Skip to Content
Investing Specialists

Company Stock in Your 401(k): Yes, It's Still a Bad Idea

Human capital and financial capital don't mix.

A Wells Fargo Bank program that incentivized employees to open accounts without clients' permission has come under fire in recent months.

The firm isn't just getting heat from its customers, though. A spate of lawsuits allege that the firm mismanaged its 401(k) plan, too.

The 401(k) lawsuits that have gotten the most attention relate to the firm's use of its own target-date funds in the plan, rather than cheaper, better alternatives such as Vanguard's.

But another lawsuit, filed in early October, relates to Wells Fargo company stock held within the plan. The suit alleges that even though the overseers of Wells Fargo's 401(k) plan knew that the practice of opening phantom client accounts was inflating the firm's share price, they withheld that information from plan participants.

Whether the plaintiffs have a shot at success is debatable; similar cases have fallen flat.

Even so, the case serves as yet another worthwhile reminder of the perils of holding too much company stock as a component of a retirement plan--either inside or outside of a 401(k), with or without a true scandal. Even if a company's shares don't go down the tubes in Enron-like fashion, employees who invest heavily in company stock are commingling their financial capital with their human capital, and making their financial plans unnecessarily risky along the way.

A Welcome Decline
If there's a silver lining to well-publicized company-stock ownership debacles like Enron, it's that they have led to a decline in investors holding company stock in their 401(k)s. According to a study of 401(k) plans where Vanguard serves as the record-keeper, the percentage of those plans that featured company stock dropped by 18% between 2005 and 2011. Meanwhile, the percentage of 401(k) participants who owned company stock within their plans fell by about a third over that same time period. 

Research conducted by David Blanchett, head of retirement research for Morningstar Investment Management, points to a similar pattern: Between early 1999 and the end of 2011, the aggregate dollar-weighted 401(k) assets invested in company stock dropped from 17% to 10%.

The Vanguard research suggests that plan design, rather than participant choice, is largely responsible for the shift. While in the past some plans may have matched employees' contributions with stock shares, many such plans have switched their matching contributions to cash or removed the company stock offering from their menus altogether.

But the Wells Fargo story illustrates that plenty of plans still offer their own shares on their 401(k) menus, and plenty of employees feast on it. Within Wells' $36 billion-in-assets plan, for example, fully a third of assets were in Wells Fargo stock, according to BrightScope data. That's three times as much as the next most popular investment option, the Wells Fargo Advantage Dow Jones target-date funds. (Curiously, Wells Fargo’s own site for consumers warns against the practice of holding too much company stock.) 

Of course, employees often willingly invest in companies stock because they believe they have an information advantage; they may feel they understand the company's prospects better than outside investors do.

Many employers, meanwhile, likely view employee ownership as a key way to align workers' interests with those of the business. In addition, the Vanguard research shows that companies offering company stock in their plans make larger matching contributions than those that don't; participant-account balances are larger, too.

The Risks Outweigh the Rewards
Indeed, there's a connection between matching and company stock: As noted above, some plans match employees' contributions in stock rather than cash. Because 401(k) participants often make few changes once they've made their initial selections (or are opted into them), those being matched in company stock often let that stock build up. That tendency toward inertia is frequently exacerbated in a rising market and/or when the company stock has been on a tear, as Wells Fargo's was; employees are reticent to mess with a good thing.

Yet numerous studies suggest that the rewards don't offset the risks of heavy ownership stakes in company stock.

Although one might expect that workers who own shares of their employers' stock would benefit from their knowledge of the company, Morningstar's Blanchett found the opposite: Companies whose employees have high aggregate allocations to company stock have tended to underperform those without, even when controlling for market capitalization, investment style, sector, and other factors.

Moreover, investors who hold substantial stakes in employer stock court risks on several levels. At the portfolio level, heavily weighting single stock--any stock--has the potential to make that portfolio more volatile than one that's more diffuse. Moreover, because company stock ownership is much heavier among larger-cap stocks than smaller ones, it's much more likely that the investor who owns a heavy stake in his or her company owns additional shares in that same company through any mutual funds in the portfolio.

And then there are human-capital considerations: Employees who invest heavily in company stock have both their human capital and financial capital riding on the fortunes of a single company; difficulties at their employer could cause their stock shares to sink at the same time they suffer job loss or an income reduction. This Morningstar research paper examines the interplay between human and financial capital. 

What Should You Do?
Due to portfolio-diversification and human capital considerations, Blanchett notes in this video that the optimal allocation to company stock, from a "pure research perspective," is zero. Such a draconian approach might not be practical for some investors, however; Blanchett notes that 10% of total portfolio assets is a reasonable upper limit for company-stock ownership. 

And given that so many employees receive company stock through matching contributions in their 401(k)s, it's a best practice for such investors to periodically liquidate those holdings and deploy the cash into better-diversified positions within their plans. Thanks to the Pension Protection Act of 2006, participants who have logged three years of service under the plan can transfer the value of the company stock into better-diversified options within the plan. 

Finally, employees who own company stock within their plans should be aware of the rules regarding net unrealized appreciation, discussed in this article. Blanchett says investors who hold company stock in their 401(k)s will have to weigh the potential tax savings of being able to take advantage of the NUA rules against the loss of diversification that accompanies holding a substantial stake in company stock. A tax advisor can provide guidance of the best course of action; the longer your time horizon to liquidation, the greater the risk of a high allocation to employer stock.