When Enron went bankrupt last year, thousands of its employees lost their life savings, spurring alarm that led the U.S. House of Representatives to pass a measure April 11, 2002, aimed at fixing some Enron-style problems. Under that measure, employers would not have the power, as Enron did, to prohibit workers from dumping company shares accumulated in their 401(k)s.
The Senate has yet to pass a pension-reform bill, and appears to be headed for a somewhat different approach. A key sticking point is Democrats’ opposition to the House provision freeing employers from liability for bad investment advice given by plan administrators. Republicans think this will open the door to better employee education. Democrats believe it would open the door for unscrupulous advisors to steer employees to bad investments.
It is too soon to say what pension reform measures Congress ultimately will adopt. But it is clear that the practices that led to the Enron 401(k) crisis are so imbedded in public policy, corporate behavior and investor psychology that none of the remedies currently under discussion can be assured of preventing another Enron-style meltdown.
The central issue: How to treat the use of the company stock in the employees’ retirement plans.
At one point, Enron employees as a group had 60% of their 401(k) assets in Enron stock, causing them to lose more than $1 billion as the share price fell from its peak above $90 in August 2000 to less than $1 when the company filed for bankruptcy last December.
This is not the only case of excessive concentration in company stock, says Wharton insurance and risk management professor Olivia S. Mitchell. “There are something like five million 401(k) plan participants that appear to hold more than 60% of their assets in company stock,” she said, questioning whether those employees “know the risks they are being exposed to.”
While most 401(k) plans do not offer company stock, the ones that do are generally very large. Overall, about 19% of 401(k) assets are tied up in company stock. Among the plans that offer this as an investment option, 29% of employees’ assets are invested in company stock. In the plans that allow employees free choice on the matter, 22% of assets are in company stock. But among plans where the employer makes the choice – generally by offering a matching contribution only through company stock – 53% of assets are tied up in company stock.
To deal with this, the House adopted a proposal by President Bush to prohibit companies from requiring, as Enron did, that employees hang on to company stock for years, sometimes decades. Instead, employees would have the right to sell their company stock after three years. Employers would have to decide whether the three-year period would begin with an employee’s hiring or be applied on a rolling basis as an employee acquires each block of shares.
The House approach appears to tackle the problem. And yet a study by Mitchell, executive director of Wharton’s Pension Research Council, and Stephen P. Utkus, principal at the Vanguard Center for Retirement Research, shows that the right to sell company stock might not in itself assure that employees would adequately diversify. Many employees choose to buy and keep their employers’ stock even if they are not required to.
The study, Company Stock and Retirement Plan Diversification, notes that company stock has become a serious hazard in America’s defined-contribution retirement plans. The category, which has some 55.5 million participants, includes 401(k)s, employee stock option plans (ESOPs), profit-sharing plans and some hybrids. The 401(k) is the largest type, with about 43.8 million participants.
Nearly half of the direct-contribution plan participants, or 23 million people, have access to company stock in their plans, and 11 million of them have at least 20% of their assets tied up in company stock. Most financial advisors would consider that to be an overly concentrated position in which risks outweigh potential rewards.
Mitchell and Utkus note that some overly concentrated employees will get rich and some will be wiped out – and that there will be more people in these two groups than there would be if fewer employees had concentrated positions.
But perhaps most importantly, the typical participant with an overly concentrated company-stock holding will end up with less than the participant who is more diversified. This is because the average individual stock experiences much wider price swings than the market as a whole. Greater volatility undermines the beneficial effects of compounding, since the big down years more deeply erode the principal on which future gains are based.
For employees with lots of company stock, the big up years cannot make up for the big down years, said Utkus. If a $100 stock were to lose 40%, it would fall to $60. If it were to then gain 40%, it would rise to just $84.
To illustrate this effect, Mitchell and Utkus calculated gains for three workers. Each earned $50,000 per year and contributed 10% to a 401(k), with contributions growing 3% per year to offset inflation. Each could invest in a stock market index and/or company stock. The index and stock each provided average annual returns of 10%. The only difference: volatility, or annual variation in returns, was 20% for the index, 40% for the company stock.
After 30 years, the median employee who invested solely in the market index had a portfolio worth $830,000. The employee who put half his investments into the index and half into the company stock had $615,000. The employee who used only company stock had $411,000.
Typically, 401(k) participants are unaware of the heightened risks posed by company stock, Mitchell and Utkus found. A survey of Vanguard 401(k) customers showed they tended to view their own company stock as less risky than individual stocks in general. That, of course, is not so.
At Enron, the company’s matching contribution to 401(k) plans was made in company stock, and employees were not allowed to sell those shares until they turned 50. The House bill would bar such requirements.
But it’s not clear how much that would help. At Enron, in fact, much of the problem was caused by the employees’ voluntary decision to put large amounts of their own 401(k) contributions into company stock, Mitchell and Utkus said. The plan offered 18 investment options, and there was no restriction on selling Enron shares employees had acquired with their own contributions. Many Enron employees also voluntarily loaded up on the company’s shares in their ESOP.
Some Enron employees have since sued, claiming executives duped them into believing the stock was a good bet.
Mitchell and Utkus believe employees at many companies bulk up on company stock in part because they trust their bosses. In addition, they feel they know more about their own companies than they do about others. For employees, owning company stock may reinforce the feeling they have judged well in picking a place to work.
Companies, too, have reasons for encouraging employee ownership, Mitchell and Utkus say. Many companies think it is cheaper to make matching contributions in stock than in cash, since contributions can be made from newly issued shares (though this does result in a cost by diluting the value of existing shares).
Companies also like to have large blocks of shares in friendly hands, making takeovers tougher. Moreover, restrictions on selling, or the employee’s unwillingness to sell, help stabilize the stock price.
And many employers believe that stock ownership encourages employees to work on shareholders’ behalf. Although Mitchell and Utkus find little research to support this view, it has long been imbedded in public policy. “Getting workers to buy their companies is thought to be a way to protect capitalism,” Mitchell said. Consequently, employers have been awarded tax benefits to encourage employee ownership, especially with ESOPs.
Early in the post-Enron debate, some Democrats proposed placing 10- or 20% caps on the amount of company that stock employees could keep in their 401(k)s. But support for that approach appears to be small. According to Mitchell, caps face a tough public-relations obstacle. Employees at firms like Microsoft who have made fortunes on company shares, are likely to protest loudly, while employees who could benefit from caps are less likely to realize it and hence aren’t likely to lobby.
One solution to the problem is to teach employees about the risks of company stock. The House bill encourages employee education by making it easier for the brokerages and fund companies that administer 401(k)s to provide education. Essentially, it would free employers from liability if plan administrators give employees bad advice.
But key Senate Democrats oppose this measure, arguing that plan administrators’ advice is likely to be tainted by conflict of interest. The firm that offers the menu of investment options is unlikely to say that any are bad, critics note. Nor would the firm, hired by the employer, be likely to discourage employees from buying company stock. “I think that, at the least, you’d like to allow some competition,” Mitchell said. “Having just one advice provider may not be a great idea.”
Republican leaders have called on Democrats to bring a final pension reform bill to the Senate floor by Memorial Day. But the key Senate Finance Committee has yet to put a final bill together, and Democratic leaders have not agreed to that deadline.
Democrats say they won’t give up their opposition to the Republicans’ employee-education provision. But Democrats generally support proposals designed to let employees unload company stock.
Whether employees, given that right, will do so, is another question.