The Decline of Company Stock in 401(k) Plans

During that period, numerous meetings were held where individuals passionately pleaded with Congress to impose restrictions on company stock investments. It was at one of these gatherings that someone made an interesting suggestion - the problem of company stock might resolve itself as target-date funds gained prominence and diverted employees' attention away from their employers' stock.

As it turns out, data from Vanguard supports this notion of a "squeezing-out" effect. In combination with plan sponsors recognizing the risks of single-stock investments, the percentage of sponsors actively offering company stock has significantly declined. This percentage dropped from 12% in 2005 to 8% in 2022. Similarly, the percentage of participants holding company stock has decreased from 29% to 8%, while the percentage of participants with concentrations of company stock over 20% has plummeted from 18% to 3% (see Figure 1).

This decline can be attributed to three primary factors.

The Rise of Target-Date Funds

Target-date funds, along with equity index funds, have experienced a substantial surge in popularity. When combined, these funds now account for almost 80% of defined-contribution plan assets.

Recognition of Risk

Sponsors have come to acknowledge that having their employees heavily invested in company stock poses risks for both parties. Companies have learned valuable lessons from cases like Enron. Consequently, a Vanguard study conducted in 2020 revealed that over half of the companies that previously offered company stock no longer do so. Furthermore, those that still offer it often allow immediate diversification to mitigate risk.

The decline in the presence of company stock in 401(k) plans signifies a significant shift in investment strategies and the increasing focus on diversification and risk management. As target-date funds continue to dominate the landscape, it is clear that both sponsors and participants are recognizing the potential pitfalls of relying heavily on employer stock.

Introduction

The Risk of Concentrated Portfolios

Holding a single stock, such as company stock, significantly increases the riskiness of a portfolio. In comparison to a diversified portfolio consisting of around 30 stocks, relying heavily on one stock offers no potential offset of higher returns. This situation arises because most participants are not sophisticated investors and tend to underestimate the risks associated with investing in a single stock.

Factors Contributing to Holding Company Stock

Participants often make the mistake of investing in what they know, leading them to buy company stock. They observe executives accumulating wealth through company stock and wish to gain similar opportunities. Furthermore, the employer's matching contributions in company stock may inadvertently endorse this investment choice. Historically, companies have preferred matching in stock rather than cash to preserve their valuable cash reserves. However, a series of lawsuits over the past 15 years have somewhat diluted this preference.

The Consequences of Excessive Company Stockholdings

Participants who heavily rely on company stock face considerable risks. Not only do they risk losing their retirement savings if the company encounters financial trouble, but they also jeopardize their employment status. Since the value of company stock is closely tied to earnings, any downturn can have severe consequences for participants.

Addressing the Issue

In defined-benefit plans, ERISA regulations prevent participants from holding more than 10% of plan assets in company stock, effectively avoiding excessive concentrations. However, this safeguard does not extend to defined-contribution plans, where participants have more control over their investments. Considering the current landscape, pushing for similar limitations in defined-contribution plans is a relatively low priority.

Conclusion

While progress has been made in reducing company stockholdings within retirement portfolios, there is still work to be done. Participants must be educated about the risks associated with concentrated portfolios, and employers should consider diversification options beyond company stock. By promoting a balanced approach to investment, we can better protect the long-term financial security of retirement savers.