Voice | Published in February 2006

Into the Pool

Solving the problem of employer stock in 401(k)s

By PS | February 2006

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.  


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.


—Michael Schloss

Michael Schloss is of counsel in the Labor and Employment practice of Thelen Reid & Priest LLP'soffice. 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.