Data and Research December 15, 2020

Plan Design Decisions Can Reduce Overconcentration in Company Stock

Research from Vanguard supports the continuation of rethinking decisions about company stock offerings in defined contribution plans.

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A recent analysis from Vanguard explores the gradual abandonment of company stock in defined contribution (DC) plans.

In the report, “Company Stock in DC Plans,” authors John A. Lamancusa and Jean A. Young note that at the time the Employee Retirement Income Security Act (ERISA) was adopted, defined benefit (DB) plans were the dominant type of retirement savings plan in America. ERISA imposed a 10% limit on company stock holdings in DB plans; however, no comparable company stock restriction was imposed on DC plans.

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The authors also note that employee stock ownership plans (ESOPs)—which are invested principally in company stock—and the offering of company stock in 401(k) plans are attempts to incentivize employees by aligning their interests with interests of the company. Yet concentrated stock positions are in opposition to ERISA’s fiduciary standard to diversify plan investments.

For decades, DC plan sponsors have faced litigation alleging plan fiduciaries continued to offer company stock as an investment when it was no longer prudent to do so. Lamancusa and Young note in their report that high-profile losses in DC plans that offered company stock led to diversification rules being included in the Pension Protection Act (PPA) of 2006. Under these rules, plan participants are able to diversify their company stock holdings purchased with their own contributions at any time and can diversify holdings purchased with employer contributions once the participants have been credited with three years of service.

But, while the PPA enhanced participants’ ability to diversify from company stock holdings, litigation continued, and, in many cases, courts decided plan sponsors were afforded a “presumption of prudence” when offering company stock in ESOPs or other DC plans. In 2014, the U.S. Supreme Court negated this presumption. Since then, plan sponsors have continued to evaluate the prudence of offering company stock in their retirement plans.

Vanguard examined the changing incidence of company stock in plans it recordkeeps by analyzing 826 plan sponsors that were continuously on its recordkeeping systems between December 2005 and June 2020. Over that period, the percentage of plan sponsors offering company stock fell from 11% to 7%, a relative decline of 36%. The percentage of participants with a concentrated stock position (greater than 20% of total account balance) dropped by nearly three-quarters.

Between December 2005 and June 2020, 54% of company stock funds were closed to new money and/or eliminated from the plan.

Plan Design to Mitigate Risks

“A concentrated position in company stock can pose a substantial risk to a participant’s retirement security,” Lamancusa and Young say in their report. “It also raises litigation risks for plan fiduciaries.”

A Vanguard analysis found demographic characteristics such as age, income, education, job tenure and nonretirement wealth, while statistically significant, are not strongly related to the percentage of company stock in a participant’s account balance. The researchers found plan sponsor design decisions have the strongest relationship to the proportion of participant holdings in employer stock.

When a sponsor directs the employer match to company stock, a typical participant holds 3.3 percentage points more company stock than when an organization matches “in cash.” If a sponsor restricts the participant’s exchanges into company stock, the typical participant holds 1.3 percentage points less in company stock. When an organization restricts exchanges out of company stock, the typical participant holds 12.8 percentage points more in company stock.

Many sponsors have come to recognize the risks associated with single-stock ownership—for participants and for plan fiduciaries—and have imposed restrictions on concentrated company stock holdings. Two-thirds of sponsors limited employee contributions and/or exchanges into company stock as of June. And permitting immediate diversification of employer contributions directed to company stock has become the norm, even though the PPA allows a three-year service requirement.

The authors point out that the average five-year annualized company stock fund return was 4.8% for the organizations in Vanguard’s data set. However, there was wide variation in those returns—the five-year annualized return was negative 16.5% at the fifth percentile and 20.1% at the 95th percentile. “This wide range underscores the risk of company stock. A five-year annualized return of negative 16.5% translates to a cumulative loss of 59% over the period, whereas a five-year annualized return of 20.1% translates to a cumulative return of 150%,” the report says. “Prior research suggests that participants holding company stock do not understand the risks involved.”

A Word About ESOPs

In its analysis, Vanguard found that plans that offer company stock as an investment tend to be more generous and better-funded than non-company-stock plans. Median account balances are higher in company stock plans, as are median employee and employer contributions.

One reason for the greater generosity, according to Vanguard, is the prevalence of employer matching or other employer contributions. All plans with company stock make matching or other contributions, compared with 96% of all Vanguard-recordkept plans. Three-quarters of organizations with active company stock funds make both matching and other employer contributions to participant accounts—compared with 35% of all Vanguard plans.

Organizations that actively offer company stock make employer contributions that are about one-third more generous. Their participants have account balances that are about 7% larger after controlling for participant demographic and plan design features.

Another point the researchers made about the Vanguard data is that large employers, which are more likely to offer company stock, are also more likely to sponsor multiple DC plans. As a result, participants at large companies often have more than one DC plan account with the plan sponsor. For example, participants at one company might have a 401(k) account with no company stock and a standalone ESOP account with company stock. At another company, participants may have a 401(k) plan/ESOP plan with company stock and a standalone profit sharing plan with no company stock.

Offering more than one DC plan seemingly solves the lack-of-diversification issue.

Administration December 15, 2020

COVID-19 Having Major Impact on Pensions

Many terminated or furloughed employees have taken early retirement, curtailing contributions and raising payout obligations.

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“The Impact of COVID-19 on Retirement Plans,” a webinar hosted by the American Academy of Actuaries Pension Practice Council, explored how the coronavirus pandemic has affected various types of pension plans.

Linda Stone, senior pension fellow, American Academy of Actuaries, said, “Equity markets have recovered following a significant downturn during the first quarter of 2020. Year-to-date through November 30, U.S. equities have returned 15%. However, that has been offset by interest rates falling to historic lows. As a result, long-term corporate bond yields are down 70 basis points [bps] year-to-date through November 30.”

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That aside, Stone said that “interest rate and asset smoothing mechanisms mitigate much of the effect of recent volatility on 2021 funding calculations. Recognition of asset gains or losses will be delayed for plans using asset smoothing, while stabilized interest rates used by single employer plans may fall less than market rates.”

Stone also said that the impact COVID-19 has on plans will vary widely across geographies, industries, plans and participants. She also noted that layoffs and furloughs have accelerated retirement and that the impact this has on plans will depend on whether the plan offers any early retirement subsidies.

Eric Keener, chairperson of the Retirement System Assessment and Policy Committee at the American Academy of Actuaries, noted that single employer pensions offered by companies in the S&P 500 had a funded status of 87% at the beginning of the year. At the height of the market volatility in March and February, that slipped to 80%, but the funded status has since risen to 89.3%.

“Sponsors of single employer plans likely need to consider the impact of the pandemic in preparing 2020 year-end disclosures and 2021 expenses,” Keener said. “While mortality may seem like the area where adjustments are most needed, turnover, retirement salary increases, lump-sum elections and other factors may be more material.”

Keener said that even though more than 300,000 people have died from COVID-19 in the United States, this increased mortality is unlikely to have a significant impact on benefit obligations for most pension plans. As to whether it might in the future, it depends on how quickly the nation can overcome the pandemic, Keener said.

To reflect their experience in 2020, single employer pension plans need to adjust data for impacted groups, i.e., those who have been terminated from the plan or who have retired, Keener said. They also need to estimate the impact from these factors on this year and reflect them as an adjustment to roll-forward assumptions, he said.

Citing Aon’s September “COVID-19 Employer Pulse Survey,” Keener noted that about one-third of employers have taken workforce actions in response to the pandemic. Thirty-one percent had either downsized their workforce via layoffs or were considering doing do, and 33% were implementing or considering long-term restructuring of their operations and workforce. Thirty-one percent had canceled or deferred base salary adjustments or merit increases, or were considering doing so.

So, while employers have made rather drastic changes to their workforce, Keener said, changes to their retirement plan have been more muted. Only 9% had either temporarily suspended or reduced employer contributions to defined contribution (DC) plans.

However, single employer defined benefit (DB) funding relief is under considerable strain, Keener said. “Some businesses are facing challenges that make it more difficult to manage pension contributions, even if such contributions were anticipated prior to the pandemic,” Keener said. “But the impact varies widely by company and industry.”

Christian Benjaminson, chairperson, Multiemployer Plans Committee at the American Academy of Actuaries, said the full impact of COVID-19 mortality on multiemployer plans is not yet known. “It will likely depend on the industry, geographical location of the plan and where retirees live,” Benjaminson said.

Like single employer pension plans, multiemployer pensions have seen a spike in retirements in some industries, with some participants choosing to retire if they are laid off, Benjaminson said. “Increased retirement is generally a loss to the plan,” he said.

Plan funding will depend on the industry. Among all industries, 63% of multiemployer plans are in the green zone. But 53% of manufacturing plans are either in the critical or declining zone. Forty-eight percent of retail/food plans are in in that state, and this is true for 39% of transportation industry plans.

“Multiemployer plan funding will depend on hours and plan contributions,” he said. A big question is “will hours return fully to pre-COVID levels or will there only be partial improvement? Will there be an increase in bankruptcies? Will the pandemic affect future bargaining by putting pressure on health and welfare costs?”

Benjaminson noted that the Pension Benefit Guaranty Corporation (PBGC)’s fiscal year 2020 report shows the insolvency of the multiemployer program occurring in fiscal year 2026. PBGC says COVID-19 has not accelerated that insolvency.

However, Benjaminson says he believes that “COVID-19 is likely to accelerate the insolvency of already troubled plans and push more plans into critical and declining status. Even healthy plans will need extended time to recover from the market and demographic losses. The need for pension reform remains high for both PBGC and plans.”

Addressing public plans, Todd Tauzer, chairperson of the Public Plans Committee at the academy, said the estimated average funded status of public plans is around 71%. Most of these plans have June 30 fiscal years. “They experienced the full downturn as well as partial recovery,” Tauzer said. “Fiscal year median plan returns were up around 3.2%. Longer-term impact remains to be seen, but economic volatility is anticipated.”

Plans that have medical workers and first responders could experience some COVID-19 mortality, Tauzer said.

Like the other types of pension plans, public plans are seeing increased voluntary terminations and retirement, directly and indirectly related to COVID-19, Tauzer said. “This directly impacts contributions coming into plans. There are broad, sweeping revenue declines anticipated for state and local governments, resulting in economic disruption. Those revenue declines have created heightened competition among expenditures, including pension contributions. Some plans have eliminated supplemental pension contributions, postponed anticipated contribution increases or taken out loans.”

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