Great strides have been made by 401(k) plans in recent years -- reducing costs, simplifying investment menus and automating portfolio allocation. But a surprisingly large number of plans still include one feature that really should go: offering the plan sponsor's own shares to workers.
Research consistently shows that owning your employer's stock in a workplace retirement plan is risky. And although concentration of employer stock in workplace plans has been declining in recent years, stubbornly high pockets of concentration remain.
Research by benefits consulting firm Aon Hewitt shows that, at companies where stock is available, more than half of workers own the shares -- and that 23 percent of those workers had at least 20 percent of their portfolios in their employer's stock. That's a heavy concentration by any measure.
The continued use of company stock runs counter to best practices in retirement portfolio construction. "People don't understand how risky it is to own their own employer's stock," says David Blanchett, head of retirement research for Morningstar Investment Management.
"If you went to the typical corporate plan sponsor and suggested that they add some other company's stock as a plan option, they'd tell you it's a crazy idea. But for some reason, it's not crazy to offer their own stock. If companies are going to do it, it's important to be very proactive about making sure people understand the risk and use this option responsibly."
Research by Blanchett found that the stock of companies with high allocations of their own stock in a 401(k) plan tended to underperform peers on a relative performance and risk-adjusted basis. Making matters worse, investors aren't compensated for the risk.
"Diversification is the only 'free lunch' associated with investing," says Blanchett. "You should only take on risk if there is an expected reward. For example, why would you put money in a stock if the expected return is the same as a money market account, but it had something like 10 times the volatility? Holding a single employer stock is an idiosyncratic risk of that sort."
Another major risk is the high correlation of the employer's stock and "human capital" -- that is, the employee's ability to earn income. A plunge in the employer's stock could also be associated with greater risk of job loss. "Ask yourself: How risky is my job and how does it relate to the stock market?" Blanchett says. "If I'm a Realtor, I'm in a very risky profession. So, I should have more cash in my portfolio for a rainy day, and I don't want to hold REITs [real estate investment trusts] because you already have that risk in your professional work. Just ask yourself -- what is risky about my job and how can I hedge against that risk?"
Net unrealized appreciation
Even the critics concede there are a couple of potential advantages to company-stock features in retirement plans. One is the opportunity to buy your employer's stock at a discount -- a feature often found in these plans. The other is net unrealized appreciation, known as NUA, an IRS rule that allows you to take distributions and pay taxes on the difference between cost basis and market value at long-term capital gains tax rates, rather than ordinary income rates.
That approach can make sense if you've held company stock for a while and it has appreciated substantially.
Purchases outside retirement plans
There's also been renewed interest in employee stock purchase plans, known as ESPPs. These plans let workers buy their employers' stock outside retirement plans using after-tax dollars, often at a discount of up to 15 percent below market rates. ESPPs have been around for a while, but interest cooled off following 2005 accounting-rule reforms that required companies to expense the cost of plans. The recession also dampened interest in the plans because of their cost.
But interest in ESPPs may be returning. Fidelity Investments reports a 36 percent increase since 2013 in the number of participants in ESPP plans that it administers and a jump in purchases of 180 percent over the same period, to $2.5 billion.
In a recent Fidelity survey, 86 percent of respondents younger than 40 said they would want their new employer to offer a company-stock plan if they changed jobs, and 40 percent said they considered a company-stock plan as a must-have benefit when making a decision to change employers.
Mark Miller edits and publishes RetirementRevised.com. His column is distributed by 50+ Digital LLC.