Defined contribution (DC) plan participants have been advised for decades on the benefits of diversification, but many still hold large portions of their account balance in employer securities. That poses risks not only for the participants, but for plan sponsors as well.
Offering company stock in a DC plan can be a retention incentive and can be used to align employee interests with those of the corporation. The corporate tax benefit of offering company stock is also potentially attractive: the company gets a tax deduction on the value paid out, and another deduction on dividends paid.
Company stock represents an average of 22.5% of defined contribution plan assets among plans with more than 5,000 participants, according to the Profit Sharing Council of America’s 2014 annual survey. But an outsized position in a single security might be considered inherently risky for participants.
In addition to the risks participants face, corporations can be legal targets for “stock-drop” lawsuits, which have been prevalent over the last decade. Plan sponsors want to avoid protracted litigation, settlements, and legal fees, so they may want to consider preventing participants from over-allocating to company stock.
If a sponsor decides to continue to offer a company stock fund, it could also take the following actions to help mitigate the potential risks of doing so:
- Consider plan design features to protect participants from over-allocating to company stock.
- Consider re-enrollment into target date funds, when appropriate.
- Thoroughly review plan documents related to company stock.
- Review trading procedures around company stock, including monitoring cash drag if the stock fund is unitized.
- Consider the benefits and costs of hiring an independent fiduciary.
Helping Manage Risks of Investors in Company Stock
Company stock as an investment proposition can be very difficult to justify. We know that a single stock is not diversified and that a participant’s human capital (defined as the present value of future earnings) is already tied to the prospects of his or her employer.
The results of our analysis of single stock positions shouldn’t surprise anyone. As shown in Exhibit 1 below, the average volatility of all stocks in the Russell Top 200® Index for 2014 was 18%, compared to the volatility of the index itself at 7.9%. In fact, our analysis shows that from 2005–2014, the average single stock volatility was twice that of the index, and could have been as much as four times greater.
Given actual risk, return, and correlation between individual stocks and the broad market, what does a certain percentage allocation to company stock tell us about participants’ expectations for return? In 2001, Russell Investments completed an analysis — “DC participants’ implicit return expectations for employer stock” — to determine the implicit return expectation, relative to expectations for investments in other asset classes. Exhibit 2 below follows a reverse volatility optimization to reveal the hypothetical expected outperformance of company stock, using data from the 2001 study as well as today’s statistics.
Based on the current analysis, an allocation of 20% to employer stock and 80% to the S&P 500 Index would mean that the stock would have to outperform the index by 3.9% per year to justify the additional risk. This outperformance may be difficult to justify on a year-in, year-out basis.
Given this reality, how do you help guide participants away from over-allocating to an asset class with such uncertain outcomes? Here are several steps that various plan sponsors have taken. This list is not prescriptive, but rather is an example of things a plan sponsor could do in order to mitigate the potential risk of an undiversified allocation to company stock.
- Increase participant education. Educational materials have proven to be effective in moving small numbers of people to diversify. However, we know that inertia is high in DC plans, and sometimes a more proactive approach is necessary.
- Place limits on company stock holdings. An upper limit on the amount of company stock a participant can hold may curb excessive allocations. Yet explicit limits (for example, 20% to 30% of a participant’s assets) may imply a recommendation to participants as to the appropriate amount of stock to hold. For plan sponsors who often don’t want to imply asset allocation advice, this may not be palatable.
- Close the company stock option to new participant money. This may stop the flow of new assets, but it does nothing to help existing participants diversify. Furthermore, this may send a mixed message to participants about whether the company believes company stock is a suitable investment.
- Re-enroll participants into the Qualified Default Investment Alternative. The process of re-enrollment, or a participant’s positive election to keep the current asset allocation, is an effective way to move many plan participants into diversified asset allocations.
- Monitor trading of company stock. If it continues to be offered, trading and cash drag can have a big impact on participant returns. It is easy to think of the trading function of the recordkeeper and custodian as a relatively benign process, but a few nuances as to how the stock is traded can be observed. For instance, is company stock bought at the beginning of the day, or the end? Is the party doing the trading simply looking for execution or also concerned about price? Finally, how is that party compensated?
- Monitor cash drag if the fund is unitized. Some company stock funds actually hold both stock and cash for transaction purposes. Plans with this structure have the additional responsibility of setting an appropriate level of cash and revisiting the allocation.
Managing Fiduciary Risk: Implications of Fifth Third Bancorp et al. v. Dudenhoeffer et al.
Generally, the biggest fear a DC plan sponsor has is the prospect of being sued by participants. Prior to 2014, there were several ways fiduciaries sought to protect themselves and still offer company stock as an investment option. In light of recent litigation, some of these options may not be as relevant going forward. We will discuss each in turn.
Before discussing the Fifth Third Case, some background is needed. Fifth Third Bancorp offered company stock in its DC plan during the 2008 financial crisis, and the stock precipitously declined in value, due largely to the company’s exposure to subprime mortgages. Plaintiffs argued that the fiduciaries knew or should have known that the stock was overvalued before the stock fell in value. Thus, the plaintiffs argued, the plan should have taken action to preserve the participants’ assets.
The Supreme Court ruled in favor of the defendants, but the opinion written by the justices uncovered a few areas that plan sponsors should know about.
Prior defenses of company stock had relied on the so-called “Moench Presumption” — the presumption that an offering of company stock was in itself prudent. The Fifth Third decision by the Supreme Court said specifically that this was not the case. The Court said that while company stock doesn’t have to meet the diversification option like other options, it must be monitored for prudence like any other investment. The Court stated that, absent any special circumstances, the market price of a stock is a prudent indicator of the firm’s value.
Prior to the Fifth Third decision, investment committees were taking actions to protect themselves. Most common was “hard-wiring” the company stock into the plan by requiring, via plan documents, that company stock be offered. After the ruling, the Court made it clear that there still has to be a determination of prudence.
Committees also took steps to remove insiders from the investment committee. While this may be good practice for removing the potential for insider trading actions, the decision specifically stated that inside information should not be used in making a determination of whether to offer company stock as an option.
Since this ruling, we have seen plan fiduciaries take other actions. First, they are trying to amend potentially ambiguous language in plan documents that relate to company stock. Second, they are establishing a diligent process for determining whether company stock is a prudent investment. This may mean bringing in outside experts to evaluate the option. It may also mean establishing a process for removing the stock as an option if that option is deemed imprudent.
Lastly, investment committees are responsible for determining what would constitute a “special circumstance” where the market price could no longer be relied upon as a measure of value.
What If You Want to Liquidate Company Stock?
Given the aforementioned risks, some plan fiduciaries have decided to terminate their company stock plan altogether. If you had to get rid of company stock as an investment option, how would you do it?
An effective liquidation would minimize the market impact of selling company stock and ensure that everyone is treated fairly. That is a difficult task, but an independent third party, rather than the plan sponsor, may be able to decide and deliver on a conflict-free solution to these issues.
But how does one actually wind down a company stock program? Participants are given notice to make new investment elections, well in advance of any selling. The party charged with the task of liquidating the company stock will begin a systematic process, informed by market conditions, whereby the market impact of selling the company stock is minimized, and ensuring that accurate records are kept. Finally, that party will oversee the transition of the company stock program into a designated investment option, which in many cases will be an age-appropriate target date fund.
However, simply hiring someone to liquidate the company stock position does not relieve the plan sponsor of its fiduciary liability for prudently selecting plan providers and advisers. A third-party provider most commonly acts as a discretionary ERISA 3(38) Investment Management Fiduciary over the stock position, though it can take many different roles. Plan sponsors would need to evaluate the provider of these services, just as they would monitor any other investment manager.
The plan sponsor must make sure that all decisions on liquidating the company stock and the methods chosen for such a liquidation are in the best interests of plan participants. That’s what ERISA requires plan sponsors to do.
There are benefits to offering company stock as an investment option, but there are also risks, both to the plan sponsor and to the participants. For participants, the biggest risk is that they will invest too much of their balance in the stock fund, and that the stock will underperform. We have shown that participants’ implied expectations for extra return from company stock may not be realistic, given the concentration that many investors have. Thus, if you decide to continue to offer company stock as a sponsor, we think it’s prudent that you help participants understand and manage these risks.
For the fiduciary of the plan, the biggest risk is that the plan may be sued for not acting prudently. Even when a plan sponsor acts in a prudent manner, participants can still bring a lawsuit, which can be costly in terms of lost time, legal fees, and reputational risk, even if it is later dismissed.
The key is to be able to demonstrate a prudent and thorough process for evaluating the appropriateness of, and monitoring the implementation of, the company stock program.
Mark Teborek is a senior consulting analyst at Russell Investments.
Note: The original article, including footnotes and disclosures, is available on Russell Investments’ website.