Risks of Investing 401k Retirement Plan Savings in Company Stock and how to Minimize that Risk
Many Corporations have learned from the fraud cases of Enron and WorldCom that they have to minimize their risk when most of their employees' retirement savings are invested in company stock. What happens when the stock takes a deep plunge and employees lose a big chunk of their retirement savings? Million dollar lawsuits!
The fraud case of Enron is a big mind opener for companies that have too much of their employees' 401k retirement savings invested in company stock. About 57.3% of all Enron employees (11000 employees in total) had their retirement savings invested in the company's stock, which lost 99% of its value in 2001. The value of their 401k retirement savings plunged by $1 billion in just six weeks!
Michael Weddell, Retirement Consultant with Watson Wyatt WorldWide quotes, "There is substantial risk associated with offering company stock as a 401(k) plan investment. A company can expect a lawsuit every time the stock price drops significantly—not just when there is criminal activity."
So what can be done to prevent employees from losing their retirement savings due to declining company stock? There are 3 possible solutions:
1) Eliminate Company Stock as a Possible 401k Investment Option
Firms should check whether their stock is an appropriate investment for 401k investors. These checks should be done every quarter using the 401k Plan's Investment Policy Statement.
Investing 50% in your own company's stock is a major risk and there is no diversification of investments to reduce the unsystematic risk. What is the solution to this problem? Eliminate company stock as a 401k investment option entirely! However, this is not as easy as it sounds. Why?
Lori Lucas, Research Director at Hewitt Associates quotes, "Removing company stock from a 401(k) plan can be a challenge." This is because if the stock is going up in value, the employees may object to the total elimination of company stock as a 401k investment option. If the stock however is NOT going up, the employees might object because they will not be able to recover their losses should the company stock go back up in value.
Furthermore, if a firm eliminates company stock as a 401k investment option, this is negative publicity. This is because the shareholders will wonder why the company had such a move? Doesn't the company believe and have faith in the performance of its own stock? This could have the negative effect of driving the stock price down. It's all about speculation baby!
2) Modify the Company Stock Option Plan
If a company really wants to offer its stock as a 401k investment option, it needs to modify the plan by limiting liability and responsibility of the firm, with respect to declining stock value.
Instead of making Match Up contributions in the form of company stock (which most companies do), firms can offer cash as a 401k match up contribution. This cash offering will force the employee to diversify his investment portfolio, and not put all the cash into his company's stock.
Firms can also enforce a maximum amount that an employee can invest into his company's stock. For example, a rule stating that ONLY 30% of an employee's total 401k retirement savings may be invested in company stock is a good one. This forces the employee to diversify the other 70% of his retirement assets into other investments.
3) Educate Employees about Investment Diversification and Risk
Companies need to educate their employees on topics such as investment diversification and the elimination or minimization of as much risk as possible. Investment diversification is as simple as diversifying your stock portfolio across many different industries and companies, as opposed to investing in 1 single corporation. Should that corporation fail to deliver, atleast the employee holds many other stock investments that will deliver results.
When employees self direct their 401k retirement assets, it is very easy to make the wrong investment decisions and hold their employers liable for their losses. Classes on investment diversification and minimization of risk can remove the liability from the employer's head, and pass it on to the employee, who then solely becomes responsible for his investment decisions.
David Marberger, CFO of Tasty Baking Corporation further quotes, "During this process, we asked whether employees really understood where their retirement money was being invested. he issue is not just how much to invest in company stock, but how much risk they are willing to take and what their goals are. We want employees to understand that putting all of their retirement savings into a single money market fund can be just as bad as investing all of it in company stock. "