Too Much of a Good Thing

How to manage the pitfalls of company stock in 401(k) plans.

Companies that allow employees to invest their 401(k) accounts in company stock face a serious risk if the stock declines precipitously. Faced with large losses, employees can take legal action to recover their retirement savings.

To head off trouble, companies should consider limiting how much 401(k) money employees can invest in company stock. Left to their own devices, many employees invest heavily in these shares. In a recent survey 27% of those who could invest their 401(k) in company stock had half or more of their plan assets invested in this way.

There are steps CPAs can recommend companies take to avoid lawsuits. This includes capping the amount of company stock an individual can hold, making company matching contributions in cash rather than stock or, if matching is done with company stock, letting employees immediately diversify.

CPAs can help educate employees about the risks of inadequate diversification. Companies should offer mandatory education sessions for all employees and counsel specific employees who have too much company stock in their plan accounts. The goal is for employees to understand how their retirement money is invested.

Another key step is for CPAs to help companies understand the fiduciary issues related to maintaining a 401(k) plans. It’s possible some employees may be unaware they are “functional fiduciaries” based on their job titles or actions.

Joanne Sammer is a freelance business writer. Her e-mail address is .

hen companies talk about managing their risks more effectively, many overlook a key risk area in their 401(k) retirement plans. It’s not only the Enrons and WorldComs of the world that have to worry about lawsuits when stock price declines hurt employees who invested in company stock; other companies are being sued as well. While it would be unrealistic to try to avoid all potential 401(k) lawsuits, there are some steps CPAs can recommend companies take to head off legal action and to defend themselves if they are sued.


In 2006, 16% of companies that offer company stock as a 401(k) investment option will either limit employees’ stock purchases or eliminate stock as an investment alternative.

Source: Hewitt Associates 2006 study of more than
220 large U.S. companies, .

Enron is the poster child for companies whose employees had too much of their 401(k) invested in company stock. Some 57.3% of its employees’ 401(k) assets were invested in Enron stock when it fell in value by almost 99% in 2001. Nearly 11,000 Enron employees lost $1 billion in just six weeks. While such enormous losses are rare, all companies can learn from what happened at Enron. “There is substantial risk associated with offering company stock as a 401(k) plan investment,” says Michael Weddell, a retirement consultant with Watson Wyatt Worldwide in Detroit. “A company can expect a lawsuit every time the stock price drops significantly—not just when there is criminal activity.”

According to a Watson Wyatt analysis of the 86 Fortune 100 companies that offer employer stock as a 401(k) plan investment option, 21 are currently being sued by employees over company stock losses. Weddell says most companies don’t appreciate the risks as much as they should. Even when cases are settled before going to trial, the cost is significant, with the smallest settlements in the $10 million to $30 million range. When Electronic Data Systems Corp. tried to settle a case for $16.5 million, the judge rejected the settlement offer as too low.

Few companies are taking the steps necessary to avoid or limit the damages from such lawsuits by, for example, restricting the amount of 401(k) assets employees can invest in company stock. In a survey of 458 businesses by Hewitt Associates, 83% of companies that offered company stock as a 401(k) investment did not place any restrictions on how much employees could invest in company stock.

So what can CPAs recommend to their clients and employers who are worried about the rise in 401(k) lawsuits? The recommendations fall into four major categories—deciding if company stock should be an investment option, modifying the plan to make sure employees don’t overinvest in these shares, educating employees about diversity and other retirement planning issues, and making sure plan fiduciaries take their responsibilities seriously.

While ERISA restricts traditional pension plans from investing more than 10% of plan assets in company stock, there is no similar restriction on 401(k) plans. This means companies must impose their own limits. The first step is for CPAs to help companies develop a process for determining whether their stock is an appropriate investment option for 401(k) participants. This type of review should take place periodically, perhaps as often as quarterly.

In many cases, the process for conducting this review and the criteria for evaluating company stock as a plan investment option is already spelled out in the plan’s investment policy statement. If the current process is insufficient, the fiduciaries can modify it and the frequency with which the plan performs the review to help meet the growing risks.

With few exceptions companies that conduct such reviews come to the conclusion that company stock is a prudent investment for employees. “There is no evidence of a company voluntarily removing its stock as a 401(k) plan investment,” says Weddell. “But it is something some companies should seriously consider.”

Left to their own devices, a substantial number of employees heavily invest their 401(k) assets in company stock. Another Hewitt Associates study of 401(k) plan participants found that more than 27% of the nearly 1.5 million employees surveyed who could invest in company stock had 50% or more of their 401(k) plan assets invested in those shares.

As legal problems become more costly, more companies may need to drop employer stock as a 401(k) investment option. That decision is not one to be undertaken lightly. “Removing company stock from a 401(k) plan can be a challenge,” says Lori Lucas, director of participant research for Hewitt Associates in Lincolnshire, Ill. If the stock is doing well, employees will object to losing the upside potential. If it isn’t, they may object because the decision prevents them from earning back their losses should the stock rebound.

“Typically, only the CEO can decide to pull stock out of a retirement plan,” says Bradford Hall, CPA, managing director of Hall & Company, an Irvine, Cal.-based accounting firm. “This move may have negative consequences for the stock price as investors contemplate why the company made such a decision.”

Indeed, removing company stock as an investment option can send a message to the marketplace that something is wrong. This can be particularly problematic when members of the 401(k) plan’s investment committee are company insiders with obligations to both the company and the plan. “Those two roles can conflict and create a dilemma,” says Lucas.

If a company is determined to continue offering its stock as an investment option, it can limit its liability by modifying the 401(k) plan design. Many companies already have changed or eliminated rules that limit participants’ ability to diversify employer contributions made in company stock. According to Hewitt Associates, in 2001 only 15% of companies allowed employees to immediately diversify contributions made in company stock; today, 46% permit it.

Most public companies with 401(k) plans make their matching contribution in the form of company stock. Even when the plan permits them to do so, few employees take the time to diversify by having the plan sell the shares and reallocate the proceeds to other investment options. In addition to allowing immediate diversification of employer contributions, companies also can make matching contributions in cash, which is then allocated according to the worker’s investment instructions. That forces employees to decide how much stock to buy rather than just holding on to what the company gives them.

Companies also can cap the amount of their stock an individual can hold in a 401(k) account to encourage greater diversification. Hall recommends a 20% maximum investment for self-directed participant accounts.

That’s the approach Philadelphia-based Tasty Baking Co. is taking. Last summer, it placed a limit of 25% on how much 401(k) money employees can invest in company stock. “We wanted employees to make an active rather than a passive decision to invest in company stock,” says David Marberger, CPA, senior vice-president and CFO. “We also wanted to avoid someone’s getting too heavily invested in company stock.”

  What’s at Stake?
Kmart Corp. paid out $11.5 million to settle a class action lawsuit brought by 401(k) plan participants. The suit alleged participants lost an estimated $100 million when the company declared bankruptcy in 2002. After attorneys’ fees the settlement provided a return of only about 10 cents on the dollar.

Lucent Technologies settled a 401(k) lawsuit for $69 million. The stock, which traded at more than $100 a share in late 1999, had fallen into the single digits by mid-2001 and currently trades at only about $3 a share.

Electronic Data Systems Corp.’s $16.5 million settlement offer was rejected by a judge who deemed it insufficient. The plaintiffs alleged they had lost $352 million by investing their 401(k) assets in company stock.

Another important thing companies can do is to educate employees about the risks of investing in company stock and the need for proper diversification. “In self-directed retirement accounts, the employee has all the discretion and can easily make the wrong investment choices,” says Ken Burke, CPA, tax partner, Mengel, Metzger, Barr & Co. LLP based in Rochester, N.Y. “The company may be liable if it has not provided the means or opportunity for employees to learn how to make appropriate investment decisions.”

For this reason CPAs should encourage corporate clients or employers to modify plan documents to clearly spell out the risks of investing 401(k) assets in company stock—namely, that the stock price is volatile and the value of the investment can go up or down.

Companies should conduct mandatory formal education sessions for employees through brown-bag lunch seminars with the requirement that employees sign in to prove their attendance. CPAs can play an important role in planning or executing these seminars. “Accountants can make sure the company takes this issue seriously and is taking steps to educate employees about diversification,” says Andy Gibson, a CPA and partner of BDO Seidman in Atlanta. “ERISA section 404(c) compliance involves following very complex rules and that’s an area where CPAs are well-equipped to help companies.”

CPAs also can play a direct role by talking to employees who are heavily invested in company stock about investment alternatives either individually or in groups. “This is about educating people not to have all their eggs in one basket,” says Gibson.

Tasty Baking Co. embarked on a broad employee education effort following significant changes to its retirement plans. In addition to the 25% limit described earlier, the company changed its 401(k) plan matching contributions from company stock to cash and froze its defined benefit pension plan. It launched what it calls a “cash retirement plan” that provides weekly contributions equal to a percentage of salary. Because employees control the investment decisions for this new plan, as well as their 401(k)s, and because they can invest their 401(k) contributions in company stock for the first time, the company held information sessions to explain the plan’s investment options and the risks involved.

“During this process, we asked whether employees really understood where their retirement money was being invested,” says Marberger. “The issue is not just how much to invest in company stock, but how much risk they are willing to take and what their goals are. We want employees to understand that putting all of their retirement savings into a single money market fund can be just as bad as investing all of it in company stock.”


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Fiduciaries are a final area where CPAs can offer companies advice. Every 401(k) plan has fiduciaries who are responsible for its ongoing administration and governance, including the selection of investment options and plan service providers. These individuals are responsible for determining whether company stock is a prudent investment option, so it’s important for a company to clearly identify who is and is not a fiduciary and what conflicts of interest they may face.

There are two types of plan fiduciaries: Named fiduciaries are designated as such in the plan document; functional fiduciaries take on fiduciary status because of their actions. “The board of directors and human resources professionals are two obvious functional fiduciaries,” says Debra Davis, an employee benefits tax manager with Deloitte Tax LLP in McLean, Va. “They often have influence over the plan because of their actions within the company.”

Practical Tips
Help employers develop a process for determining whether company stock is an appropriate investment option for 401(k) participants. Conduct this review periodically, perhaps as often as quarterly, but no less than annually.

Encourage companies to modify their 401(k) plan design to limit liability. Companies can eliminate rules that restrict participants’ ability to immediately diversify employer contributions made in company stock or begin making matching contributions in cash instead of stock.

Advise elderly clients to think twice before gifting their homes.

In many cases functional fiduciaries don’t even realize they hold that designation. For example, a company’s CEO or CFO can become a functional fiduciary if he or she exercises discretionary control over plan assets, such as by influencing the investment of those assets in employer stock. “CPAs within a company can identify these individuals and alert them to their responsibility to act prudently in the best interests of the 401(k) plan,” says Davis. “Internal auditors who audit 401(k) plans can make management aware of these issues, identify conflicts of interest and monitor plan internal controls. They can suggest the named fiduciaries determine whether functional fiduciaries are the best people to serve in that role and ensure they fulfill their fiduciary duties.”

CPAs have the expertise to advise fiduciaries whether company stock is a prudent 401(k) plan investment. “The best course of action is to help the company periodically review its process for determining whether company stock remains an appropriate investment choice,” says Lucas. “It should not offer company stock just because it has always done so. There are other ways to offer employees ownership in the company beyond a 401(k) plan”—through stock options, ESOPs and similar arrangements.

Companies also can retain an independent fiduciary to help with decisions about the 401(k) plan’s investment options, including company stock. While this move does not completely insulate a company from liability, it can provide some protection. “The cost of bringing in an independent fiduciary can run between 10 and 15 basis points of plan assets,” says Hall. “This is fairly cheap insurance that shows the company has made a conscientious effort to consult independent investment experts and strengthens the case that the company is acting in plan participants’ best interest.”

As long as company stock remains a 401(k) investment option, companies must remain vigilant. It’s a good idea to consider the total level of 401(k) assets invested in company stock at least annually. “CPAs can help companies look at the extent to which employees are investing in stock—not just the average allocation but the distribution of that allocation,” says Lucas. Then they can help the company define its comfort level and determine whether current allocations go beyond that level. If so, the company is at risk of a lawsuit and should act accordingly.

  CPAs’ Role With Individual Clients
H eavy 401(k) plan investments in company stock also are a concern for CPAs in private practice and offer an opportunity to educate clients about diversification. “Corporate executives often have company stock holdings, stock options and depend on the company for their salary,” says Ken Burke, CPA, tax partner, Mengel, Metzger, Barr & Co. LLP. “The result is they end up with an enormous amount of their net worth and earnings tied to one company.” For an employee with 5,000 shares of company stock in various plans, a $10 drop in the stock’s price will cut his or her net worth by a whopping $50,000.

“People sometimes get excited about things that are going on in the company that employs them and buy more and more stock, particularly if the stock is performing well,” agrees Ray Nute, CPA, a partner with Sullivan Shuman Freedberg LLC in Natick, Mass. It’s up to CPAs to point out the potential for disaster if the stock price declines significantly.

This is not always an easy task for CPAs. While an executive still is employed by a company, there is sometimes internal pressure to maintain stock holdings. “In many cases, the board of directors and senior management expect executives not to sell their stock,” says Burke. “But even if the company’s stock price is going up 15% to 20% a year, the risks of lack of diversification may not be worth the potential gain.” And all companies permit management to sell some stock for a variety of reasons, including diversification.

When Burke urges clients to consider changes to their overall asset allocation, he often reviews retirement programs first, because reallocating those assets typically has limited or no tax consequences. Since diversification doesn’t have to be an all or nothing proposition, CPAs can recommend a more gradual process to executives who aren’t comfortable with selling a significant portion of their holdings at one time.

There are many reasons why individuals don’t diversify their company stock holdings. “In many cases, clients are emotionally tied to the stock and reluctant to sell,” says Karen Goodfriend, CPA/PFS, vice-president of Allied Consulting Group in Los Altos, Calif. Some clients are fixated on the tax consequences of selling company stock without clearly understanding the risks. “It’s important to understand and talk about why the client is reluctant” before developing a plan, she says. Some clients may need coaching to overcome their reluctance, while others will respond well to hard analysis and data about how selling company stock might affect their tax position and their ability to achieve long-term financial goals.

Nute’s firm often begins discussions about these issues after handling the client’s tax return. The information the client provides each year to prepare his or her return can spur conversations about other financial issues, including company stock holdings inside and outside of retirement accounts. “This is an opportunity to discuss these issues and address them appropriately,” says Nute.

Public practice CPAs can play an important role for clients by reinforcing the information many companies are beginning to provide to help them make better retirement choices.


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