With the wave of stock drop litigation a decade ago, the offering company stock in defined contribution (DC) plans has decreased. According to the PLANSPONSOR DC Plan Benchmarking report, in 2013, 7.9% of DC plans overall included company stock investments in their retirement plans, increasing to 22% for large plans and 41.6% for mega plans. In 2019, this decreased to 5.7%, 13% and 34.6%, respectively.
Plan sponsors used to have the advantage of a court-standard presumption of prudence when faced with lawsuits over their DC plan company stock offerings. But in 2014, the U.S. Supreme Court, in its decision in Fifth Third Bancorp v. Dudenhoeffer, took that away.
Should plan sponsors offer company stock as an investment option? Robyn Credico, North America Defined Contribution practice director at Willis Towers Watson in Arlington, Virginia, says—from a participant and fiduciary risk perspective—no.
She explains that from a participant perspective, company stock is an undiversified risk. “It doesn’t matter how good the company is doing, it’s just not diversified,” she says. From a fiduciary perspective, the threat of lawsuits is real and requirements to monitor company stock are very challenging. “Some companies outsource that fiduciary risk, but it tends to be expensive and doesn’t always meet company objectives,” Credico says.
In fact, in 2017, Aon, a large financial firm that would be considered to be doing very well, discontinued the Aon Stock Fund as an active investment option in the Aon Savings Plan. At the time, the company said, “We have eliminated the option to invest in the company’s stock to encourage greater diversification of retirement savings. Colleagues will reallocate their investment in the Aon Stock Fund into another, better diversified, investment option within the 401(k) plan.”
However, some sources agree that company stock can have a valuable place in investment portfolios—some companies offer it for their match contributions, and ownership gives employees a vested interest in performing well. A corporate tax benefit can be an added bonus.
Robert R. Johnson, a professor of finance at Heider College of Business at Creighton University in Omaha, Nebraska, notes that in the past, employees were often eager to invest in company stock because they know and understand their employer better than other companies or funds in which they can invest. “Additionally, employees often feel very positively about the company that employs them. Cognitive dissonance (a psychological conflict from holding incongruous beliefs—in essence, convincing one’s self that the company they work for is in better shape than it actually is) may lead employees to believe that their employer’s future is much brighter than dictated by the facts,” he says.
Johnson believes company stock in DC plans is problematic for several reasons. For one, he says the biggest asset many people have, particularly early in their careers, is their human capital. “We build our human capital, often going into debt with student loans to do so, and then draw on that human capital for the rest of our careers. Oftentimes, one’s human capital is highly concentrated in a specific occupation or industry. If that is the case, the best investment policy is to diversify away from our human capital. Investing in company stock further concentrates one’s total portfolio (both human capital and invested capital). When a company one works for struggles or even fails, if one has invested his DC plan in own company stock, he stands to lose both his job and suffer significant losses in his DC plan,” Johnson explains.
He adds that one need to look no further than Enron to see the dangers of investing in company stock. At the time the firm failed, more than 60% of pension assets were in worthless Enron stock.
Protecting Participants—and Plan Sponsors
The Pension Protection Act (PPA) of 2006 and resulting regulations attempt to help plan sponsors manage their fiduciary liabilities for offering company stock. Regulations for Section 901 of the PPA generally provide that an applicable DC plan allow each individual who is a participant who has completed at least three years of service, a beneficiary of a participant who has completed at least three years of service, or a beneficiary of a deceased participant to elect to direct the plan to divest employer securities allocated to the individual’s account and to reinvest an equivalent amount in other investment options. The regulations say the plan must offer individuals not less than three investment options, other than employer securities, to which the individuals may direct the proceeds from the divestment of employer securities, each of which is diversified and has materially different risk and return characteristics.
The IRS said a plan does not fail to meet the requirements if it allows individuals to divest employer securities and reinvest the proceeds at periodic, reasonable opportunities occurring no less frequently than quarterly. Credico says most large plan sponsors allow for immediate diversification, giving them a little more protection than the PPA.
She notes that plan sponsors of employee stock ownership plans (ESOPs), which by definition primarily invest in company stock, have some fiduciary protection. However, there are also regulations providing protection for participants from not being adequately diversified in their investments. After ESOP participants reach age 55 and have participated in the plan for 10 years, they have the right during the following five years to diversify up to a total of 25% of company stock that was acquired by the ESOP after December 31, 1986, and has been allocated to their accounts. During the sixth year, they may diversify up to a total of 50%, minus any previously diversified shares. To satisfy the diversification requirement, the ESOP must offer at least three alternative investments under either the ESOP or another plan or distribute cash or company stock to the participants.
Credico says for plan sponsors that choose to offer company stock in their plans, it is also important to educate participants and explain the risk of investing in company stock. She also suggests it is preferable not to have the company CEO or chief financial officer on the plan investment committee. “They may have a conflict of interest; they may know something. Plan sponsors can’t make decisions based on inside information,” she explains.
Another way to keep company stock allocations in check is to limit, or cap, participants’ employer stock holdings to a percent of their total assets. Employers that want to continue making company match contributions in company stock might consider shortening the vesting period for company stock so participants have an opportunity to be able to diversify their investments sooner.
Johnson agrees that best practices for plan sponsors that choose to include company stock as a DC plan investment option would be to limit the allocation to company stock and encourage participants to diversify much more broadly.
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