Enron Corp.'s spectacular collapse might be proof that company stock can be a risky investment, but a recent paper makes the case that it is also an inefficient investment for even the most risk-tolerant defined contribution plan participant.
Plan sponsors also lose because the cost of paying employees in company stock is greater than the market value of the stock to the participant, according to the working paper by Lisa K. Meulbroek, associate professor of business administration at Harvard Business School, Boston.
Participants lose an average of 42% of their company stock investment by taking on risk that could have been diversified away. The number is even higher for Internet firms, she wrote.
Using assumptions consistent with those of the Black-Scholes option-pricing model, Ms. Meulbroek derived formulas for determining the value of company stock to employees who are not fully diversified and those who have only some of their money in company stock compared to the market values of the stocks.
Under Ms. Meulbroek's analysis, participants who have 50% of their total wealth in their defined contribution plan and 25% of their account balances in company stock would sacrifice 27% of the stock market value by owning company stock for 10 years. The number is smaller for employees working in the average New York Stock Exchange-listed firm, 16%, and higher for employees in Internet-based firms, 48%.
Employees who have 50% of their defined contribution plan assets in company stock, meaning 25% of their total wealth in employer securities, would lose on average 42% of the stock's value if they hold it for 10 years. If the same employees own the company stock for 15 years, 52% of the stock's market value will be sacrificed, she said.
At the extreme, if 100% of an employee's defined contribution assets are in company stock, 80% will be lost over 15 years and 68% in 10 years.
On average, 401(k) plan participants invest 19% of their account balances in company stock, according to the Employee Benefit Research Institute/Investment Company Institute 2000 data base. Participants in plans that have a company stock match invest a higher percentage of their self-directed balances in company stock, 33%, than participants in plans with cash matches, 22%, the data show.
"Employees bear more risk but receive exactly the same return as fully diversified investors," Ms. Meulbroek said.
Twice the risk
At worst, defined contribution plan participants employed by an NYSE-listed firm would bear twice as much risk on average with portfolios made up of only company stock as they would with diversified all-equity portfolios; participants employed by Internet-based firms would assume five times the risk, the paper finds.
"In effect, their investments in company stock become lottery tickets. The cost of lottery tickets far exceeds their expected payouts; they are not `actuarially fair' bets, and their purchase would never be considered sound financial practice," Ms. Meulbroek wrote.
Significant losses occur even at levels of company stock ownership that fall within the newly proposed legislative limits, she said.
Under the bill that passed the House of Representatives last week, sponsors would have to allow plan participants to diversify out of company stock in three years. None of the bills now before Congress places limits on how much participants can invest in company stock. Should the three-year holding requirement become law, it would cost the typical participant 10% of stock market value if they only held company stock for three years under Ms. Meulbroek's formulas. Employees working at Internet-based firms would lose 19%.
Meanwhile, plan sponsors lose too, she wrote. To grant an employee stock worth $42,000, a company must hand over stock with a market value of $100,000, the paper contends.
"In effect, the firm compensates employees in a currency worth less to them than its cost to the firm," Ms. Meulbroek wrote. "Both employees and firm would be better off with cash compensation."
At the same time, sponsors sell stock to employees at the expense of issuing it publicly to diversified investors, who value it more highly, she points out. As a matter of fact, some 40% of sponsors that contribute shares to 401(k) plans purchase those shares on the open market, she said, citing a 2001 paper by Shlomo Benartzi, assistant professor of accounting at University of California's Anderson School.
"The firm's cost of granting company stock is its market value, but its value to employees is much less than that," she writes.
Not necessarily the case
One of the reasons employers frequently cite for providing employees with company stock is that broad-based employee ownership translates into greater shareholder value. However, this isn't necessarily the case, because most employees have little personal influence on stock price, she said. Even if stock ownership helps to align top managers' incentives with those of shareholders, stock ownership by mid- or low-level employees may not have the same effect, Ms. Meulbroek contends.
However, whether companies receive shareholder value in exchange for broad-based holding of company stock by employee is a matter of some dispute.
While she agrees that under investment theory employees who invest in any one stock are not rewarded for the risk, there are human resources and fiscal advantages of offering employer stock, said Robyn Credico, defined contribution practice leader for Watson Wyatt Worldwide, Bethesda, Md.
For two years running, Watson Wyatt's human capital index study indicated there is a positive correlation between broad-based stock ownership by employees and shareholder value, Ms. Credico said.
"I would say that it is risky and it's unrewarded risk," Ms. Credico said. However, companies cannot always afford to pay company contributions in cash and may make a larger company match if they make it in stock, she explained. If a participant had to choose between a smaller cash match and a larger company stock contribution that allows quick diversification, the employee would be better to get the company stock match, Ms. Credico said.