Taking stock of company stock—and its risks—in a 401(k) plan

While a potentially attractive option because it offers participants a convenient and tax-efficient opportunity to invest in their employer, company stock comes with significant fiduciary and investment risks, especially if the allocation to company stock becomes too concentrated.

Because it’s a single, nondiversified investment, a high concentration of company stock in a portfolio can lead to substantial losses if the stock performs poorly or if the company faces bankruptcy.

The volatility of some company stock has been an impetus for lawsuits brought against plan sponsors when the price of the stock drops—but also when it goes up.

To avoid possible litigation, sponsors should periodically examine their company stock and determine if it’s a prudent investment to include in their plan’s fund lineup. If history is any indicator, sponsors have indeed done this and are gradually backing off from including company stock in their plans and portfolios. 

Plan sponsors who continue to offer company stock have several options to help absolve themselves of liability for participant investment decisions while still helping participants understand the downside of company stock.

Section 404(c) of ERISA protects plan sponsors from possible litigation stemming from company stock performance if they can show that they offer a broad range of investments, let participants control their own investments, and provide participants with enough information to make informed decisions about where they put their money.

Sponsors should also be prepared to show the process used to determine that company stock is a prudent investment for their plan. This should include, among other things, establishing clear goals for the plan’s investments, evaluating the company stock against benchmarks, and conducting regular committee reviews of the company stock.

For participants, sponsors are required to provide notices explaining that participants have the legal right to diversify out of company stock if the investment doesn’t suit their objectives. But beyond that, sponsors can—and should—regularly communicate both the benefits and risks of holding company stock in their portfolios.

Plan design can play a major role in accumulating savings in both good markets and bad. And sponsors have made it easier for employees to save for retirement—stripping away anxiety and intimidation and building plans that are more welcoming.

But even so, investing is not without risk, and if sponsors want to lessen risk while still offering company stock to participants, they can alter their plan design to do so. Among the steps sponsors can consider:

• Limit exposure to company stock. Sponsors can set a limit on money being directed to company stock, say 10% or 20%. This could apply to employee and employer deferrals, exchanges, and rebalancing. Currently, many Vanguard plan sponsors place some sort of restriction on contributions to company stock. Once the limit has been met, further allocations to company stock could be prevented. Any amount that would push a contribution over the limit could be redirected to other options in the plan.
  
  
• Close the fund to new money. Like placing a limit on company stock allocations, closing the fund to new contributions would potentially decrease higher concentrations of company stock, mitigate risk, and still maintain a company stock fund in the plan. However, participants currently directing contributions to the company stock fund would have to choose another fund for that portion of their allocation.
  
  
• Remove company stock altogether. This is the most extreme measure a sponsor can take, but it can be time consuming. The removal of company stock would depend on the stock’s liquidity. Further, participants with company stock in their portfolios would have to be given time to select other investments in the plan. The decision to remove the stock must be clearly communicated to participants and all documentation would need to be updated.

While eliminating the risks associated with company stock in a 401(k) plan is challenging, plan sponsors can reduce these risks. By maintaining a consistent and documented process, considering thoughtful plan design changes, and regularly evaluating the importance and desirability of company stock, sponsors can offer the benefits of company stock while safeguarding the interests of the company and its participants.

For more on minimizing the risk and liability inherent in a 401(k) plan’s company stock, don’t miss the Vanguard commentary Mitigating the Risk of Company Stock in Defined Contribution Plans.

Note:

• All investing is subject to risk, including the possible loss of the money you invest.