Company Stock in 401(k)s: Proceed With Caution

401(k) plans have made great strides in recent years--reducing costs, simplifying investment menus, and automating portfolio allocation. But a surprisingly large number of plans still include one feature that really should go: offering the plan sponsor's own shares to workers.

Research consistently shows that owning your employer's stock in a workplace retirement plan is risky. And although concentration of employer stock in workplace plans has been declining in recent years, stubbornly high pockets of concentration remain.

Vanguard, for example, says that 9% of defined-contribution plans that it administers offered company stock in 2014, down from 11% in 2005 (see orange line in the chart below). The percentage of plan participants who were offered or invested in company stock fell by larger amounts--and the percentage of participants with a concentrated position (over 20% of total account balance) dropped by about half. But among those participants who are offered company stock (dark blue line), over half still own it, although that number has also been declining.

Aon Hewitt research similarly finds that, at companies where stock is available, more than half of workers own the shares--and that 23% of those workers had at least 20% of their portfolios in their employer's stock. That's a heavy concentration by any measure.

The continued use of company stock runs counter to best practices in retirement-portfolio construction. "People don't understand how risky it is to own their own employer's stock," says David Blanchett, head of retirement research for Morningstar Investment Management. "If you went to the typical corporate plan sponsor and suggested that they add some other company's stock as a plan option, they'd tell you it's a crazy idea. But for some reason, it's not crazy to offer their own stock. If companies are going to do it, it's important to be very proactive about making sure people understand the risk and use this option responsibly."

How are plan participants doing with their company stock? Vanguard's research found the average five-year annualized return was 21%, but there was wide variation: The five-year annualized return was negative 0.04% at the fifth percentile and a positive 44% at the 95th percentile.

"If you happened to work for a company with returns in the top 5%, you earned a 44% return--that's pretty sweet," says Jean Young, senior research analyst in Vanguard's Center for Retirement Research. "People who see that kind of return become very attached to their company stock, but it's a type of error in portfolio construction. They don't understand the risks they are taking."

Research by Blanchett found that the stock of companies with high allocations to their own stock in a 401(k) plan tended to underperform their peers on a relative performance and risk-adjusted basis. Making matters worse, investors aren't compensated for the risk. "Diversification is the only 'free lunch' associated with investing," notes Blanchett. "You should only take on risk if there is an expected reward. For example, why would you put money in a stock if the expected return is the same as a money market account, but it had something like 10 times the volatility? Holding a single employer stock is an idiosyncratic risk of that sort."

Another major risk is the high correlation of the employer's stock and "human capital"--that is, the employee's ability to earn income. A plunge in the employer's stock could also be associated with greater risk of job loss. "Ask yourself: How risky is my job and how does it relate to the stock market?" Blanchett says. "If I'm a realtor, I'm in a very risky profession. So, I should have more cash in my portfolio for a rainy day, and I don't want to hold REITs because you already have that risk in your professional work. Just ask yourself--what is risky about my job and how can I hedge against that risk?"

Employers also face risks. There has been a sharp increase in litigation filed by workers against companies with heavy concentrations of their own stock in retirement plans--so-called "stock drop" cases. Most recently, the U.S. Supreme Court ruled (in Fifth Third Bancorp v. Dudenhoeffer) that including company stock in a retirement plan would no longer be viewed as prudent by default--a decision that has left plan sponsors unsure of their potential fiduciary liability.

Federal law also discourages the practice. The Pension Protection Act of 2006 required plan sponsors to enable employees to diversify out of any company stock they had purchased and to unload shares contributed by the employer after three years on the job. The law also required employers to provide quarterly communication and education about the importance of diversification.

Net Unrealized Appreciation Even the critics concede there are a couple potential advantages to company-stock features in retirement plans. One is the opportunity to buy your employer's stock at a discount--a feature often found in these plans. The other is net unrealized appreciation (NUA), an IRS rule that allows you to take distributions and pay taxes on the difference between cost basis and market value at long-term capital gains tax rates, rather than ordinary income rates.

This approach can make sense if you've held company stock for a while and it has appreciated substantially.

Purchases Outside Retirement Plans There's also been renewed interest in employee stock purchase plans (ESPP). These plans let workers buy their employers' stock outside retirement plans using aftertax dollars, often at a discount of up to 15% below market rates. ESPPs have been around for a while, but interest cooled off following 2005 accounting-rule reforms that required companies to expense the cost of plans. The recession also dampened interest in the plans because of their cost.

But interest in ESPPs may be returning. Fidelity Investments reports a 36% increase in participants in ESPP plans that it administers since 2013 and that purchases jumped 180% over that period to $2.5 billion.

ESPPs don't trigger fiduciary responsibility for plan sponsors, and they are attracting interest for shorter-term investing goals, says Emily Cervino, vice president of Fidelity Stock Plan Services, which sets up and runs ESPPs for corporations. "They are far less expensive for companies to operate than stock-option plans, and they can be offered to a very broad base of workers," she says. Although ESPPs are gaining ground in a variety of industries, they are especially popular in technology and life-sciences companies, she says.

Although not all plans offer purchase price discounts, some that do will also feature "look-backs" that permit discounting from the start or finish date of the stock offer period, whichever is lower. Some ESPPs also permit employees to flip their shares for an immediate profit, although tax treatment is less favorable. (Most ESPPs are tax-qualified under Section 423 of the Internal Revenue Service Code. In qualified plans, investors pay ordinary income tax on the discounts and short- or long-term capital gains taxes on any appreciated amounts.)

A recent Fidelity survey found that 86% of respondents under the age of 40 said they would want their new employer to offer a company-stock plan if they changed jobs, and 40% consider a company-stock plan as a must-have benefit when making a decision to change employers.

Cervino doesn't dispute the double-down risks involved in owning your employer's shares. "We're seeing a lot of employers re-evaluating whether they should offer their shares in retirement plans," she says. Cervino argues that ESPPs offer a more liquid form of saving. "It's a way to supplement retirement accounts or to use for immediate or mid-term goals, like buying a house, sending a child to college, or paying for a wedding."

Share discounts support that line of thinking. But accumulating savings in the shares of a single company still strikes me as risky. If you doubt it, ask anyone who worked for Enron.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.