Careful With That Company Stock

Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Employer stock is a common component of many employee-compensation plans, but holding too much in company stocks isn't often a very good idea. Joining me to discuss the role of company stocks in financial plans is David Blanchett. He is head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett: Thank you for having me.

Benz: So, David, first let's take a look at the trends that we've observed in terms of employer stock in employees' compensation plans. I know there was a big spike in the 1990s. Everybody had to have company stock. What have the trends been since then?

Blanchett: Well, the good news is that employees are holding less of their employer stock in their 401(k) plans. You have seen a dramatic decrease in employees that are buying it. Employers aren't even offering it. You have seen a lot of employers now have stopped offering their stock to employees in the year 401(k) plans. So there's been a definite positive trend in terms of helping employees make better decisions with their 401(k) monies.

Benz: So what has been driving it down? There were obviously some high-profile blow-ups, Enron and so forth. Has it been just sort of a trend due to some of those bad experiences?

Blanchett: I think a lot of plan sponsors are scared. It's their decision to include it in the 401(k) plan. And so, if you have participants who go out and buy the stock in the 401(k) plan, unless you qualify for certain types of relief, it's like the plan sponsor had. So, if I am a plan sponsor, I don't want to kind of have that risk in my 401(k) of all my participants are buying the company stock and then it performing poorly. This is because you kind of have two bad things happening: The first you have a lot of employees who have lost a lot of money and then you have also probably the bad business with having the bad turn to your stock.

Benz: So let's discuss the key disadvantages to having too much in company stock. Obviously, you could be underdiversified, so you could have a lot of eggs in that one basket. Let's discuss the other considerations there that would work against having employer stock be a big part of your plan?

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Blanchett: I think the biggest reason is human capital. If we think about what we own as individuals. Human capital is for most people the largest asset. Human capital is simply your earnings. So, someone who is younger, who is 30 years old, most of their future wealth, they haven't earned yet. It's going to be them working through time, and so if you think about, well then, what are the different components of someone's total net worth? They've have got their human capital and their financial capital. Their financial capital are their assets. It's their 401(k) plan; it's their IRA. And when you blend the two together, it's very risky. Because you know, for example if you worked at Enron, it's a perfect example. They had over half of the 401(k) in Enron securities. So if you worked at Enron, all of a sudden you could lose your job and then you lost all of your retirement money as well. So it's very dangerous to kind of tie those things together. So to diversify yourself it's good to kind of have your human capital be where you work and then also have your financial capital be in a more diversified portfolio.

Benz: So, in most cases holding too much in your employer stock is a bad idea.

Blanchett: Yes.

Benz: But let's talk about those few situations when it may make sense actually to hang on to that company stock?

Blanchett: There's one in particular; it's called net unrealized appreciation. This is a very complicated topic, but the key is, if you've bought employer stock and it's gone up materially and if you roll it out currently into an IRA, the gain can be taxed at long-term capital gains rates. IRA distributions are normally taxed at ordinary gains rates, which can be up to 35% right now. So there's a significant benefit to that 15% possible long-term capital gains rate versus the ordinary rate of 35%.

Benz: So, how in a nutshell does this net unrealized depreciation work, and how should investors think about it as they're managing company stock within their portfolios?

Blanchett: Well, one thing that I think is important to think about is what is your gain? Because whenever you hold an employer security you're subject to more risk. Stocks on average have twice the risk in terms of standard deviation as the market itself. So there's a much higher chance that you'll kind of gain or lose money any given year. If you work for a company that is relatively stable, then you know you can think more about holding it and then waiting to kind of realize these tax benefits, because you can't realize these benefits until you roll out of the plan. So, if you are 40 years old you can only roll out if you leave your employer or you can roll out when you hit the retirement age, but the longer you have to go, the kind of more dangerous it is to hold the employer stock in the 401(k) plan.

Benz: You also mentioned that there are certain types of company stock that may have less risk than others. Let's talk about some of those instances of when maybe it's not quite as risky as holding other types of company stock?

Blanchett: I can give some general examples. I'm not sure about the true strength. General Electric is an example of a company that has a relatively diversified balance sheet. [Another is] a company like Berkshire Hathaway, a company that we would expect to be around longer because it has different business units. A smaller company that, it is very focused on one industry is a lot more subject to risk and then you know possibly going bankrupt than a larger company would be.

Benz: Let's discuss the upper end of company stock that one would want to own. So assuming that you are holding some company stock in your portfolio what would be the high-end that you would recommend?

Blanchett: So from the pure research perspective I have to say you should never hold it.

Benz: Zero.

Blanchett: But that's not realistic because I do think that there are definitely positive attributes to holding employer stock. It's good to kind of align employee interest with company performance. So personally I think 10% is kind of the upward threshold. So don't ever have more than 10% of your money in your employer stock.

Benz: So that would be sort of all-in, such as the value stock options as well as company stock.

Blanchett: Yes. For example, if you have a lot of stock options, again you kind of have this embedded employer security that could be dangerous if things end up going poorly.

Benz: David, thank you so much for sharing these guidelines. It's very helpful information.

Blanchett: Thank you for having me.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.