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No. 2, April 2011
The stock market has been on a roller coaster in recent years, and such volatility always creates winners and losers among investors, especially those who concentrate their bets on a few individual stocks instead of a broadly diversified investment portfolio. The S&P 500 plunged over 40 percent from the third quarter of 2008 through the first quarter of 2009 before fully recovering by the beginning of 2011. Regardless of the broader performance of equities, there are always underperformers. The risk of overbetting on underperforming stocks is particularly acute to the security of US workers’ retirement savings. In this Outlook, I focus on asset diversification within employer-sponsored defined-contribution plans. After discussing the importance of diversification generally, I explain how overinvestment in company stock in retirement accounts poses grave risks. I conclude with potential policy safeguards that could ensure that workers’ retirement accounts more effectively manage the tradeoff between risk and expected return.
Key points in this Outlook:
The increasingly dominant vehicle for private, employer-sponsored retirement savings for the last thirty years has been the defined-contribution plan. For the sake of simplicity, I will refer to all employer-sponsored defined-contribution plans as 401(k)s, as other plans such as 403(b)s or 457 plans are in the minority and do not differ significantly from 401(k)s for the purpose of this Outlook.
Congress established and refined tax-favored 401(k)s–so called because they are defined in section 401(k) of the Internal Revenue Code–in the late 1970s and early 1980s, leading to their steady rise in popularity. In 2009, 49 million American workers were active 401(k) participants, and 401(k) assets totaled $2.8 trillion, accounting for 17 percent of all retirement assets. Other employer-provided defined-contribution plans, such as 403(b)s, accounted for approximately 8 percent of all retirement savings in 2009, while Individual Retirement Accounts totaled roughly 26 percent. The remainder of retirement assets was held in private defined-benefit plans (13 percent), government pension plans (26 percent), and annuities (9 percent).
401(k) Tax Treatment and Rules
To encourage retirement savings, particularly among moderate-income workers, employer-sponsored retirement savings plans are tax favored in the United States. Contributions to 401(k) accounts are tax deferred, meaning contributions are not considered income in the year they are made. Furthermore, the income earned and the gains realized on assets held within a 401(k) are not subject to dividend or capital-gains taxes. Interest income is also not taxed. When funds are withdrawn from a 401(k), generally at retirement, withdrawals are taxed as ordinary income. If a worker’s marginal income tax rate when the contribution is made is the same as when the withdrawal occurs, the tax deferral itself does not yield a financial gain to the worker. However, if the worker’s income is lower during retirement, his or her marginal tax rate may be as well, yielding an additional tax benefit.
The benefit of this tax-free treatment while assets are being accumulated in the account depends on how the funds are invested. For example, 401(k) funds invested in high-yield dividends or interest-bearing accounts enjoy more tax savings than an account holding low- (or non-) dividend-paying equities or zero-coupon bonds. Similarly, actively traded mutual funds with significant capital gains yield more tax benefits inside a 401(k) than a fund of equities that trades infrequently and realizes few capital gains.
Certain rules come with the tax benefits, however, namely an annual limit to 401(k) contributions and a minimum age at which workers can begin to withdraw funds without a penalty. For 2011, an employee eligible to participate in a 401(k) plan may generally contribute up to $16,500 into a 401(k) account ($22,000 for workers over 50). The minimum age to begin withdrawing funds from a 401(k), without a 10 percent penalty, is 59.5. In addition, most 401(k) participants enjoy some amount of employer match for their contributions. Typical for many workers is a match of 50 percent up to the first 6 percent of income contributed. In this case, a worker contributing 4 percent of his or her income would be matched with an additional 2 percent into the 401(k) account. Employer matches do not count toward the maximum contribution.
Principles of Diversification
A basic tenet of modern portfolio theory is that for a given preference of risk, a properly diversified port-folio will maximize expected return. Because the returns of any particular asset bear some correlation to the returns of all other assets, proper diversification is prudent. It is unwise to put all your eggs in one basket, as the saying goes. The theory concludes that an investor can earn the same expected rate of return with less risk by investing in a portfolio of assets whose returns are not perfectly positively correlated.
Diversification is particularly important in retirement accounts, as assuming unnecessary risk jeopardizes essential retirement income. The favorable tax treatment and the restrictions on withdrawals before retirement are policies intended to assist workers in accumulating assets to support their consumption during their retirement years. Finance theory dictates that consistent with these goals, accounts should not assume unnecessary risk for a given level of expected return.
In addition, market volatility, as we saw when the stock market declined 39 percent in 2008, can pose risk to retirees and near-retirees if they are not properly diversified and hedged. One approach to addressing this risk has been the development of lifecycle funds that automatically transition from equity holdings into less risky bonds as a worker approaches retirement, but other diversification risks exist. In particular, many 401(k) accounts have concentrated holdings of individual investment products, often employer stock, former employer stock, or other single-issue equity products. A disproportionate concentration in any single asset will likely exacerbate the volatility within a retirement account. As the market fluctuates, so does the well-being of America’s retirement security. Every year, some major publicly traded corporations experience big stock declines. If near-retirement-age employees hold large concentrations of these assets, their retirement security is jeopardized.
Company Stock in 401(k)s
One type of investment that acutely demonstrates the risk associated with poor diversification is company stock in employees’ retirement accounts. For an example of the devastating consequences of this practice, we need look no further than the Enron bankruptcy in December 2001. At the end of 2000, 62 percent of Enron employees’ 401(k) assets were invested in company stock. Between January 2001 and January 2002, the value of Enron stock fell from over $80 per share to less than $0.70 per share, decimating many employees’ retirement accounts just when they lost their jobs.
This aspect of retirement security has received diminished attention in recent years, perhaps coinciding with the decline in the percentage of 401(k) accounts invested in company stock. According to data collected by the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI), the share of aggregate 401(k) assets invested directly in company stock declined from 19 percent in 1996 to 9 percent in 2009. However, while the share of all 401(k) assets invested in company stock has trended down in the aggregate, two concerns persist based on disaggregated EBRI/ICI data. First, some employees’ retirement funds are still highly invested in their employer. In 2009, 46 percent of 401(k) participants had company stock available to them in their plans. Of those, 48 percent did not have any company stock in their 401(k)s, but 28 percent held more than 20 percent, and 5 percent held more than 80 percent. Second, company stock is still prevalent in bigger companies–in 2009, company stock was available as an investment choice for 66 percent of those in plans with more than five thousand participants. New employees are less likely to hold company stock in their 401(k) plans, but for older workers–those nearer to retirement–who remain invested in company stock, the risks associated with failure to adequately diversify are great.
Neither the decline in the percentage of 401(k) assets invested in company stock nor the trend among younger workers away from this practice should lead to complacency. International Paper, facing a liquidity constraint induced by the economic downturn, began to match employee 401(k) contributions with company stock instead of cash in 2009. The fact that any company is moving in this direction–particularly one of such size and stature–is of great concern and indicates that the lessons of Enron and similar companies have not been properly learned.
Another warning sign is the lawsuit brought by Lehman Brothers’ 401(k) retirement plan and its participants against former CEO Richard Fuld and other executives after the company’s bankruptcy in September 2008. The suit blames these executives for the losses on company stock in the 401(k) plan. At the end of 2007, $228.7 million of the plan’s assets was invested in the Lehman Brothers Stock Fund, which had 10.6 percent of its assets in Lehman shares that became worthless after the bankruptcy. Whether Lehman executives are culpable for the losses is beside the point for the purpose of this Outlook–the primary concern is that the company’s 401(k) assets were invested in company stock despite the associated risk.
Pros and Cons of Holding Company Stock in 401(k)s
The detrimental effects of company stock in 401(k)s are not a foregone conclusion. Some employers and employees praise the practice and actively engage in it. It is thus important to acknowledge the claims that are typically made in support of company stock, as well as the legitimate intent behind these claims. It is of greater importance, however, to recognize that the risks ultimately outweigh these perceived benefits.
Benefits of Holding Company Stock. From the employees’ perspective, common arguments in favor of company stock in 401(k)s include the tax benefits, the advantage of having private information about the company, and the satisfaction of feeling part of a team by being both invested in and working for a company.
From the employers’ perspective, they would arguably want to make matching contributions to 401(k)s in the form of company stock as well as encourage employees to invest their own 401(k) contributions in the company. Common arguments include the increased productivity that follows from employees being invested in their own company, employer tax benefits, lower fiduciary risk, protection from hostile takeover, a cheaper means of matching 401(k) contributions, and easier financial reporting. In addition, this practice seems to better align worker interests and incentives with shareholder objectives. If workers are invested in a firm, other investors may perceive it as a positive signal.
Many of these arguments are based on reasonable goals, but their rationality is questionable. The key point is that 401(k)s have one primary goal, and that is retirement security. However reasonable or unreasonable the goals are that drive 401(k) investment in company stock–and however effective or ineffective company stock is at achieving these goals–they are made irrelevant by the fact that holding company stock in a 401(k) jeopardizes retirement security, as detailed below.
Downsides of Holding Company Stock. In addition to the risks of 401(k) investments being poorly diversified, as established above, there are also other downsides to company stock in 401(k)s. The most obvious is the Enron phenomenon: for workers, investing retirement funds in the company is a “doubling down” of their bet on that employer–if the firm goes bankrupt, the workers may lose both their jobs and their retirement savings.
Research has shown that there is inherent inefficiency in investing 401(k) assets in company stock. According to economist Lisa Meulbroek, “Because employee investors earn exactly the same returns as fully diversified investors, but are exposed to greater risk, holding company stock is inefficient for all employees, irrespective of their risk tolerance.” The inefficiency lies in the “[e]xposure to greater risk without commensurately greater returns.” In other words, employees are not compensated for the assumed risk, so the stock effectively has less value for an employee even though the returns are identical to a fully diversified investor’s returns.
Given that some employees have 401(k)s heavily invested in company stock and given the inefficiencies of non-diversified investment, policy measures for protecting workers from this kind of risk are worth considering. 401(k)s are retirement-security products, and allowing unduly risky behavior within these tax-preferred accounts defeats that purpose. Given that diversification enhances financial stability, a worthy policy goal is to ensure adequate diversification.
Some argue that government has no business interfering with individuals’ investment decisions, and they protest against attempts to set rules governing individuals’ choices about retirement accounts. The type of government intervention that would limit options by requiring diversification has been called “arrogant meddling.” But this complaint misses an important point: government policy created the tax carve-out for retirement savings. Tax preferences on defined-benefit and defined-contribution plans combined are the second-largest tax expenditure in the 2010-14 budget window. Government intervention in an individual’s ordinary investment decisions would indeed be inappropriate. However, government can have a say in the rules overseeing retirement security when, in our current income-based tax system, retirement accounts are tax favored. Put simply, not having an efficiently diversified 401(k) is an unequivocally bad idea, and the government should not subsidize bad ideas. In addition, taxpayers themselves bear the risk: if people lose their private retirement savings, they will require greater government assistance in their advanced years.
Conclusion: Policy Options
Policies guiding 401(k) diversification would address two related issues: the risk from being overly invested in one’s employer, and the risk from being too invested in any other single stock. While the policy objective is clear and straightforward–ensure adequate 401(k) plan diversification–implementing it may prove more difficult. The 401(k) accounts that pose the greatest risk are accounts heavily invested in company stock and held by older -workers. To avoid another Enron, rules would need to be established to bring current 401(k) plans into compliance with new diversification protocols. This would require mandating that employees sell company stock and buy more diversified assets. But this may result in the exact outcome the policy is attempting to avoid–forcing workers to sell company stock when it is inopportune.
One way to address this problem is to establish rules governing future 401(k) contributions and to prohibit workers from purchasing additional company stock with existing plan assets. This policy is likely more workable but would not address the most pressing risks of current and near-current retirees. Short of mandating diversification, establishing default 401(k) settings to promote investment allocations that exclude company stock (and possibly narrowly constructed mutual funds) could help steer workers toward more sensible investing.
A related option is to impose diversification requirements in 401(k) plans similar to those imposed on mutual funds themselves. While there is a clear precedent for these diversification criteria, one drawback is the difficulty for employees to rebalance their portfolios on a regular basis. These problems could be avoided if the worker’s 401(k) assets were invested only in mutual funds.
Going forward, the most feasible option for addressing company stock in retirement accounts seems to be prohibiting employers from providing company stock to employees inside a 401(k) plan. It is unlikely that this would cause employers to be less generous with their plans or to cancel their plans. While a future ban on companies’ matching 401(k) contributions with company stock falls short of addressing the entire problem, it is a good first step to broader reform. It could be coupled with a policy ensuring that workers are, at a minimum, aware of the risk posed by failure to adequately diversify. This could take the form of warning letters from 401(k) managers to workers who currently exceed a threshold for company stock or other individual equities, along with financial literacy efforts.
The author wishes to thank Jessica Milano for helpful comments.
Alex Brill ([email protected]) is a research fellow at AEI. Previously, he served as chief economist and policy director for the House Committee on Ways and Means.
1. Chris Farrell, “The 401(k) Turns Thirty Years Old,” Bloomberg Businessweek, March 15, 2010.
2. Jack VanDerhei, Sarah Holden, and Luis Alonso, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2009” (EBRI Issue Brief no. 350, Employee Benefit Research Institute, Washington, DC, November 2010), www.ebri.org/pdf/briefspdf/EBRI_IB_011-2010_No350_401k_Update-092.pdf (accessed April 20, 2011).
3. Investment Company Institute, “The US Retirement Market, 2009,” Investment Company Institute Fundamentals 19, no. 3 (May 2010), www.ici.org/pdf/fm-v19n3.pdf (accessed April 21, 2011).
4. Internal Revenue Service (IRS), “IRS Announces Pension Plan Limitations for 2011,” news release, October 28, 2010, www.irs.gov/newsroom/article/0,,id=229975,00.html (accessed April 21, 2011).
5. IRS, “401(k) Plans,” www.irs.gov/taxtopics/tc424.html (accessed April 21, 2011).
6. Reuters, “S&P 500 Posts Third-Worst Year Ever in 2008,” January 1, 2009.
7. Patrick J. Purcell, The Enron Bankruptcy and Employer Stock in Retirement Plans (Washington, DC: Congressional Research Service, March 11, 2002), http://fpc.state.gov/documents/organization/9102.pdf (accessed April 21, 2011).
9. Jack VanDerhei, Sarah Holden, and Luis Alonso, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2009.”
13. International Paper Company, 2009 Annual Report, Form 10-K (Washington, DC, 2010), http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9Mzg3Nzd8Q2hpbGR RD0tMXxUeXBlPTM=&t=1 (accessed April 21, 2011); and Eleanor Laise, “Despite Risks, Workers Guzzle Company Stock,” Wall Street Journal, March 5, 2009.
14. Linda Sandler, “Lehman Retirement Plan Sues Fuld over Repo 105,” Bloomberg Businessweek, December 7, 2010.
15. Shlomo Benartzi, Richard H. Thaler, Stephen P. Utkus, and Cass R. Sunstein, “Company Stock, Market Rationality, and Legal Reform” (John M. Olin Law and Economics Working Paper no. 218, University of Chicago, Chicago, IL, July 2004), www.law.uchicago.edu/files/files/218-crs-stock.pdf (accessed April 21, 2011).
18. Lisa Meulbroek, “Company Stock in Pension Plans: How Costly Is It?” (Working Paper no. 02-058, Harvard Business School, Cambridge, MA, March 2002), www.hbs.edu/research/facpubs/workingpapers/papers2/0102/02-058.pdf (accessed April 21, 2011).
20. See, for example, Alan Reynolds, “Big Brother Wants to Run Your 401(k),” Creators.com, September 5, 2002, www.cato.org/research/articles/reynolds-020905.html (accessed April 21, 2011).
22. Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2010-2014, JCS-3-10 (December 15, 2010), www.jct.gov/publications.html?func=startdown&id=3718 (accessed April 21, 2011).
23. Other critics may argue that the tax treatment of 401(k)s is neutral tax policy, not advantaged tax treatment, and that the tax treatment of all other savings is disadvantaged relative to optimal tax policy. Put differently, advocates of consumption taxation over income taxation would not consider the tax benefits enjoyed by 401(k) accounts to be a subsidy. While debate of income versus consumption taxation is beyond the scope of this Outlook, it should be noted that 401(k) accounts do not constitute consumption taxation per se, and regardless of tax policy preference, the US tax system is currently income based.
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