Company Stock Can Still Be a Prudent Investment

Like most things in life, including company stock as a defined contribution (DC) plan investment option comes with pros and cons.

Giving a workforce the chance to buy company stock can instill in employees a sense of ownership, says Krista D’Aloia, vice president of Fidelity Investments, and it may increase their incentive to be productive. “Employee ownership of company stock may contribute to improved employee morale, and financial benefits for both employees and employers,” D’Aloia tells PLANSPONSOR.

Company stock continues to be an important part of the U.S. DC market, according to Fredrik Axsater, global head of State Street Global Advisors in defined contribution—constituting about 10% of all DC assets. “What is changing is that plan sponsors are increasingly reviewing their company stock plan,” he tells PLANSPONSOR. Of SSgA’s retirement plan clients, only one is eliminating company stock, Axsater says, and many others are reviewing the option and considering the use of a third-party fiduciary.

But the number of plan sponsors offering company stock seems to be dropping. More and more plan sponsors are backing off from offering company stock in their defined contribution plans, according to Stephen Moser, a retirement consultant for RetireAdvisers Services at Pension Consultants. “Our experience with our own clients confirms this trend,” he tells PLANSPONSOR. He also cites a study of Vanguard plans showing that one-third of sponsors who had previously offered company stock no longer do: From 2005 to 2014, the percentage of participants using company stock in their portfolio decreased by 42%.

One reason is a spate of recent lawsuits—among them, Fifth Third Bancorp v. Dudenhoeffer—that may make retirement plan sponsors leery. “The Fifth Third Bancorp v. Dudenhoeffer ruling last year is certainly causing sponsors to evaluate whether or not they want to continue to offer company stock in their DC plan,” Moser says.

A presupposition of prudence once protected plan sponsors when they hardwired company stock into the plan by mandating the investments in the plan documents. “That’s no longer the case,” Moser says. “Now sponsors must show actual prudence and regularly examine the company stock to make sure it’s appropriate for their participants, just like they do with other investment offerings in the plan.” Understandably, plan sponsors have a stark reaction to the removal of that protection. “It scares many plan sponsors,” Moser says.

Other court cases have brought to life an additional layer of risk that can come from offering company stock as a DC investment option, says attorney Kyle Halberg, a research analyst in ERISA services at Pension Consultants. Citing the Supreme Court decision in Tibble v. Edison, Halberg points out that the fiduciary to a retirement plan has more than just a duty to ensure that the investment decisions are prudent at the time that an investment option is added to the plan’s lineup.

“The fiduciary also has a duty to continually monitor the investment lineup to ensure that those investment options are prudent on an ongoing basis,” he tells PLANSPONSOR. “Before deciding to add company stock to your DC plan’s investment lineup, ask yourself whether you will be able to fulfill that ongoing duty to monitor the investment, and in the event that its performance is suffering, replace it with a more prudent alternative.”

Halberg says it can be hard for a company official to separate the two functions, as the same person is likely have an interest in protecting the stock that is in the plan’s lineup, and is a fiduciary to the retirement plan.

As questions mushroom around how companies evaluate their company stock investment option, Axsater emphasizes that a third-party fiduciary always has a process, so outsourcing this function can be a boon to the plan sponsor. This division at State Street Global Advisors has expanded over the last year and a half, and the company now oversees $60 billion in company stock assets as a third-party fiduciary.

Plan sponsors must make sure their plan committees follow a prudent procedure for choosing and monitoring all the investments available in the plan, Moser cautions. “They need to review the Investment Policy Statement, the plan documents and the written procedures used – and document, document, document!” he says. The process, the findings, the actions resulting from those reviews must all be documented. And any time a plan sponsor is concerned about accusations of conflicts of interest, the committee may also want to consider hiring an independent fiduciary to evaluate the company stock.

Plan sponsors also need to show they are actively helping participants avoid over-concentration of their investments in one area, perhaps by setting a cap on ownership of company stock, Moser suggests. More than half of Vanguard plan sponsor clients restrict employee elective contributions or exchanges into company stock, he notes, with the most common threshold at 20%. 

Companies that provide employer contributions in the form of company stock have another task: “It’s important to allow immediate diversification of those contributions into other investments,” Moser says. “And educate, educate, educate! Educate those who have high exposure to company stock in their portfolio with a targeted campaign to make sure they understand the risks of over-concentration. Educate participants holding stock about the process of how to move out of company stock holdings if they wish to do so. And educate all participants about the importance of diversification and asset allocation, possibly providing them with asset-allocation models based on risk tolerance and age.”

The plan fiduciary’s paramount consideration, when weighing the offer of company stock, is the Employee Retirement Income Security Act (ERISA) duty of prudence and the duty of loyalty, Halberg says.

The fiduciary must act as a prudent person would act in the same situation, and answering whether allowing company stock in the investment lineup is a prudent decision is not easy, “especially as someone who is going to be inherently biased toward an optimistic outlook on your company’s future,” Halberg says.

Halberg cites the recent Court of Appeals case, Tatum v. RJR Pension Investment Committee, to highlight the complexity and potential liability of using company stock in a DC plan. The company chose to divest the stock of the recently spun-off Nabisco company, a decision that “seemed reasonable on the surface,” Halberg observes. “After all, isn’t it inherently risky to be offering an individual company’s stock in your investment lineup? The committee thought so, and decided to divest without giving it much more thought.”

But after the stock was removed, it increased in value by nearly 250%, moving some very unhappy participants to sue the plan. The 4th Circuit held that the prudence test requires a determination that a prudent person in the same situation would have made the same decision, rather than that they merely could have made the same decision, Halberg says, a decision that raised the bar with respect to the fiduciary duty of prudence. “It should give pause to any fiduciary who is considering adding company stock to their plan,” he says. “Again, it’s hard to take off those rose-colored glasses that led to that initial reaction, saying, ‘Of course my company’s stock is a prudent investment.’”

If there are any silver linings to some of the court decisions, Moser says the Fifth Third ruling adds some protection for plan sponsors. Regarding publicly traded stocks, it says that “allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances,” he points out.

A plan committee that takes no action based on inside information about company stock in the plan is also afforded some protection by the Fifth Third ruling, Moser says. “A plaintiff must plausibly allege an alternative action that the defendant could have taken that would have been consistent with the securities laws and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than to help it.”

The process for deciding whether to keep company stock in the plan or not resembles the way individual participants decide how to allocate investments in their accounts: it’s all about risk versus reward. “On the reward side, providing participants with company stock aligns their goals with those of the company, provides them with a sense of ownership, and helps increase loyalty and decrease turnover,” Moser says. “On the risk side, perceived exposure to fiduciary liability due to stricter standards for loyalty, prudence and diversification can be a powerful deterrent.” 

The recent court cases haven’t actually increased the overall risk of liability for most plans, Moser says, “but they have made it more important to pay attention to the policies, procedures and investments in the plan,” he observes. “Deciding what level of risk is acceptable in order to gain the rewards of company stock ownership by participants is an individual decision for each plan sponsor.”