Financial Planning Blog

The perils of holding too much of your employer's stock is widely acknowledged in financial planning circles. In Part 1 the key reasons why you should seriously consider diversifying away from your company's stock are outlined. If you are not convinced, ask yourself why defined benefit pension plans (old style pensions where investment professionals manage money set aside in trusts to fund the retirement of employees) are restricted by law to hold no more than 10% of their assets in company stock? If it is not wise, or lawful, for pension professionals to invest too much in company stock, do you really think it is a good idea for you to do so?

The fear of litigation stemming from employees stung by major drops in company stock, along with new diversification guidelines set forth by the Pension Protection Act of 2006, has encouraged 401K plan sponsors to make it easier for plan participants to diversify away from employer stock. Although the concentration of employer stock in 401K plans has decreased over the last several years, it is still a notable risk for many investors preparing for retirement. At several large, well-respected companies employees still hold remarkably high percentages of their retirement plan assets in employer stock. For example:

• Proctor and Gamble employees reportedly hold over 90% of their 401K plan assets in P&G stock.
• General Electric employees still hold 40%, even though GE's stock price is essentially at 1997 levels. (Granted, there have been some major ups and downs since then!)
• ExxonMobile employees, who hold about 65% of their 401K assets in company stock, undoubtedly breathed a collective sigh of relief when it was a BP well, not one of their own, that blew out in the Gulf of Mexico. ExxonMobile is up about 25% over the last year, while BP was down over 50% at one time in 2010. Almost 30% of BP's 401K assets were in its own stock.

If you are still holding a significant (e.g. >10%) share of your retirement savings in your company's stock, you are certainly not alone. Separate studies from the Employee Benefit Research Institute (ERBI) and the Vanguard Center for Retirement Research show the following:

• Large companies are more likely to offer company stock as an investment option than small companies. Even though the vast majority of 401K plans do not have employer stock as an investment option, a sizeable proportion of overall plan participants (46% in the ERBI sample and 36% in the Vanguard study) do have company stock as a choice. In plans where it is an investment option, the ERBI study found about 20% of total plan assets invested in company stock.
• Of those participants who have company stock as an option, close to 50% (ERBI=48%, Vanguard=45%) are wise and choose to hold none of it. (We can only assume they are avid readers of financial planning blogs such as this one.)
• Although the majority of participants with company stock as an option hold only reasonable amounts (<20% of their 401K balances), there are still a sizeable minority with dangerously high holdings. About 30% of participants hold more than 20% of their portfolio in company stock, and there are 5 to 10% of participants holding almost all (> 80%) of their retirement funds in employer stock.

A Potential Tax Benefit to Company Stock

Before you rush off to reallocate your 401K investments, be aware of one potentially advantageous tax strategy available to you if you hold highly appreciated company stock in your employer sponsored plan at retirement. It is called "net unrealized appreciation", or NUA. Basically, the NUA strategy allows you to separate out your company stock from the rest of your 401K assets and immediately pay ordinary income tax on the cost basis of the stock (i.e. what you originally paid for it). Then, when you decide to sell the stock, you will pay only the long term capital gains tax rate on the appreciation. The end result of choosing NUA taxation may be more favorable than keeping the assets in the plan or rollover IRA, where you will eventually pay ordinary income tax on the entire amount when withdrawn. This strategy is complicated, and the IRS is reportedly unsympathetic to those who don't execute it according to the rules. If you think you are a candidate for NUA, definitely do your homework and plan on consulting with a qualified financial advisor or your tax professional prior to rolling over your retirement plan. (For a detailed review of NUA see this 2007 white paper from the Fidelity Research Institute.)

In Part 3, we'll look at some of the reasons put forward as to why people choose to hold so much company stock in their 401K.