Be wary of employer stock in your 401(k)
If ever you needed another reason not to invest in your company’s stock inside your 401(k), this would be it.
A new Morningstar Investment Management study shows that companies that allocate higher-than-average amounts of employer stock to 401(k) plans tend to underperform those of their peers the following year, both in terms of relative performance and on a risk-adjusted basis.
To be fair, the level of underperformance wasn’t large. Over the time period studied, firms with comparatively high allocations to employer stock in 401(k) plans underperformed those without by about 2%, according to David Blanchett, head of retirement research for Morningstar and the author of the study.
But that underperformance adds to the reasons why you shouldn’t invest in your company stock in your 401(k). “Our findings appear to contribute to the already strong argument against employees holding significant company stock allocations employees not hold significant amounts of company stock,” Blanchett wrote. Read Employer Stock Ownership in 401(k) Plans and Subsequent Company Performance.
According to Blanchett, much of the underperformance can be attributed to the period of analysis—firms with higher company stock exposure tended to be larger-cap companies with lower betas during a period in which these attributes were unfavorable. However, he also noted that underperformance persisted even after adjusting for size, value orientation, momentum and liquidity.
“I don’t understand why companies with significant employer stock exposure in the 401(k) underperform, but they definitely have historically,” said Blanchett.
For the record, Blanchett initially set out to show that companies with employees who had high allocations to employer stock within a self-directed 401(k) plan would outperform those without employer stock. That hypothesis, he wrote, was consistent with some past research on similar subjects, which largely focused on employee stock option plans (ESOPS), as well as with the general notion that those individuals who decide to own individual securities (despite their noted risks) would only do so if they were knowledgeable investors and that by doing so they could generate higher returns. Alas, he wrote, that his general findings were the exact opposite of his expectations.
Employer stock in 401(k)
So what else did Blanchett discover in his study? Well, one bit of good news is this: Employer stock, though still common in 401(k) plans, is becoming less so. According to an AonHewitt report, when employer stock is available, 76.3% of participants either had no assets in company stock or limited their company stock allocations to no more than 19% in 2012.
By contrast, in 2011, 72.7% of participants either had no assets in company stock or limited their company stock allocations to no more than 19%. And the Employee Benefit Research Institute and Investment Company Institute reported that the share of 401(k) accounts invested in company stock was 8% in 2011. In 1999, it was 19%.
There is, of course, one big reason why employees continue to owning employer stock in their 401(k), according to Blanchett’s study. Many companies match employee deferrals with employer stock as opposed to making a matching cash contribution.
But even that practice is changing, Blanchett wrote. For instance, AonHewitt research shows that among plans that offer employer stock as an investment option, only 12% require matching contributions to be invested in employer stock. That’s down from 17% in 2009 and down from 36% in 2005.
What’s more, among those firms that still match with employer stock, 90% permit immediate diversification through the sale of the stock, Blanchett wrote.
Blanchett also called attention to another big change in employer stock allocations in the Past decade. Fewer plans have significant allocations to employer stock. In Blanchett’s study, for instance, about 5% of the companies had more than 50% of 401(k) assets invested in employer stock at the beginning of 1999 and by the end of 2011, less than 1% did.
Despite the improvements, Blanchett noted that there are still a few firms with significant allocations to employer stock in their 401(k) plans. For example, companies such as Exxon Mobil Corp. (NYSE:XOM) , McDonald’s (NYSE:MCD) , and Lowe’s Companies (NYSE:LOW) , each had more than 50% of total 401(k) plan assets invested in that company’s stock at the end of 2011.
Reasons not to own stock in your 401(k)
To be sure, there are a number of significant risks associated with owning employer securities in your 401(k), according to Blanchett and other experts. And chief among them are under-diversification, the high correlation between value of the employee’s human capital, and potential fiduciary litigation for the employer.
“One of the most frequently cited dangers associated with owning employer stock is that it is inefficient from a total wealth diversification perspective, because it blends an individual’s human capital and financial capital,” Blanchett wrote. “Human capital can be defined simply as the ‘earnings power’ of an individual based on that person’s unique set of education, skills, and experiences, while financial capital can be defined simply as one’s financial assets or investible wealth.”
By using your financial capital, your 401(k) money, to purchase employer stock, Blanchett wrote than an individual is “effectively over-allocating to the future success of his or her current employer, or ‘doubling up’ on their human capital risk exposures. This is especially noteworthy because individual stocks contain unsystematic risk unrewarded by the market.”
“Investing your retirement savings in company stock, the stock of your employer, is the opposite of diversification—it’s concentrating risk,” said Drew Carrington, president of DC Squared Retirement Consulting. “Further, it’s worse, and more dangerous, than owning a concentrated stock portfolio, because of the potential financial consequences—your job, your benefits, your health insurance for your family, and your retirement savings, all tied up in the same corporation.”
Limit ownership to 10% or less
So what should you do if you own or have designs on investing in your employer’s stock in your 401(k)?
Blanchett recommends that you limit your exposure to company stock in your 401(k) as much as possible. “If you must own company stock, try to owning 10% or less,” he said. “I’m sure it’s hard not jumping on the bandwagon if lots of people someone works with own the company stock, so own some, but not too much.”
Others experts are in the same camp.
“It seems obvious doesn’t it to not hold a significant amount in any one stock, let alone your employer’s stock,” said Ron Surz, president of PPCA Inc. and its division, Target Date Solutions. “Company stock can be a double-whammy, Enron-flavor disaster, arguing for 401(k) diversification in industries other than your own.”
And however low the probability of a decline in the company, the consequences are simply too high to own more than a token amount of company stock in your retirement plan, said Carrington. “The rules for diversifying even company matches in company stock are far more liberal today, and everyone should actively monitor their concentration in company stock, and diligently rebalance their portfolio to keep it below some reasonable threshold, such as 10%,” he said.
Others issued similar but different warnings. “When consulting employees on their 401(k) portfolio, we use an analogy where the investment options in the plan are ingredients, but ultimately it is the recipe by which you put those ingredients together that determines the outcome of the portfolio,” said Chad Griffeth, the co-founder of BeManaged. “Company stock is an ingredient that can behave like hot sauce…a little goes a long way. I personally love hot sauce, but I am not going to drink the stuff, which is ultimately what employees are doing when they have large allocations to company stock.”
As a point of reference, the average allocation to employer stock across all employees was 9% in 2012, according to AonHewitt’s 2013 Universe Benchmarks report. But if you look at only participants with access to the option, the average allocation to employer stock in 2012 was 13.8%, down from 41.8% in 2002.
Also of note, Blanchett suggested that if you own more than 10% of your employer’s stock in your 401(k) there’s no optimal way to reduce your stake. “I would say just reduce the exposure as much as possible,” Blanchett said. “There’s not necessarily an optimal way, except selling after the company has done well is generally a good strategy.”
When to invest in company stock
To be fair, there are times when it might make sense to invest in your company’s stock in your 401(k). For instance, Surz said investing in discounted company stock, either outright or with a preferential company match might make sense. “Bargains are good,” Surz said.
And, one obvious potential benefit of employee ownership is, according to Blanchett, a reduction in agency costs when employee owners become more interested in the long-term success of the company because they get to participate in the gains.
Implications for plan sponsor
There’s one last word of warning from Blanchett’s study worth noting. And it’s a message for plan sponsor fiduciaries who allow participants to invest in employer stock in the 401(k) plan and those who are considering doing so in the future. Beware of fiduciary litigation.
According to Blanchett, there have been a number of lawsuits brought against plan sponsors related to employer stock in qualified plan—especially after a substantial decline in the employer stock price. In these so-called “stock-drop cases,” plan fiduciaries are accused of failing to protect participants from losing money in their company stock investment, Blanchett wrote. Recent court rulings have provided mixed relief to plan sponsors, Blanchett wrote. But that doesn’t mean plan sponsor won’t continue to be sued.
So, Blanchett offered this advice to plan sponsors that offer or that have designs on offering company stock as an investment option in a retirement plan. Be sure to educate your participants about diversification, asset allocation, and the risks related to investments in company stock. Also, be sure to monitor any restrictions on the transfer or sale of company stock in the same manner as other plan investments. And, it might be prudent to set limits on the amount of company stock a participant may hold in his or her account to, say, 20% of the account balance.