It’s time to end the tax deduction for a contribution of company stock to qualified retirement plans. It’s bad for employees, bad public policy, bad accounting and bad tax policy.
Here’s a modest suggestion: If you hold your employer’s stock in your 401(k) dump it; if you are a plan sponsor you should terminate any option for company stock in your plan. In fact, the SEC and Department of Labor should prohibit it.
While use of employer stock in retirement plans is decreasing, there is no excuse for allowing it all. We certainly don’t have to look far to find hundreds of thousands of employees where all or a good portion of their retirement funds vaporize when their company failed. To name a few of the most notorious including Enron, Global Crossing, United Airlines, US Airways, and now General Motors, where State Street Bank and Trust is being sued in federal court for including an option to buy GM stock in that company’s two 401(k) plans.
From the employee’s point of view 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.
It’s easy for employees to deny the problems of the employer, or think that they have “insider” knowledge of the company’s position. They are too close and emotionally vested to make objective decisions. I saw this in a past life as an Eastern Pilot where employees were buying company stock right up to the day the doors closed.
As deliberate company policy employees were 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.
Of course, we have all heard about all the millionaire and billionaire employees at Microsoft MSFT, Apple AAPL, and Facebook. They won the lottery, but for every one of them, there are hundreds of employees laboring away with company stock going nowhere. Retirement investing is not about winning the lottery; it’s about building security and reducing risk. Employer stock is a huge concentrated stock risk.
The spirit and intent of the Employee Retirement Income Security Act (ERISA) holds that pension plans are for the sole and exclusive benefit of the participants. The act mandates that pension fiduciaries adhere to prudent investment practices including the duty to educate and advise employees, diversify investments, and limit risk. That’s pretty straightforward.
But, in the initial ERISA hearings special interests testified that if they didn’t have the right to donate company stock for all or part of their contributions, they would simply not have a retirement plan at all! So, Congress caved, establishing a loophole large enough to fly a 747 through.
From the employer’s side this is a wonderful opportunity.
- Large employee ownership may foster loyalty and increase productivity.
- The stock is held by “friendly” hands that are unlikely to vote against management.
- The employees “sweat equity” funds the company’s capital requirements.
- The company receives a tax deduction as if they had contributed cash.
- If the plan is buying stock on the open market, it supports and enhances the stock price.
But, its’ also a huge conflict of interest where the interests of the participants and shareholders diverge, putting the fiduciary in a hopeless position. For instance, if the fiduciaries were to sell company stock as a result of deteriorating financial results, it would drive the stock price down for other shareholders. The pressure to hold it from the board and other concerned interests conflicts with their duty to make decisions solely on the basis of the employee participants.
In some cases, employees may be required to purchase company stock in order to obtain the “match,” but, it even gets worse. Employers actively encourage employees to purchase even more company stock inside the plan. As if that weren’t bad enough, restrictions on the sale of company stock are routinely imposed on plan participants. Ask any Enron employee how that turned out for them.
It’s time to clean up the 401(k) loopholes that threaten to destroy so many employees’ retirement plans. Make employee stock purchase options in retirement plans a prohibited transaction under ERISA.