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Perils of Owning Company Stock

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Here’s a little food for thought: The August 23 issue of Pension and Investments states that that 43.8% of the total assets of the 50 largest defined-contribution plans in America were invested in the sponsoring company’s stock. Procter & Gamble PG employees had an astounding 95.7% of their plan assets tied up in P&G stock.

Now there are dumb investments, and then there are really dumb investments. These employees have signed up for a great deal more risk than they need to.

The general rule that diversification is good doesn’t stop at the company fence. A diversified portfolio helps protect investors against all the things that will go wrong that we can’t even imagine today. Any first-year finance student knows that diversification carries no penalty in return reduction. Diversification is as close to a free lunch as investors can hope for. Likewise, concentration of investments is bad, leading to higher risk without any higher expected return.

But, the problem of employer stock is particularly acute. Economists make a distinction between investment capital and “human capital.” Human capital is the value that the individual brings to society, and may be (very roughly) measured in lifetime wages. Human capital is a “wasting” asset. It’s also a risky asset. Once it’s gone, it’s gone. The flying fickle finger of fate can intervene at any time. So, at least some of it must be converted to investment capital over time. That’s why we set up retirement plans, buy life and disability insurance, and save.

Another problem with human capital is that it is difficult to diversify. Few of us can manage more than one career at a time. So, it makes sense to diversify away from the employer risk in our investment capital. After all, if your company does poorly, some employees (or all of them) may find themselves out of a job at the same time that their stock is in the tank.

I have witnessed this devastation up close. My hometown, Miami, saw most of its major employers go toes up in just a very short time in the early 1990s. We lost probably 100,000 jobs as Eastern Airlines, Pan American, Air Florida, NorthEast Airlines, Jartran, South East Bank, Amerifirst S&L, Centrust S&L, and several other smaller banks disappeared. Jartran and NorthEast Airlines were startup companies, but the rest were long-established, major national or dominant regional institutions. It’s a safe bet that in 1985 no one expected them to disappear without a trace.

It’s easy for employees to deny the problems of the employer, or think that they have “insider” knowledge of the company’s position. Many of those Miami employees were buying company stock right up to the day the doors closed. In fact, employees are often carefully kept in the dark to keep up morale. To ensure an orderly liquidation, Eastern kept information under wraps right up until the hour they shut down. Employee briefings are not held to the same standards that analyst briefings are.

I can remember trying to tell a Pan American captain that when a company’s bonds are selling for less than the amount of the next interest payment, the market is saying something about the likelihood that the dividend will be paid. He bought them anyway. The rest, as they say, is history.

But even high-growth healthy companies can experience dramatic swings in their stock prices, subjecting employees’ finances to gut-wrenching roller-coaster swings. An employee recently confessed on TheStreet.com TSCMthat his 401(k) balance was 70% invested in employer stock, and before he could roll it over when he left it fell more than 50%. Ironically, he went on to say that his former employer, Charles Schwab SCH, would be the first to warn against concentration in any single stock. “I have a bunch. But…my account doesn’t look so hot,” he said.

Companies often make stock available to their employees at a discount. This discount can take the form of incentive stock options, and discount stock-purchase plans. It’s easy to see the advantages for the employer: increased loyalty and identification with corporate goals by the recipients, reduced payroll costs, and even a reduced cost of capital. Startup companies often finance their operations with “funny money” stock options.

But it’s a mixed bag for the employees. On one hand there may be something to be said for turning employees into rugged capitalists. On the other hand it defies the logic of diversification and compounds the problem by lumping the human capital of your job into your investment capital. Still, these employees are supposedly making informed free-market choices. Of course, we have all heard about all the millionaire employees at Microsoft MSFT. Microsoft employees have won the lottery. But for every one of them there are hundreds of employees laboring away with company stock going nowhere. Investing is not about winning the lottery; it’s about building security and reducing risk.

It’s shocking that Congress allows corporations to fund their retirement plans with company stock. Tax-qualified retirement plans are supposed to be for the exclusive benefit of the beneficiaries, and fiduciary standards should apply. Employees trapped in pension plans requiring funding with company stock should complain to management and write their elected representatives.

How much of your employer’s stock should you own? Maybe zero. Employees that hold more than a token amount of their employer’s stock do so at their peril