Is It Ever a Good Idea to Hold Company Stock in a 401(k)?
Even if you earn your match in company shares, it doesn't mean you have to stick around.
Company retirement plans have changed significantly over the past few decades, with a few trends coming on strong.
In light of the fact that 401(k) participants are famously hands-off, plans have increasingly added “nudge” features to get more people saving: Roughly two thirds of plans now offer automatic enrollment, for example, up from just about half in 2012. Roth accounts have also shot up in popularity. Whereas 37% of plans offered a Roth option in 2009, exactly two thirds did in 2016, according to a survey from Callan Institute.
Yet even as automatic and Roth features have grown more popular, another trend is clearly on the wane: company stock on the 401(k)-plan menu. Whereas nearly half of employers offered company stock in their 401(k) plans a decade ago, either as part of the 401(k)-plan menu or as part of an employee stock-ownership plan, that figure had dropped to less than 40% as of 2016, according to Callan.
Why the demise? Well-publicized employee stock-ownership debacles like Enron and Lehman Brothers have surely contributed to the diminished presence of company stock on 401(k)-plan menus. General Electric (GE), whose shares have dropped a stunning 27% on an annualized basis over the past three years, is the latest example of a firm whose employees have gotten burned by holding company stock in the 401(k) plan. A lawsuit lodged against the firm in late 2018 alleged that GE stock was being artificially inflated and that the plan’s fiduciaries should have known about it.
In an effort to avoid such issues, plan sponsors have taken steps to reduce their liability in case the stock runs aground. And employees also appear to have gotten the message about the dangers of company stock: Vanguard's How America Saves report about defined-contribution plan participant behavior shows that just 5% of employees in Vanguard-administered plans had concentrated positions in employer stock in 2017, down from 11% at the end of 2008.
Why Avoid It
The drop-in popularity of employer stock in 401(k)s--both on plan menus and in the percentage of employees who invest in it--is a positive development for one major reason: risk.
At the portfolio level, heavily weighting single stock--any stock--has the potential to make that portfolio more volatile than one that's more diffuse. Moreover, because company stock ownership is much heavier among larger-cap stocks than smaller ones, it's much more likely that the investor who owns a heavy stake in the company also owns additional shares in that same company through any mutual funds in the portfolio.
And then there are human-capital considerations: Employees who invest heavily in company stock have both their human capital and financial capital riding on the fortunes of a single company; difficulties at their employer could cause their stock shares to sink at the same time they suffer job loss or an income reduction.
Of course, employees might like to own company stock because they believe they have an information advantage over other market participants. Although one might expect that workers who own shares of their employers' stock would benefit from their knowledge of the company, Morningstar Investment Management's head of retirement research, David Blanchett, found the opposite: Companies whose employees have high aggregate allocations to company stock have tended to underperform those without, even when controlling for market capitalization, investment style, sector, and other factors.
Blanchett concedes that employee-stock ownership, while less than ideal, is “less bad” in a small handful of situations, such as when one's company is especially large and well-diversified. In that case, however, it’s also more likely that the stock would appear elsewhere in the investor’s portfolio. Company stock is also less dangerous if the employee is able to purchase it at a discount, as is the case with some 401(k) plans, or if the employee's portfolio is already extremely large and well diversified. The flip side is that company-stock ownership can cause the greatest harm to investors who can least afford it: those with small and relatively undiversified portfolios.
Because of portfolio-diversification and human-capital considerations, Blanchett notes in this video that the optimal allocation to company stock, from a "pure research perspective," is zero. Such a Draconian approach might not be practical for some investors, however. Blanchett notes that 10% of total portfolio assets is a reasonable upper limit for company-stock ownership.
What About the Match?
Why wouldn't a total divestiture be practical in some cases? The key reason is that some plans match employees' contributions in stock rather than cash. If you’re matched on your 401(k) contribution in the form of company stock, it’s a best practice to periodically liquidate those holdings and deploy the cash into better-diversified positions within your plan. Thanks to the Pension Protection Act of 2006, participants who have logged three years of service under the plan can transfer the value of the company stock into better-diversified options within the plan.
In addition, the rules regarding net unrealized appreciation, discussed in this article, are another reason why investors might take a deliberate approach to liquidating company stock. Blanchett says investors who hold company stock in their 401(k)s will have to weigh the potential tax savings of being able to take advantage of the NUA rules against the loss of diversification that accompanies holding a substantial stake in company stock. A tax advisor can provide guidance for the best course of action; the longer your time horizon to liquidation, the greater the risk of a high allocation to employer stock.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.