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401(k) Plans With Employer Stock – A Vanishing Breed

401(k) Plans With Employer Stock – A Vanishing Breed

In my last blog article, I talked about how retirement plans had evolved from employer sponsored and employer run profit sharing plans into outsourced participant directed 401(k) plans. One of the big differences between the old profit sharing plans and today’s 401(k) plan that I did not get to mention in the last article is the use of employer stock in the retirement plan. Back in the 80’s and 90’s, it was common practice for companies to fund their contributions to retirement plans with company stock. Later in this article we will discuss a few of the financial reasons for doing this, but companies also did this for non-financial reasons. Many companies believed that making employees part-owners of the company gave them incentive to work harder to make the company succeed, and a greater feeling of satisfaction when it did. If the employer was a publicly traded company, then employer stock was often the largest investment in the profit sharing plan. It was often the primary funding source when the employer made their profit sharing contribution and was often used to fund the employer matching on both 401(k) contributions and employee after tax 401(m) contributions. In today’s 401(k) plan, employer stock is either nonexistent or is gradually being phased out. This article will address some of the benefits of using employer stock in a 401(k) plan, but more importantly, why employer stock is vanishing from today’s 401(k) plan.
Let’s first talk a little about the benefits of employer stock, as there are benefits to both the employer as well as to the participant. The US Tax code has a special tax benefit for any plan participant that takes an in-kind distribution of employer stock when they take a distribution from the plan. In-kind meaning that they take the actual shares rather than having them converted to cash and then taking the cash distribution. Let’s say a participant takes a distribution from their retirement plan and decides not to rollover the cash value of the employer stock, but instead takes the actual shares and pays the taxes on that part of the distribution. On a normal distribution of cash from a plan after age 59 ½, then there would be no early withdrawal penalty but you would owe ordinary income tax on the full amount of the distribution. By taking the actual employer shares instead, then the participant only has to pay taxes on the amount originally paid for the shares. The difference between what you paid for the shares in the plan and their market value at the time of the distribution is called Net Unrealized Appreciation or NUA. The NUA would be exempt from income taxes at the time of the distribution. The participant could then continue to hold the shares in their name or could sell them. When the shares are sold, the NUA portion that was not taxed earlier would be taxed at long term capital gains rates and any appreciation in the stock after the distribution would be taxed as long term or short term capital gain depending on how long the shares were held. In addition to the tax benefit, employer shares in a plan have very little carrying costs for the employee and it has been shown that employers are more generous with their contributions and are more likely to provide a match than those employers that do not provide for employer stock in their retirement plans.1
From an employer’s perspective, there are financial benefits from contributing employer stock to a qualified retirement plan. The most obvious being that profit sharing contributions or the matching contributions made by the employer do not require an outlay of cash. There is also a tax benefit on dividend payments if structured properly. Normally when a corporation pays dividends, it is not deductible by the corporation. However, if the employer stock is held in an Employee Stock Ownership Plan or ESOP plan, if the dividends are reinvested by the participant to acquire additional shares of employer stock, then the corporation can deduct the cost of the dividends paid on their corporate tax return.
So with benefits for both participant and employer, why is employer stock vanishing from today’s retirement plans? Can you spell Enron? Ever heard of the Pension Protection Act (PPA)?
I think you can go back to the downfall of Enron to see when employer stock in retirement plans really started to fall out of favor, and for good reasons. 57.73% of the Enron 401(k) plan assets were invested in Enron stock and in 2001, those shares dropped in value by 98.8%.2 That pretty much wiped out most of those employees retirement savings. Fast forward from 2001 to 2006 and you see the passing of the PPA (Enron is specifically called out in the Act). The PPA of 2006, among other things, required employers to allow employees to diversify their holdings away from company stock. Once an employee had three years of service, they could move employer funds from employer stock to other investment options within the plan. Prior to the PPA, many plans with employer stock prevented their employees from diversifying out of employer stock when the stock had been purchased as an employer match or profit sharing allocation. The PPA now allowed for more diversification in the plan, a fundamental concept in any financial investment plan.
Now let’s fast forward to June of 2014 and look at the Supreme Court decision in Fifth Third Bank vs. Dudenhoeffer. This ruling struck down the presumption of prudence, a legal principle which employers often used when defending the purchase of employer stock after being sued by participants when the employer stock suffered a significant drop in value.3 This is just one more reason for employers to question whether they want to fund their contributions to an employee retirement plan using company stock.
I don’t think many 401(k) recordkeepers will complain about the absence of employer stock in the plans they recordkeep. Most recordkeeping systems are designed for securities with end of day pricing, like mutual funds, rather than the intraday pricing of equities. This means the recordkeepers have to place these employer stock trades prior to market close, which requires sweeping participant directed transactions during the day and trading them before 4PM. Most mutual fund trades in retirement plans are traded after hours, usually in the early hours of the next morning after the recordkeeping systems have run their nightly cycle to extend their trades. Of course, the participant directed trades have to be received by the recordkeeper by the 4PM cutoff to get that day’s closing NAV price, they just don’t get traded till after hours. There are other issues too, with employer stock. Things like dealing with thinly traded stock, providing liquidity for redemptions and tracking and calculating the NUA on in-kind distributions we referenced earlier. My favorite though, ( for the real 401(k) nerds reading this) is the calculation of NUA when a participant makes an in-service withdrawal of employer stock that was purchased with after tax 401(m) money which includes both pre 87 and post 86 contributions.
In closing, employer stock in a 401(k) plan can provide significant benefits to both the employer and participant, but there are dangers and difficulties associated with it. If you must have employer stock in your plan, then I say apply the principle that applies to most of life, “moderation in everything”.

Burton Keller

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