By Cary Springfield
If you are an investment banker, the fourth quarter heralds the performance appraisal period that will determine your compensation for next year’s bonus season. Recent trends in how bonuses are being paid mean that it is doubly important to take inventory of company stock in your retirement plan.
A recent survey of 401k plans by Vanguard indicated that, on average, 401k plans had a 9% allocation to company stock. For most retirement plan investors, this is 9% too high. For investment bankers in particular two changes in how bonuses are structured may further increase the already high opportunity cost of holding company stock in a retirement plan. First, employers are increasingly splitting bonuses between cash and company stock, resulting in higher exposure to company stock than has been the case historically. Secondly, whereas previously most bonuses were paid in a lump sum, increasingly bonuses have a deferred component. With vesting periods for deferred bonuses ranging up to three to five years, those who resign or are laid off before these bonuses vest could lose that deferred component. These two developments mean that investment bankers are even more anchored to the fortunes of their employers that in the past. Having company stock in a retirement plan portfolio further amplifies that anchoring to an employer’s future prospects.
The remainder of this article makes the case for why holding company stock in your retirement portfolio is likely to undermine your retirement investment strategy.
Pension plan participants, especially highly compensated employees who receive stock based compensation, are exposed to concentration risk due to company stock. When making investments, we often think of those investments in the context of specific asset class buckets (real estate, fixed income, equities, etc.) to which we want exposure because of the characteristics they offer. In the same vein, components of your life equate to various asset class exposures just as your investment portfolio provides exposure to various asset classes. For example, you have exposure to real estate as an asset class through your primary and vacation residential properties. Your salary can be viewed as a single issuer fixed income security that is highly correlated with financial health of your employer. Likewise, the company stock component of your bonus, other forms of stock based compensation you may receive from your employer, and company stock in your retirement portfolio all translate to exposure to a single equity that is highly correlated with the financial health of your employer. The combination of both a salary and company stock holdings result in concentration risk tied to your employer.
As the financial crisis underscored, it is not too farfetched to be hit with the quadruple whammy of losing a job (loss of single issuer fixed income security correlated to the financial health of your employer), having no bonus, losing the unvested portions of deferred compensation, and taking a hit on company stock (single equity that is highly correlated with the financial health of your employer) in your retirement plan portfolio. While one cannot insulate against a job loss, one can at least insulate a retirement portfolio from company and industry specific volatility by building a diversified retirement portfolio with exposure to a broad range of asset classes, which each have diversified underlying portfolios.
In addition to concentration risk, there are other problems with holding company stock:
- Behavioral finance research suggests that pension plan participants might not sell company stock when it is optimal to so. Research conducted by Olivia Mitchell and Stephen Utkus found that the majority of pension plan participants with company stock in their retirement portfolio perceived company stock as having the same or lower volatility than a diversified stock portfolio. Their research indicated that pension plan participants’ perception of risk of company stock was based on extrapolating (good) historical company performance into the future. Their findings are supported by a study of pension plan participants conducted by Shlomo Benartzi, which found that participants’ allocation to company stock were highly correlated with the past performance of the stock – resulting in employees increasing allocations to company stocks that subsequently underperformed and vice versa. Empirical evidence indicates that investors are loss averse, with a strong tendency to avoid realizing losses. Pension plan participants’ underestimation of the risk of company stock combined with loss aversion suggests that pension plan participants with company holdings in their retirement portfolio are unlikely to sell company stock when it is optimal to do so.
- Suboptimal asset allocation – Depending on tenure in a company and how long company stock has accumulated, pension plan participants could potentially build up very high allocations to company stock over time. Unfortunately, inertia and procrastination may result in pension plan participants with significant company stock holdings in their portfolios being inappropriately overweight to equities (and underweight fixed income and other assets). Asset allocation could be sub-optimal given a risk budget and an investment horizon.
If you are now fully convinced about the dangers of company stock in a retirement plan, you may be wondering how to go about mitigating the risks posed by company stock. If you have a chunk of company stock and have no employer restrictions on liquidating the stock, consider replacing all your company stock holdings with a diversified equity fund. If you receive company stock on a periodic basis, that is for example, as a company match in your retirement plan, or as the non-cash component of your bonus, consider coming up with a process to incrementally reduce your company stock holdings on a periodic basis (quarterly, annually, semi-annually), as your company stock vests.