Also: Creative use of stock options

Illustration: Johnathan Evans/Artville

Today, 401(k) plans are as much a part of corporate America as casual Fridays. Such plans are great, but plan participants aren’t diversifying enough and own too much of their company’s stock.

If your 401(k) includes your employer’s stock, as do about 40% of plans, you probably don’t realize just how big a chunk you own. A study by the Employee Benefits Research Institute found that 401(k) participants who have employer stock as a 401(k) option, half have invested an average of 40% of their plan assets in company stock. And when you focus on employees who receive their employer’s matching contribution in the form of company stock, the figure climbs to nearly 55%. Too many employees are placing all of their eggs in one basket.

Why It’s a Problem
As recently as 1992, employees of Pacific Gas & Electric (PG&E) had 82% of their $2.4 billion in 401(k) plan assets invested in PG&E stock. Fortunately, PG&E encouraged its plan participants to diversify. Now, only 34% of their 401(k) assets is invested in PG&E stock. Even that is far too much for PG&E employees, since PG&E stock has plummeted from a high of almost $32 a share to the current $19.16 (it dipped to $6.50 in 2001).

David Wray, president of the Profit Sharing/401(k) Council of America, which represents plan sponsors, says, “Most professional money managers would say that investing more than 5% of a portfolio in an individual stock is inappropriate and unbalanced.” Peter Corippo, manager of investment and benefit finance at PG&E says, “I would never hire a portfolio manager who put 34% of the portfolio assets into a single stock.” And yet some large companies such as Coca-Cola, Abbott Laboratories, Bank of America, and Bell South, whose 401(k)s are often loaded with company stock, have booked dazzling market results for the past three decades—even outperforming the market during downturns. For example, Coca-Cola’s $2.6 billion 401(k) has booked an annualized 15-year total return of 26% from 1982 through 1997. The S&P 500’s annualized total return was only 15% during the same period. General Electric (GE) is an even bigger success story: GE’s 401(k) plans have approximately 65% of assets invested in GE stock. From 1981 to 1996, GE stock outperformed the S&P 500 by an astounding 125%.

“In retrospect, no fiduciary could criticize the returns that GE stock has generated for the company’s 401(k) plan participants,” says Wray. So what’s the problem? The trouble is that allocating more than 5% of a 401(k) plan’s assets to a single stock dangerously raises the stakes for plan participants. On Tuesday, March 7, 2000, for example, Procter & Gamble’s (P&G) CEO announced that third-quarter and fiscal-year earnings would fall considerably short of expectations. The news set off a brutal wholesale dumping of the company’s shares, driving the stock price down by more than 30%. How would you like it if you were scheduled to retire on or shortly after that date and 35% of your 401(k) was invested in the company? P&G retirement plan participants were taken to the cleaners.

According to Hewitt Associates, a human resources and management consulting firm, more than 95% of P&G’s profit sharing and defined-contribution retirement plan assets were invested in P&G stock. Maybe we shouldn’t be too sympathetic, because P&G employees have enjoyed solid gains in the company’s stock for many years. Also, employees chose to invest their savings in their company’s stock—no one forces them to do it, right?

Not always. Many employer plans use their stock to fund retirement plan obligations such as profit sharing and 401(k) plan matching contributions. And some companies not only make contributions in the form of company stock, but also restrict employees from selling shares until they are 55 and have more than 10 years of service. Employers enjoy several advantages by using company stock to fund retirement plans, including special tax breaks, no cash flow impact, take over protection, and alignment of company and employee interests. Employees enjoy the ride when the stock is rising. But sometimes the party ends with a cold shower!

The issue of excessive portfolio concentration in company stock has raised some concern in the pension community and in Congress. Legislation that took effect in 1999 limits the amount of company stock that can be invested in 401(k) plans, but the law unfortunately has many loopholes that diminish its effectiveness.

According to a survey of 400 corporate 401(k) plans, only 17% set any limits on the amount of assets that employees may invest in their stock. One shining example is Motorola, which limits participants’ holdings in company stock to a 25% maximum. Perhaps several incidents like the P&G drop will trigger more assertive action from other companies. We’re told that the reward for taking risk is return. But not all risk increases returns. This is something participants in P&G’s plans learned painfully. Ditto for IBM staff, who were stunned in the early 1990s when company stock plummeted by almost two-thirds.

More recently, 15,000 Enron employees lost a collective $1.3 billion from their company 401(k) plan when Enron filed for bankruptcy. Employees’ matching contributions were made in company stock (now worthless) that could not be quickly sold. The largest corporate collapse in U.S. history has ruined many Enron employees’ retirement plans.

Action Plan
Financial advisers often set broad limits such as “No more than 10% of a portfolio should be allocated in a specific security.” This one-size-fits-all recommendation ignores individual circumstances. The appropriate amount of employer stock to hold in your retirement portfolio is a personal decision, but you should take into consideration

• the amount of time until you’ll substantially reallocate your investments because of retirement or a planned job change. If you have 10 years or more until you’ll need to sell your employer’s stock, don’t worry too much about holding a large portion if it’s a good investment. However, if you’re going to change jobs or retire and reallocate your investments in the near future, start trimming your company stock. Sell when you can, not when you’re forced to.
• the size of your employer stock holding relative to your other retirement investments. If 100% of your 401(k) plan is in company stock but that represents only 15% of your total retirement assets, that’s probably okay.
• your ability to analyze the investment risks that are associated with your employer’s stock. Don’t hold a large portion of employer stock if all you know about your employer is what your company does.
• your prospects for future employment and ability to save and invest for retirement. If your skills are narrow, employment outside your industry does not look promising, or your retirement savings are falling short of your retirement goals, limit the amount you invest in your employer’s stock.

Creative Use of Stock Options
According to research conducted by the management consulting firm Towers Perrin, the battle for executive and skilled professional talent in a tight labor market has led a growing number of employers to offer options to even their newest employees. This use of stock options continues in today’s lackluster job market.

Towers Perrin reports that special option grants were awarded to newly hired senior managers in nearly 75% of almost 200 participating U.S. companies with nonfinancial company median revenues of $3 billion and financial company median assets of $24 billion. Almost 40% of companies making up-front grants to new hires do so as a part of their standard granting policy, with the remainder making option awards on a case-by-case basis.

What these findings indicate is that companies across a broad spectrum of industries are using recruitment grants to attract top talent, which is contrary to the conventional wisdom that the practice is heavily concentrated in technology and Internet companies (remember them?).

And not just senior managers are sharing the bounty. The expectation that the lion’s share of recruitment grants is going to top senior managers isn’t true, particularly in industries in which the competition for those with specialized skills is fierce, such as in the information technology industry. The Towers Perrin data show that 44% of companies made special stock-based grants to professionals in high demand. Unlike senior manager recruitment grants, most grants to this group were made on a case-by-case basis.

Companies using option grants to lure employees away from their current jobs are also increasingly making use of so-called “retention grants” to prevent employees from leaving. Almost half of the companies in Towers Perrin’s survey have made stock-option retention grants above normal levels to one or more individuals during the past three years. Ninety-three percent of these companies furnished retention grants to executives, frequently as a result of mergers or acquisitions, sometimes to match competing job offers. Fourteen percent made special stock grants to one or more executives in connection with a corporate relocation. Sixty-six percent of companies that made stock-based retention awards reported grants to nonexecutives, with nearly half of those to meet a competing job offer. Thirty-six percent cited a merger or acquisition, while 7% cited corporate relocation.

There are conflicting views on the effectiveness of retention grants. Some compensation experts believe companies are giving away plenty while getting little in return. Other compensation experts say that given the job-hopping proclivity of many younger employees, vesting schedules for stock options are now meaningless as a retention tool unless they’re awfully long.

The choices companies make in awarding stock options depend on each employer’s compensation philosophy, desired competitive positioning, reward strategy, and recruiting and retention needs. The increasing prevalence of these awards, however, is a marketplace certainty, which makes careful and well-implemented strategic administration an increasingly important aspect of effective 401(k) management.