Employer stock in a 401(k) plan

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By Kara W. Tedesco | 05 September 2017

The number of employers offering employer stock as an option in 401(k) plans and the percentage of plan assets invested in employer stock are both on the decline. Why is employer stock included as an investment option in a 401(k) plan? Why are some employers continuing to offer this option while others are moving away?

There are many reasons a plan might offer employer stock as an investment option:

  • Expectation of returns that might exceed those available in other investment vehicles
  • An efficient, low-cost approach for employees wishing to invest in employer stock
  • The added attention to the plan derived from the opportunity for employees to easily buy and hold employer stock
  • Help in retaining employees and aligning the interests of both employer and employees
  • The ability to fund the plan without incurring an out-of-pocket cash expense or an accounting expense
  • Potentially favorable tax treatment upon distribution based on net unrealized appreciation
  • Reduced risk of a hostile takeover

These factors may be compelling. However, increased risk of litigation has caused many employers to reconsider the decision to offer employer stock as an investment option. There have been numerous participant claims regarding participant stock in employer-sponsored plans. Potential claims include the following:

  • Investment in the employer stock was not prudent and participants suffered losses.
  • The stock declined during a "black-out period" related to a plan change and participants were unable to sell at a critical point.
  • The sponsor should have known (or did know) that the value of the employer stock was about to decline.
  • Inadequate employee education or other factors resulted in over-allocation to employer stock, subjecting the account balance to increased volatility and potential underperformance.

Even if the employer stock is entirely appropriate from the viewpoint of fiduciary requirements as a plan investment, the employer and the plan are not fully protected from risk of a lawsuit and the negative consequences deriving from such a course of action regardless of the outcome. In many cases, employers are able to prevail in suits alleging the investment in company stock was improper. However, the win is often accompanied by significant legal expense, organizational distraction, disgruntled employees, and bad press. None of these is a win for the employer.

Employers that elect to continue offering employer stock in 401(k) plans may find the following initiatives can mitigate these concerns:

  • Establish a formal process for documenting an ongoing fiduciary review of the prudence of offering employer stock and of continuing to allow employees to hold employer stock. The following steps may be considered in developing the process:
    • Document the concept that the market price of the stock generally provides an adequate measure of the value of the stock based on public information, including but not limited to such factors as:
      • Trading volume
      • Market capitalization
      • Bid-ask spread
      • Trading on a major exchange
    • Note that the usual practice of comparing a mutual fund against a benchmark is not generally appropriate for monitoring the employer stock fund.
    • Carefully consider how and whether to react to the availability of insider information.
  • Retain an independent fiduciary to provide ongoing guidance regarding the decisions related to employer stock.
  • Provide frequent and robust participant education. There are additional risks associated with the investment in an employer stock fund. Employers can limit potential claims against the fund and the employer by carefully educating employees about these risks. In addition to topics normally covered in participant investment education, education regarding the employer stock fund should provide additional emphasis on:
    • The importance of diversification among asset classes
    • The importance of diversification by industry
    • The historical volatility of the employer stock
    • The potential future volatility of the employer stock

Employers that elect to remove their 401(k) plan’s employer stock option typically follow an extended process during which they lay the groundwork for such elimination as follows:

  • Establish that while offering employer stock as a 401(k) investment option has been prudent historically, the ongoing viability of this alternative is trending downward in the current financial and legal environment.
  • Confirm that closing the employer stock fund will help employees reach their retirement savings goals by reducing investment volatility and increasing diversification.
  • Close the employer stock fund to new investments for an extended period.
  • Communicate the proposed termination date of the employer stock fund well in advance, giving participants an extended opportunity to choose a liquidation date.
  • Schedule the termination date of the employer stock fund so as to avoid proximity to any expected impending events (such as corporate transactions) that may significantly affect the value of the stock.

Regardless of the decision to maintain or discontinue offering employer stock as an investment option, employers are well-advised to discuss the legal issues with competent plan counsel and to review the investment issues with a trusted financial adviser.