Don’t Concentrate

John Yeigh

WHO DOESN’T LIKE free money? I know I do. If you’ve worked for a major U.S. corporation, you have probably also been offered free money. But there’s a potential downside—in the form of a large, undiversified investment bet.

What am I talking about? Let’s start with the matching employer contribution that’s offered in about half of 401(k) plans. You put in a portion of every paycheck and your company then matches all or half of your contribution. In years past, the employer match often had to be invested in company stock. Today, most plans either offer more flexibility in investment choice or they allow you to diversify out of company stock after a specified holding period.

But employees often don’t sell, because of the net unrealized appreciation (NUA) strategy, which provides a tax incentive to retain, rather than diversify, those shares. NUA allows accumulated appreciation on your employer’s stock to eventually be taxed as capital gains, rather than as income.

Employee stock purchase plans (ESPPs) are another benefit plan that encourages employees to own company stock, offering the chance to purchase shares at discounts of as much as 10% or 15%. ESPPs also provide favorable tax treatment on the discount, provided the stock is held for two years or longer. While smaller in dollar amount, some plans have an associated dividend reinvestment plan (DRIP) that allows dividends to be reinvested in company stock, again usually at some discount.

Matches, NUA, ESPPs and DRIPs all encourage employee stock ownership, but they pale in comparison to the potential accumulation through grants of stock options. Options come in two main forms , incentive stock options (ISOs) and nonqualifying stock options (NSOs), each of which has slightly different tax treatment. But both have the same result: employees owning yet more shares.

Add all these incentives together and even everyday employees can accumulate lots of stock—and senior executives can amass massive amounts. Throw in some decent share price increases over the decades, and you have many employees ending up with a significant portion of their wealth in their employer’s stock.

From a shareholder’s viewpoint, having employees exposed to stock performance is great. But from the employees’ viewpoint, concentrating wealth in their employer’s stock hugely increases their financial risk. After all, their employer also provides them with a paycheck.

Result: If the company gets into trouble, employees could lose both their livelihood and a big chunk of their savings. Experts typically recommend having no more than 5% to 10% of your wealth in your employer’s stock—with good reason. Think Enron, Kodak, Lehman Brothers and even GE.

Moreover, concentrated stock ownership can be detrimental even for employees of non-bankrupt companies. What if the share price flatlines for an extended period? Nearly a quarter of the 30 stocks in the Dow Jones Industrial Average have been largely flat over the last five years, even as the S&P 500 has gained roughly 50%. Employees of these solid Dow companies have incurred the opportunity cost of lost market gains—and that may more than offset the advantages of their various benefit plans.

Every friend I know who worked for a major corporation for many years has accumulated significant, if not excessive, company stock. A broker friend several years ago told me of an unnamed client who had accumulated thousands of his employer’s shares in his 401(k)—and those shares constituted more than 75% of his wealth.

The client asked the broker for a plan to reduce the excessive holdings. Knowing the client was reluctant to sell, the broker suggested unloading 2% of the stock each year. This meant it would have taken 50 years for the client to divest all his holdings, and he wouldn’t be done until after age 110. Even then, the client refused to sell any shares, because he fundamentally loved his company, didn’t want to lose future tax benefits and felt selling 2% each year was too aggressive.

At one point, my employer stock holdings peaked at perhaps 40% of my investment portfolio. The gains were great, but I knew I owned too much. I began to lighten up and diversify, even though the company was rock solid. Later, as retirement approached, I reduced my employer stock holdings more aggressively. While I still own plenty of the stock and enjoy the dividends, today my holdings are at a more comfortable level of around 10% of my portfolio.

John Yeigh is an engineer with an MBA in finance. He recently retired after 40 years in the oil industry, where he helped manage and negotiate the financial details for multi-billion-dollar international projects. John’s previous articles were No Free Ride, Other People’s Stuff and All Stocks.

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