does not permit multiple retirement
plans sponsored by different companies to combine employer
stock accounts. The Department of Labor would need to
promulgate rules in order to permit employers to set up and
contribute to these pooled accounts. Depending upon the
ultimate parameters of pooled employer stock ownership
accounts, changes in ERISA and the tax code also may be
appropriate.
Pooled employee stock ownership accounts would not be
without limitation. Participation would be limited to
employers with publicly traded stock. Rules supporting
diversification and percentage limits would need to prevent
any one stock from making up too large a part of any pooled
fund. Managers of pooled accounts would be required to
monitor the percentage values of individual stocks in these
accounts and, where appropriate, reinvest employer
contributions in other securities in order to maintain the
accounts within mandated diversification limits. Managers
also would need to be on the lookout for stocks that are
failing and need to be sold, as well as trading abuses
(such as market timing and late trading).
In sum, there never will be a law that will prevent the
next corporate meltdown. Every year, large, publicly traded
corporations go bankrupt for reasons that usually do not
involve illegal behaviors.
Laws limiting employer stock retirement accounts to one
stock defy common sense and run counter to the public
interest in providing retirement security. Permitting
employers with publicly traded securities to pool their
single-stock pension stock accounts into diversified pooled
employer stock ownership accounts would allow them to keep
the benefits and incentives that they already enjoy under
the current system while, at the same time, protecting
their employees from the insecurity that they currently
face because of their nondiversified pension
investments.
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—Michael Schloss
Michael Schloss is of counsel in the Labor and
Employment practice of Thelen Reid & Priest
LLP's
office. He most recently served as a senior trial
attorney with the US Department of Labor where he was
responsible for representing the department in all phases
of trial and appellate litigation in cases arising under
Title I of ERISA as well as in investigations of ERISA
violations. While at the DoL, he acted as
attorney-in-charge of the Secretary's action against
Enron Corp., Kenneth Lay, Jeffrey K Skilling, Enron's
outside directors, and others for pension losses suffered
by Enron employees as a result of imprudent investments
in Enron stock.