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Employee Stock Ownership in 401(k) Plans – History, Pros & Cons

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There are several forms of stock option plans available that allow employees to purchase shares of their employer’s stock on a tax-advantaged basis. Perhaps none are better or more convenient than simply buying shares of the company inside their 401(k) plans.

However, this strategy comes with a level of risk that many employees do not understand – and may not learn about until it is too late.

Legislative History

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401(k) plans were created as a result of the Employee Retirement Income Safety Act of 1974 (ERISA). This legislation was geared toward protecting employees’ retirement security. But special interest groups representing major corporations declared that if they couldn’t at least partially fund their employees’ retirement accounts with company stock, then they would offer absolutely no retirement plan of any kind. Congress acquiesced to get the legislation passed.

Since then, companies have funded these plans with their own stock in various ways and to various degrees. Some companies match all employee contributions with their stock, while others have gone so far as to encourage their workers to invest solely in corporate shares. Some companies will only provide matching contributions (or at least a larger match) for employees who elect to purchase shares of stock in the plan.

Of course, the fallout from the collapse of Enron and Worldcom in 2002 resulted in tremendous scrutiny of this practice by both regulators and the public. The Sarbanes-Oxley Act and the Pension Protection Act of 2006 were passed as a means of protecting employee pensions from corporate meltdowns. However, neither set of rules unconditionally prohibited the use of company stock in corporate retirement plans, although they did restrict insider trading during a blackout period in the 401(k) plan when the administrator of the plan is being changed.

Many experts feel that these measures are still inadequate. They believe that further legislation should be enacted to materially restrict the allocation of company shares inside qualified plans to no more than perhaps 10% to 20% of plan assets.

Advantages of Buying Company Stock in 401(k) Plans

The benefits that come with buying stock inside a 401(k) plan are much the same as they are for most other types of employee stock purchase plans – for the employer. These benefits include:

1. Improved Employee Motivation and Retention

Purchasing company stock inside aligns the employees’ financial interests with those of the company, and can make employees feel more valued by their employer.

2. Tax-Deductible Contributions for Employers and Employees

ESOPs are the only other type of stock purchase plan that allows employees to make tax-deductible contributions they can use to purchase company stock. (Unless it is a Roth 401(k), in which case the employee makes nondeductible contributions but pays no tax on the distributions.)

3. Corporate Control

Buying company stock in 401(k) plans puts more shares in the hands of employees, who still have voting rights.

4. Possible Substantial Gains

Employees who purchase company stock can see that portion of their assets grow much faster than their mutual fund holdings if the stock performs well over time.

5. Capital Gains Treatment

Employees who sell their shares of company stock under the Net Unrealized Appreciation (NUA) rules are taxed at the lower long-term capital gain rate for shares held for more than a year. The NUA provision is the only exception to the rule in the tax code that classifies all distributions from traditional qualified retirement plans as ordinary income. This rule specifies that the stock in the plan must be spun off from the rest of the plan assets and sold separately in a single qualifying transaction.

Pro Tip: If you’re investing in your company’s 401(k) plan, consider signing up for a free analysis from Blooom. They will check to make sure you are properly diversified and have the right allocation of assets. They are also going to make sure your plan isn’t charging too much in fees.

Buying Company Stock 401k Plans Advantages

Disadvantages of Employer Stock in 401(k) Plans

Despite the advantages listed above, the majority of financial planners warn their clients about the limitations of becoming too heavily invested in shares of their employers.

1. Low Liquidity

Unless they’re age 59 1/2 or older, employees cannot sell their shares and use the proceeds in a retirement plan without incurring ordinary tax and a 10% early withdrawal penalty. Purchasing stock inside a retirement plan does not provide the same short-term benefit as other types of stock plans, such as employee stock purchase plans or non-qualified stock options. Under these plans, participants usually receive some tangible financial benefit or compensation that exceeds what they put in within a relatively short period of time.

2. No Discount Purchases

Unlike other types of employee stock plans – such as non-qualified or incentive stock options or employee stock purchase plans – there is no exercise feature when stock is purchased inside a 401(k) or other qualified plan. Therefore, no bargain element is available. The bargain element is the difference between the lower exercise price and the higher current market price of the stock at the time of exercise. The spread between these two prices becomes immediate risk-free profit for the employee.

3. Employer Liability

Many employers that push the purchase of their stock in their retirement plans also tend to forget a rather critical factor that can drastically impact them. They’re required to act as fiduciaries for their plans. That means they’re legally held to a high ethical standard that governs the investment choices they provide, as well as how they fund and administrate the plan. The legal and moral responsibility they have to their employees can cause them to end up on the losing end of a class-action lawsuit when the price of their stock declines substantially – regardless of the cause of the price drop.

4. Inadequate Diversification

The disadvantages listed above are substantial factors to consider. But by far the most important issue employees face from buying company shares in their retirement plans is over-concentration in a single position in their investment and retirement portfolios. That’s especially true for employees who are also participating in other stock purchase plans offered by their employers, such as an ESOP or ESPP.

Employers and retirement plan administrators have a fiduciary responsibility to thoroughly educate their employees on the dangers of investing too much of their money in a single stock or other security, regardless of whether or not the security is issued by the company. Individual stocks can decline much more sharply in price than mutual funds or other diversified investments, and often in a considerably shorter period.

Worst-Cast Scenario

Jim and Mary are married and both work at a publicly traded company. Jim invests 75% of his retirement savings into company stock, and also purchased 1,000 shares of stock in the ESPP offered by the employer. Mary’s retirement plan is invested in a portfolio of mutual funds that invest in several different asset classes and sectors of the economy. The company is unexpectedly devastated by a series of lawsuits resulting from a defective product that contributed to the deaths of several people. The company is forced to declare bankruptcy, and all of Jim’s shares become worthless. The only real financial asset the couple has left is Mary’s retirement plan.

Many financial experts feel that employee stock purchases should be limited in most cases to non-retirement programs, such as ESPPs or stock options, while their retirement portfolios remain safely diversified among an appropriate allocation of stocks, bonds, and cash or other alternatives. They also propose that companies take steps to beef up their employee education programs and limit the amount of stock that can be purchased in the plan to 10% to 20% of the plan balance. Companies that fail to do this should then be subject to fines or disciplinary action by the SEC.

Considering the Risks

Employees considering whether to buy company stock in their 401(k) or other profit-sharing plans should carefully consider the possible risks. What would happen to their nest eggs if their employer goes bankrupt? Of course, owning a reasonable amount of company stock can be a good idea. Plus, it can serve to motivate the employee in many cases.

However, those who wish to put a substantial portion of their investment portfolios into shares of their employer should probably do so outside of their retirement plans. Participation in a non-qualified or incentive stock option plan or employee stock purchase plan may be a safer alternative, since investors don’t have to hold onto these shares until retirement to receive the proceeds from them in cash.

Of course, it’s also possible to sell company shares inside the retirement plan, but this may reduce any matching contributions the employee receives. Some employers only match with company stock or only match contributions invested in company stock.

Do Your Homework

Employees should also carefully research their employer and obtain some analyst reports about the company to see what the experts think of its stock. These reports are often available for free online for those who have an online investment account with companies like TD Ameritrade or E*TRADE.

Independent research companies like Morningstar supply a great deal of technical and fundamental data breaking down your employer’s financial records, performance, and trading history. And, of course, if the company’s stock consistently trades at a low price without any stock splits, this should be a clear warning sign to keep the allocation of this stock within a portfolio to a minimal amount.

Considering Company Stock Risks

Final Word

Despite the legislative measures mentioned previously, recent data shows that nearly one-fifth of all 401(k) assets are still invested in shares of their parent companies. The bankruptcies of U.S. Airways and United Airlines also resulted in the loss of billions of dollars of retirement funds for their employees. But while a 2012 study by Vanguard revealed that the use of company shares in 401(k) plans is on the decline, this practice is likely to continue at least in some capacity for decades to come.

Have you invested in your employer’s stock via your 401(k) plan?

Mark Cussen
Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

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