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DEFINED CONTRIBUTION

9 misconceptions about company stock

BlackRock |Sep 12, 2019

Despite the decrease in percentage of DC assets held in company stock in recent years, the issue still matters as millions remain exposed to the risks involved.

It’s easy to see why participants might choose to invest in the one company they think they know over trying to grasp complicated investing information.

For plan sponsors, underlying assumptions that owning company stock increases employee engagement within a firm are one of the reasons they still find it an attractive offering on the defined contribution (DC) menu.

With Enron presenting the most extreme example, the risk—and potential danger—of holding company stock in a workplace retirement savings plan has been well understood. The risk is two-fold:

  • Obvious concerns about a lack of diversification through concentrated investment in a single stock
  • Employees’ double dependency on their employer’s financial health, the first through their human capital which is the current value of their future wages

While the percentage of DC assets held in company stocks has dropped within the last two decades, we believe it’s still a matter of concern. We’re going to explore nine common misconceptions about company stock and outline what plan sponsors can do about managing their company stock risk.

Misconception #1: “It’s just not that big of a problem anymore.”

Despite the decrease in numbers, there are still millions of participants exposed to large, single stock concentrations. It’s typically large plans with significant exposure. Even more concerning is that roughly 5% of DC participants in plans with company stock have virtually all their savings invested in this option.

Misconception #2: “It’s mostly executives and higher
income participants.”

When we conduct plan design analysis using participant level data, we have consistently found that it’s the lower income participants with significant concentrations in company stock. As we’ve already suggested, this may be due to a fallacy known as familiarity bias among inexperienced investors towards companies believe they know.

Figure 1: Employee company stock allocations by salary

Employee company stock allocations by salary.

For illustrative purposes only.

Misconception #3 “Our company benefits from increased engagement and productivity.”

Academic studies of both the monetary and non-monetary benefits have found mixed evidence towards this belief at best. Keep in mind that company stock is typically offered by large plans with many employees, so a rank-and-file employee effort is likely to have an extremely small impact on overall firm performance, giving him or her little incentive to work harder. It’s hard to make a case that it’s enough to justify the risk.

Misconception #4: “It’s paternalistic to assume participants don’t understand
the risk.”

While surveys do show that many participants have absorbed enough knowledge to have a sense of risk, biases and uncertainty still affects investment decisions at every level of sophistication. Surveys also find that participants rank their employer stock as less risky than a diversified equity fund, while they associate unknown or less familiar options with more risk.

Figure 2: Participant knowledge about risk/return of company stock

Participant knowledge about risk/return of company stock.

Source: Mitchell, O. S., & Utkus, S. P. The Role of Company Stock in Defined Contribution Plans. National Bureau of Economic Research, Working Paper No. 9250, October 2002.

Misconception #5: “If the risk was significant, ERISA would
prohibit it.”

ERISA (Employee Retirement Income Security Act) explicitly exempts company stock from the diversification requirement it imposes on fiduciaries. This paves the way for unsophisticated DC participants to invest their retirement savings in a single stock that is correlated with their labor income. Despite the exemption, plan sponsors have found themselves involved in costly litigation over company stock.

Misconception #6: “It’s better now – we’ve all learned from the mistakes of the past.”

Due to a shift in attitudes, it would be extremely rare to see plan sponsors matching participant contributions with company stock today. Nonetheless, as we pointed out in Misconception #1, the problem persists in many large plans because of participant inertia and the hesitation of plan sponsors to reenroll participants. That leaves it to individual participants to make the choice. Have they learned from the past? There is considerable evidence that the answer is no.

Misconception #7: “Enron was a rarity; for most companies, the risk is overstated.”

The graphs below compare the average risk and return of an equally-weighted index comprised of the 396 companies that had been listed in the S&P 500 Index for each of the previous 15 years (as of 12/31/2018), against the average risk and return of single-stock portfolios for each of the 396 companies. On a year-by-year basis, the average of the single stock portfolios only meaningfully beat the equally-weighted stock index in three of these years, yet year-by-year risk was always significantly higher.

Figure 3: 15-Year average annualized risk and return of single stock vs. equally-weighted stock index (2004-2018)*

15-Year average annualized risk and return.

Source: S&P.
*This chart shows the average annualized 15-year return and standard deviation of every single stock in the S&P 500 (as of 12/31/18) with 15 years of history vs. an equally-weighted composite index of these stocks for the period 2004-2018. Of the S&P 500 component companies as of 12/31/18, 396 had 15 years of history for inclusion in the analysis.

The conclusion: participants don’t have to work for another Enron to bear a cost for holding company stock in their DC plan. Any single stock portfolio increases risk.

Misconception #8: “There are absolutely no benefits to holding company stock.”

In the interest of fairness, there is at least one unique benefit: advantageous tax treatment. Known as NUA (net unrealized appreciation), a participant upon a job change or retirement may, assuming they meet specific conditions, elect to have all appreciation in company stock taxed at a preferential capital gains rate rather than the typically higher ordinary income rate. However, few experts (let alone participants) are aware of this benefit and therefore it’s unlikely to be a meaningful factor.

Misconception #9: “Company stock is the third rail of DC – it’s too dangerous to touch.”

Company stock not only poses risks for participants, but it can also do so for plan sponsors – regardless of whether they are keeping it in the plan or getting rid of it. Plan sponsors have been sued for removing company stock only to see the stock price escalate afterward. But they have also been involved in litigation over “stock drop” cases, in which participants claimed the plan sponsor was in a position to know that share values would decline.

Decide, document, and act

For both participants and plan sponsors, there are risks to having company stock in the DC plan and risks to eliminating it. Clearly, the trend is to reduce or eliminate company stock allocations--for good reasons, we believe—but the risk persists and company stock remains in participant portfolios to a more significant degree than many believe.

Whatever plan sponsors decide to do about their company stock allocations, it’s critical that they show due diligence for their decisions and, if possible, involve independent review as part of a well-documented and systematic process leading to a decision made in the best interest of plan participants and their beneficiaries.

To read more about the nine misconceptions about company stock and learn about managing the risks within a DC menu, download the full whitepaper.