Retirement plan sponsors are starting to get it, requiring 401(k) participants to hold company stock in their accounts exposes them to major fiduciary liability if the stock price tanks. That said it is still an option in many 401(k) plans.
According to Fidelity about 15 million people own about $400 billion in company stock across 401(k) plans that they administer.
Too dependent on your employer
Just ask former employees of Enron, Lehman Brothers or Radio Shack about this.
All employees depend on their employer for a paycheck. If you add a high level of company stock as a component of your 401(k) account you have a recipe for disaster. If the company tanks you might find yourself out of job with no income. If this difficulty causes the stock price to decline you are not only unemployed but your retirement nest egg has taken a hit as well.
How much is too much?
There is no one right answer; this will vary on a case by case basis. Many financial advisors say the total in employer stock should be kept to a maximum of 5% to 10% of total investment assets. This not only includes stock held in your retirement plan but also shares held outside the plan as well shares represented by any stock options or restricted shares that may be held.
Employers and fiduciary risk
In the past it was more common for companies to use their stock as the matching vehicle in the 401(k) plan and to require that it be held for a period of time. Both are less common today due to a number of lawsuits by employees against companies after significant declines in the price of their employer’s stock. Plan sponsors want to avoid this type of fiduciary liability.
Diversify
It is important to set a maximum allocation to your employer’s stock in your 401(k) plan and in total. Use increases in the stock price as opportunities to take profits and diversify. Within your 401(k) plan there will be no taxes to pay on the gains, though there will be taxes due down the road when taking distributions from a traditional 401(k).
Make sure you fully understand any restrictions on selling company shares held in your plan.
Discounted purchases
Often employees have the opportunity to purchase shares of company stock at a discount from the current market price. This is a great feature but the decision to purchase and how much to hold should not be overly influenced by this feature.
Net Unrealized Appreciation
If you leave your employer and hold company shares in your 401(k) plan consider using the net unrealized appreciation (NUA) rules for the stock.
NUA allows employees to take their company stock as a distribution to a taxable account while still rolling the other money in the plan to an IRA if they wish. The distribution of the company stock is taxable immediately, at ordinary income tax rates, based upon the employee’s original cost versus the current market value.
The advantage for holders of highly appreciated shares can be sizable. Any gains on the stock will qualify for long-term capital gains treatment where the rates are generally lower. For a large chunk of company stock the savings can be very significant. Note there are very specific rules regarding the use of NUA so it is best to consult with a knowledgeable financial or tax advisor if you are considering going this route.
The Bottom Line
Holding excessive amounts of your company’s stock in your 401(k) plan can expose you to undo risk should your employer run into financial difficulty. You could find yourself unemployed and with a much lower retirement plan balance if the stock price drops significantly. Set a target percentage for your overall holdings of employer stock and periodically sell shares if needed to rebalance just as you would any other holding in the plan.
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Good points. When I have conversations with people who have retirement plans with company stock in them I stress how they wouldn’t have this much stock exposure to company ABC if they didn’t work for ABC. I try to get them to see it from a different point of view where if they worked for company XYZ they wouldn’t be owning as much ABC as they do now, it would be replaced with XYZ. It becomes drilling home the idea of ‘it’s not I’m owning stock in this company because it makes investment sense, rather I’m owning stock in this company because I can and /or it’s given to me to own’ (and generally at a discount or for tax advantaged reasons). It’s tough, but it’s trying to separate people from what they are owning and instead look at it from the point of view of why are you owning and is that the best for you, which then ties into your article about the double whammy of paycheck from company ABC and retirement savings invested in company ABC. I did see one qualified plan which limited participants to holding no more than 10% of their company’s stock, which was refreshing.
Michael thanks for your comment and you are spot on with your comments, couldn’t agree more. Seeing a plan with a maximum percentage is refreshing. At a number of local major public companies here in the Chicago area it can be difficult to convince clients to lighten up on company stock (inside or out of the plan). I’ve actually invoked the name Enron in some cases to drive home my point about the risk and that at least gets their attention. I’ve had one or two cases of executives who are required to hold a certain level of ownership due to their position in the company.