December 21, 2014

Is Your 401(k) Holding Too Much Company Stock?


You should never let too much of your retirement savings rest on one company’s performance. The one that you work for should be no exception.

The new year is a good time to sort out your investments. If you have a bunch of employer stock, give it a hard look.

Following the holiday season, many will feel the effects of overindulging on festive sweets. It turns out that your 401(k) also suffers when indulging on too much of a good thing.

When choosing 401(k) investments, many employees have the option to buy an ownership stake in the company by electing to purchase employer stock. Management encourages this type of investment, thinking that employees who have a stake in the company’s success work more diligently. But employees should carefully consider before loading up on company shares.

Owning employer stock is more risky than holding any other stock. If the company goes bust or becomes seriously impaired, you not only lose your job but your savings gets wiped out as well. Diversifying these risks is essential. Economists call this diversifying your human (career) and financial (401k) capital. This is why I recommend that you limit your holdings of your employer’s stock to 10% of your total portfolio.

In a recent Kiplinger’s Jump-Start live-chat, I joined a group of financial planning experts to field a wide variety of questions about retirement, taxes, insurance, saving for college, and more. We received several questions about company stock, and one of the questioners mentioned that he had 90% in company stock in his 401(k) and asked whether this was appropriate. All four financial advisors shared the same sentiment on this issue: “Yikes—90% is way too much.”

I started to wonder how common it is for employees to have company stock in their 401(k) plan. Dan Weeks of BrightScope, a leading independent provider of retirement plan analytics, shared with me their most recent research on employers in my home town of Richmond, Virginia. The data from the largest employers in the region show a wide disparity and some room for concern.

Several companies including HCA Inc. (hospitals), CarMax (used cars), and MeadWestvaco (paper products) resisted the temptation to add employer stock to their 401(k) investment list, and I believe their employees are better off for it. According to the Employee Benefit Research Institute, company stock in 401(k) plans peaked around 19% in 1999 and recently dropped to 9%. Employers have begun to shun this option because many high-profile bankruptcies or near bankruptcies have led to undesirable lawsuits from employees of General Motors, Enron, and Lehman Brothers related to losses from drops in company stock.

The accompanying chart shows that Dominion Resources topped the list with 33.4% of its 401(k) plan held in company stock. Altria is not far behind at 20.7% and Capital One at 11.8%.

Financial advisors generally agree that you should have no more than about 15% in any one stock position in your portfolio. Even the Bible warns us, “Divide your portion into seven, or even eight parts, for you do not know what disaster may occur on the earth.” One seventh is 14.29%. Although it would be painful, you can recover from losing one seventh of your net worth.

Beginning with Dominion, many 401(k) participants in the Richmond region have too much invested in their own employer stock. In March 2011 the world witnessed a nuclear disaster in Fukushima that crippled the Tokyo Electric Power company. I certainly hope those Japanese employees did not have as much of their retirement savings invested in company stock as Dominion employees do today.

Employees in other industries have their own risks. A rare disease could destroy Altria’s crop. The hubris of management could create a financial meltdown at even the strongest company. And although it may be a stimulating intellectual exercise to imagine the inherent risks to each company, true disasters are rarely predicted ahead of time. Employees should assume their company is as vulnerable to risk as any other.

Many companies still offer employer stock in 401(k) plans because of a tax preference called net unrealized appreciation (NUA). NUA allows an employee to distribute the growth of highly appreciated company stock at capital gains rates (currently 15%) rather than the marginal tax rates that are as high as 35%. In my opinion, this tax policy encourages reckless investment choices, and should be changed.

If you end up like the unfortunate Lehman Brothers employees who lost their retirement savings along with their jobs, it’s much harder to bounce back. Those who hold more than 10% in employer stock should take this moment to login to their 401(k) website and rebalance this unnecessary risk today.

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About Matthew Illian

Matthew Illian is on the Investment Committee at Marotta Wealth Management, Inc., specializing in small business consulting and retirement plans. He loves spending time outdoors, the less pavement the better, with his wife and three energetic boys. Favorite trails: Forest Hill Park

Comments

  1. Austin English says:

    Matt,

    I agree with your blog message. After 10 years with a certain company, when I left it I found myself with a large chunk of investment in my ex-employer in the 401k. I was about to roll over my 401k to an IRA (for cost reduction and flexibility reasons) when I was told about the favorable terms of the NUA if I needed cash. Given that I have two children about to reach the college age, I decided to keep it in the 401k as a ‘cash option’ in case I need it for tuition etc. (The stock is a stable, high returning stock so I’m pretty comfortable with keeping my shares and it represents less than 10% of my tax deferred assets.) It also helps that the ‘cash’ is in a 401k which is generally an ignored asset when calculating college tuition ‘need’ by the colleges.

    I write all this to say that the NUA issue would be a good topic for a blog since it probably affects many more people who like me were unaware of the opportunities until I went to unwittingly try to roll over and loose the options I had. Explaining the ins and outs of this could help many of your readers.

    As always, I enjoy your and your company’s blogs. They are always interesting and informative.

    Austin

    • Thanks for sharing your story. While I don’t agree with the NUA preferences, I fully support taking advantage of every tax savings that is available under current law. I’ll add NUA to my list up topics to write about.

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