Plan Design Decisions Can Reduce Overconcentration in Company Stock

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.

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.