Leveraging Your Risks: The Impact of Employer Stock in Your 401(k) Account

Not only depositors and investors, but many bank employees are also suffering significant losses in their 401(k) accounts due to the recent collapse of two regional banks. The Federal Deposit Insurance Corporation took over Silicon Valley Bank and Signature BankSBNY -22.9%, rendering stock in the banks worthless. The resulting contagion from bank runs and market panics led to considerable declines in the prices of stock in other banks, particularly regional banks.

Publicly traded companies’ employees often hold employer stock in their 401(k) and employee stock ownership plans. According to Pension & Investments, approximately 19% of the assets in the SVBVB -2.7% retirement plans were invested in the company’s stock. Similarly, it is not unusual for that amount or more of bank employee retirement plans to be allocated to company stock, as indicated by published data from P&I.

Employers used to encourage or even mandate that employees invest a portion of their 401(k)s and other retirement plans in company stock. However, many employers have decreased their emphasis on owning company stock over time, primarily due to bankruptcies and significant stock price declines that could make the employers and some officers liable for losses in employee retirement accounts.

According to the Alight Solution 401(k) Index, the allocation to company stock fell from 30.6% of 401(k) plan assets in 1997 to 6.2% at the close of 2022.

As illustrated by the collapse of SVB and Signature Bank, allocating a significant portion of retirement savings to an employer’s stock can be risky.

Individuals possess both human capital and financial capital, where the former refers to the ability to earn income from employment or self-employment, while the latter pertains to the portion of those earnings that are saved and invested.

One potential risk associated with human capital is the possibility that the employer may underperform or even fail, resulting in reduced earnings until a new job is found. In some cases, the damage to an individual’s human capital may be permanent if comparable job opportunities are not available or if previous employment experiences negatively impact marketability.

This risk can be compounded if a significant portion of an individual’s retirement savings is invested in employer stock. Such concentrated investment can lead to increased vulnerability of both human and investment capital if the employer experiences financial difficulties. In such cases, employees may not only lose their jobs but also suffer significant declines in their financial portfolios.

Although concentrated investing can sometimes result in substantial returns, it can also make a portfolio more volatile. Additionally, investors may not always have access to all the information required to make informed decisions about their investments. Some investors who focused on a few stocks that had previously performed well experienced significant losses when those stocks declined sharply in value.

It is important to note that when an individual owns both employer stock and mutual funds in a retirement account, the mutual funds may also hold shares of the employer. Some people feel more confident when they hold their employers’ stock in retirement accounts, believing that they have a better understanding of the company’s performance and are better positioned to make informed investment decisions.

However, research suggests that employees who hold significant allocations of employer stock in their 401(k) plans tend to experience lower investment returns than those who do not. Furthermore, companies with 401(k) plans that have significant allocations of employer stock tend to have poorer stock performance than other companies.

The author offers a personal anecdote to illustrate these points, noting that their father worked for AT&T for many years and owned shares of the company and its successors until his passing.

Although the individual in question owned some AT&T shares, they represented only a small portion of their net worth, with the majority of their savings invested in unrelated ventures. Furthermore, during their tenure, AT&T was a regulated utility monopoly that paid high dividends and was considered a safer stock than its successors, with the company’s core business presenting low risk.

While it is rare for people to retire wealthy due to outstanding stock performance at their place of employment, stories of such success do exist. However, it is more likely that former employees benefited from stock options rather than purchasing employer stock in a 401(k) account. Unfortunately, there are numerous cases of people losing both their jobs and a significant portion of their investment capital by relying too heavily on one company.

Owning employer stock has its advantages, but employees should be aware of the risks and avoid putting their financial security at stake by investing too heavily in one company. A sound guideline is to limit investment exposure to an employer to 5% to 10% of one’s financial capital.

In certain cases, owning some employer stock is almost mandatory, especially when 401(k) matching contributions are provided in employer stock or the employer offers stock purchase discounts that are too good to pass up. In such scenarios, it is recommended to monitor the proportion of net worth invested in employer stock and sell shares when the allocation exceeds the acceptable limit.

Before selling shares, it is advisable to review the tax regulations governing the sale of company stock in retirement plans, which are referred to as net unrealized appreciation rules. You may be eligible for a substantial tax break based on the sales strategy adopted. It is often beneficial to seek advice from a tax professional to determine if you can benefit from the NUA rules.