Company Stock Continues to Present Client Challenges

Retaining the stock may be best despite litigation risk—and advisers can show the plan sponsor how to do company stock in DC plans the right way.

Why, plan sponsors wonder, should they continue to offer company stock as a defined contribution plan investment option when the result could be a “stock drop” lawsuit?

If a company was already considering cutting its own stock from the retirement plan investment menu before the conclusion of Fifth Third Bancorp v. Dudenhoeffer, last year’s Supreme Court decision has probably given it an extra push. The high court’s decision effectively stated fiduciaries of employee stock ownership plans are not entitled to any special presumption of prudence under the Employee Retirement Income Security Act (ERISA), potentially opening the door to expanded litigation.

“I said this before the Supreme Court decision in Dudenhoeffer, and it remains true, even more so. The only [completely sure] way not to get sued is to not have the investment option available to employees at all,” says Jeremy Blumenfeld, an attorney with Morgan, Lewis & Bockius LLP.

Still, Blumenfeld, who specializes in ERISA issues, does not advocate liquidating company stock willy-nilly. The company and its fiduciaries should keep the risk in mind but also evaluate the individual circumstances and decide what makes the most sense for the plan and participants, he says. Often company stock will make sense, despite the risks.

“We think a lot of plans have questions about company stock,” concurs Mark Teborek, senior consulting analyst with Russell Investments and author of white paper, Revisiting Company Stock in Defined Contribution Plans. “That’s nothing new, but with the aftermath of the Fifth Third case, there was renewed interest in what to do next.”

The adviser can answer many of these questions and, as with all financial decisionmaking for the plan, guide the sponsor through the process and help it determine the steps that best achieve its goals.

NEXT: Consider limiting employer stock allocations

When advising a client, first clarifying why a plan might be sued over company stock may help.

Plan sponsors may be surprised to learn that malfeasance need not be involved, Blumenfeld says. A company may be “doing well fundamentally and growing and … the fiduciaries doing everything they’re supposed to be doing. But you have one bad quarter, or the company loses a big contract, or there’s some underperformance relative to expectations—that company’s stock price could go down significantly,” he says.

The tipping point in litigation risk is “the aggregate percentage of the plan monies that are invested in employer stock,” Blumenfeld says. That number can range from under 10% to over 50% when looking at examples of actual plans that still offer employer stock. “The higher the concentration, the bigger the dollars invested in employer stock investments, the more likely a target a particular plan sponsor might be for litigation,” he says. Say, if $100 million is invested in company stock and the value falls 10%, that’s $10 million the plan has lost, he says. He has seen plans sued in as little as a month after a drop like this.

“The legal issues are often the same, whether the dollar amount invested for a plan is $1,000 or $100 million,” he says. “But … you’re not likely to see litigation with very small allocations to employer stock investments.”

Therefore, keeping plan participants’ allocations reasonable and appropriate is one key to avoiding company stock-related litigation. According to Lew Minsky, executive director with the Defined Contribution Investment Institute Association (DCIIA), participants are typically unschooled in how to diversify; as a result, they tend to over-allocate in any single security, especially company stock that is easily recognizable.

Experts recommend educating participants about the value of diversifying—a process that’s become easier and cheaper thanks to current technology—and greater use of automatic asset-allocation solutions. To overcome participant inertia, though, more proactive steps may be needed.

NEXT: Hard employer stock caps

Historically, a common approach has been to cap the percentage of assets participants may hold in company stock. Here, as with other important financial decisions, the adviser should guide the plan sponsor, taking into account variables such as the type, size and stability of the company, including any anticipated corporate changes over the next several years. Demographics of the work force are also important.  

One challenge the adviser commonly faces in evaluating company stock performance comes from the fact that it will likely not have a clear benchmark against which performance can be compared, in the way of a mutual fund. “What do you evaluate that performance against?” Minksy asks. “As an outsider adviser who doesn’t know the company as well as the insider fiduciaries, you can look at the investments, but does it make sense to benchmark them against the S&P 500? Against an industry-specific index, perhaps? And over what time period should one look at the company stock?”

Advisers also should have an appreciation for the fact the fiduciaries really do rely on their advice regarding these issues and that that advice can play a role in litigation. While there is no one right or wrong answer in these discussions, the advisers should use sound judgment and be able to explain the reasons for their decisions, Blumenfeld says.

Whatever the percentage arrived at for capping company stock, some plan sponsors might fear it could look like asset allocation advice. Blumenfeld sees no cause for concern here, though. “Fiduciaries are not suggesting that, by placing a limit of 25%, everybody should hold 25%.”

Where a cap can get complicated is when the stock value grows and other investments see losses, leaving participants with holdings that now exceed the maximum. Plan sponsors typically address this by prohibiting new investment in the stocks or limiting the percentage, while letting the participants keep what they have, he says.

Potentially another complication, says Teborek, is that a cap “may send a mixed message to participants about whether the company believes company stock is a suitable investment.” 

NEXT: A highly effective tool 

Automatic features, such as enrollment and re-enrollment into target-date funds or managed accounts, can be highly effective for reducing employer stock overload in the plan, experts say. Other plan design elements can be brought to bear as well. For example, much of the employer stock currently in retirement plans has arrived there through company match contributions. 

Employers that want to continue this practice and reduce allocations might consider shortening the vesting period for company stock, says Holly Verdeyen, director, defined contribution investments at Russell. This way, “participants have more opportunity, sooner, to be able to diversify their portfolios.” As three years is the maximum vesting period for company stock, she recommends reducing it to as little as one, so people can act before they forget the investment, exchanging it, say, for a diversified fund.

Minsky sees use of these tools as aiding the adviser along with his clients. “Being on the leading edge of this and helping clients understand ways to improve participants’ outcomes through plan design, advisers have a real opportunity to set themselves apart and differentiate on something other than a race to the bottom on cost,” he says.

For plan sponsors that decide to eliminate the plan’s holdings entirely, it should be planned out carefully. Even plan sponsors not deciding to liquidate might prepare for the possible need to do so down the road, Teborek says. He recommends discussing with the investment committee possible scenarios under which the plan would need to take action, then putting a strategy on paper.

Blumenfeld, on the other hand, advises making any such decisions at the time, based on the circumstances then. Even if a plan is sued, he says, liquidation may be unwarranted. “The fact that somebody files a lawsuit against the plan fiduciaries is not a reason for them to change their behavior or change the investment options in a plan. If they continue to believe those are good investment options they should continue to offer them,” he says. “If they don’t, an investment shouldn’t be an option—even if there’s no litigation.”