You’d think the fall of Enron and WorldCom taught investors a valuable lesson in the dangers of having too much of their company-sponsored retirement plan in company stock. But judging by what appears to be the pending demise of Bear Stearns, whose stock plummeted from $160 per share to less than $10 per share, apparently not. Bear Stearns employees owned about one third of the investment firm’s stock.
Small business owners sometimes make similar mistakes. People who start companies typically invest the bulk of their net worth in their businesses. And just as often they only seek to diversify when they are ready to begin removing themselves from the business. While small business owners can sell a portion of the firm to employees, many don’t take advantage of this opportunity until well into the business’ life cycle, leaving the founder’s retirement savings tied up in his business for a long period of time. Individual businesses may not have a comparable rate of return compared to the broader market. (Of course, they might hit it big, but the idea here is to lower risk).
If a small business owner does decide to sell a portion of his company to employees, as is the case with ESOPs (Employee Stock Ownership Plan), much of that risk then can get passed on to the employees, as sometimes there is not a ready market for selling those shares.
Usually valuation methods exist so shares can be sold back to the company – a share of stock, after all, is only worth what someone else is willing to pay for it – but that doesn’t solve the problem of company-owned stock lagging other investment options.
The refrain from corporate fallouts such as Enron and Bear Stearns is always the same: diversify, diversify, diversify. In fact, even the government promotes the magic d-word – the Pension Protection Act (PPA), signed in 2007, states that if 401(k) participants receive company stock as a portion of their matching contributions, they must be able to move out of the stock after three years of service.
Not that it should end there. Business owners of all stripes can diversify their holdings by offering an ESOP while at the same time protecting their employees by adopting even more liberal safeguards than those mandated by the federal government.
Of course, employees will still need to practice common sense. A recent study by the Investment Company Institutes found that employees that have access to company stock in their retirement plans have nearly 27% of their money there.
Why do these situations persist? Many employees believe they know the ins and outs of their company or think they understand its performance better than any of the other investment options in their 401(k). Indeed, there might be an advantage for those who can sense upcoming changes in earnings or investor sentiment.
But one need not look too far to find situations where that could prove dangerous. Local company CarMax is off more than 25% in the last year, and Capital One is down almost 40%. Likewise, Circuit City has seen its shares plunge more than 75% in a year while Media General, the company that owns the Times-Dispatch, is trading around $14 a share. That’s down from a high of $60 three years ago.
Hopefully, employers and their employees at these and other locally-based, publicly traded companies have learned that it is just too risky to rely on one company’s performance for both a paycheck and retirement. And hopefully small business owners aren’t too far behind.
A quick guide for employees:
- First you should know how much of your 401(k) plan is invested in company stock and the policies about divesting of that company stock inside the plan.
- If you own more than 10% of your total portfolio in company stock, you should look to diversify.
- Get to know the other offerings within your plan. This does not mean understanding the nuances of each investment approach. But you should at least know what each fund invests in. Does it invest in bonds, or stocks? Does it invest in large cap stocks or small cap stocks? Does it invest in U.S. companies or international companies? Investors should at a minimum attempt to pick investments that expose them to several different areas of the market, including bonds, U.S. stocks and international stocks.