Will Company Stock Help—or Hinder—Your Retirement Dreams?
When a 1996 study revealed that a towering 42% of the money in large company retirement plans was being invested by employees in the stock of just one company—their employer—it rocked the retirement plan community. A decade later, substantial progress has been made on this front, but there is clearly still work to be done.
Most people remember watching the high-profile implosions of companies like Enron and Worldcom with a mixture of horror and fascination. Companies that big simply aren't supposed to crumble so quickly. In addition to losing their jobs, many of those employees also lost their retirement savings as a result of holding a large amount of company stock within the plan.
Recent surveys indicate that some employees learned the lesson of these tragedies—the percentage of employees holding half or more of their 401(k) balance in company stock declined from 27% in 2004 to 20% lately. But that still means one in five employees are probably too heavily invested in company stock and are putting their retirement savings at risk.
If a mutual fund wishes to meet the diversification standards of the Securities and Exchange Commission, it can invest no more than 5% of its holdings in the stock of any one company. The Department of Labor limits the amount of company stock a company can hold in a traditional pension plan to 10%. Given that these regulatory bodies have established such strict limits, it's worth considering: What level of commitment to any one security is appropriate for an individual investor within their 401(k)?
The answer is actually a little less clear-cut than you might expect. It really depends on how much of your total retirement holdings are contained in your retirement plan at work. The SMI philosophy is that all of your long-term investments go into the same "pot," and it is the portfolio mix of the entire pot that matters. For example, assume that all of your retirement plan assets are worth $100,000, but only $25,000 of that is in your 401(k). If you invested 32% of that $25,000 in your company stock, your holdings would amount to $8,000. This is a reasonable amount in a $100,000 portfolio. On the other hand, if $80,000 of your $100,000 was in your 401(k), then a 32% allocation would mean that $25,600 was invested in your employer's stock. This is too high.
How is it that so many employees hold so much company stock in their 401(k)? The four most common ways this happens are: stock-purchase plans that let employees buy shares at a discount, stock-options being given to employees, company stock offered as an option in 401(k) retirement savings plans, and companies using their stock to match employee contributions into 401(k) plans. All of these avenues have one thing in common—the employee gets a "good deal" on the company stock, either receiving a discount from current market value or, in the case of 401(k) matching programs, getting shares "for free."
Obviously, there are pitfalls that arise from being dependent on a single company for one's income, health and life insurance, and retirement investments. If something happens to the company, not only could a worker lose their job and health benefits, they could also watch the value of their retirement assets plummet as the price of their company's stock falls.
However, in the past few years, many companies have started imposing limits on the use of their own stock within company retirement plans. The reason? The potential for lawsuits and legal liability. Coca-Cola is a good example of this trend. They were recently sued by workers regarding the amount of company stock held in the company 401(k) plan, much of it the result of Coke matching employee contributions with company stock over the years. The suit points out that 57% of the $1.33 billion in the Coke 401(k) plan was invested in company stock at the end of 2005. Yet just 3.4% of the $1.9 billion in Coke's traditional pension plan was invested in Coke stock. Obviously the pros managing the pension plan handled that account quite differently than the rank and file Coke employees did in managing their own.
Coke isn't alone in defending themselves against charges that they didn't provide proper oversight to their company retirement plans. Many other high profile companies have either been sued or have settled claims regarding company stock in their retirement plans. As a result, roughly 30% of large companies recently surveyed either currently limit or have plans to begin limiting the amount of company stock employees can own.
Shifting our attention to the individual employee, the reasons that many fail to prudently limit their investments in their company stock are both emotional and financial. They include the fear of being considered disloyal, fear of "missing out" if the company stock does well, peer pressure from co-workers, wanting to take full advantage of stock offered at low prices (or even free), and blind optimism concerning the company's future. From a strictly financial view, it's foolish to pass on free money given in the form of options and 401(k) matching. But where many workers fail is in diversifying out of their employer stock as they are given the opportunity.
Don't underestimate the powerful appeal of loading up on company stock, especially for those working for companies that are growing rapidly. For much of the 90's it was hard to pick up a business magazine without reading about a company secretary at some hot company who was retiring early as a millionaire due to parking their 401(k) money in company stock. Initially, for example, employees of Krispy Kreme Doughnuts watched their stock soar and their 401(k) balances with it. But more recently, employees are wising up to the risks. Krispy Kreme is just one of several companies whose stock has plummeted and has offered millions to settle lawsuits centered on the use of company stock within their 401(k).
So how much company stock is too much? There is no hard and fast rule concerning this because, as we saw earlier, individual situations can vary widely. However, a general range that is useful is to limit your investing in any one stock (your company or otherwise) to 5%-15% of your total investable assets. Given that you already have so many of your financial eggs in your employer's basket, the lower end of that range is probably more appropriate. Also, the smaller the value of your total portfolio, the more you should gravitate to the lower end of the range.
If you find yourself in a situation where you need to diversify, you might consider spreading your selling out over several tax years. This minimizes both the tax impact (for shares held outside your retirement plan) as well as the risk of selling too much during a period of market weakness. And if your retirement plan allows you to switch between investments within your retirement plan, check out your other options. It may be easier to diversify than you think. If you own company stock within your plan that has appreciated significantly in value, it's worth discussing with a tax professional what is the best way to liquidate it. There may be ways to take advantage of the lower long-term capital-gain tax rates depending on your age and situation. 
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