Naïve Investing – Company Stock

PADM 5111 – Microeconomics for Policy Analysis

Presented by Amanda Wright & Glenn Horne

Friday, April 21, 2023

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Agenda

BackgroundSurveyEmployee AttitudesEmployer AttitudesDouble NudgeConclusion

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Background Employee Retirement Income Security Act 1974 (ERISA)

puts forth three fiduciary principles for retirement plan investments:

– Exclusive benefit rule requires that plans be managed for the benefit of participants

– Prudence rule requires that plan assets be invested according to a ‘prudent investor’ standard

– Diversification rule requires that plans be diversified so to minimize the risk of large losses

Company stock is exempt from the diversification requirement

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Post Enron U.S. Congress has considered a range of legal reforms that

would protect employees against the risks associated with investments in their employer’s security (company stock)

The most cautious proposal would require an annual disclosure about company stock risks to participants and would limit an employer’s ability to restrict a participants right to diversify company stock

More ambitious initiatives would require mandatory diversification above some limit or disallow employee contributions in stock when employers already match

Legislation has not been passed because of questions regarding its necessity

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The Study: Reality and Perceptions Survey 501 employee respondents at 100 different

companies Goal to obtain a better understanding of how employees

think about the costs and benefits of owning company stock

The employer survey was 150 firms that offer company stock in their retirement savings plans

Goal was to obtain better understanding of employers perspectives on the costs and benefits of requiring employees to own company stock

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Employees and Company Stock 11 million participants is U.S. define-contribution plans

have more than 20% of their account balance invested in company stock.

Within this group 5 million have more than 60% concentrated in their employer’s stock.

According to estimates $1 in company stock is worth less than half the value of $1 in a mutual fund.

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Employer Company Stock %

Procter and Gamble Co. 90

Abbott Laboratories 78

Pfizer Inc. 75

General Electric Co. 68

Southern Co. 65

Marsh & McLennan 64

Target Corp. 60

Chevron Texaco Corp. 60

Meadwestvaco Corp. 59

Textron Inc. 55

Kimberly-Clark Corp. 55

Bank of America 54

Merrill Lynch & Co. 52

Johnson & Johnson 50

Merck & Co. 50

Allocation of Retirement Plan Assets to Company Stock

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Benefits to EmployeeAdvantageous Tax Treatment: Investment in company stock does have tax advantages that

are not available for other investment funds in 401(k) plans Only 1/10 respondents aware of the preferential tax treatment 12% think that company stock is taxed at higher rates Most respondents either didn’t know (35%) or think that

company stock has the same tax treatment as other investments (44%)

Those who know company stock has preferential tax treatment allocate 20.9% of monthly contributions to company stock

Those who thought has tax disadvantage allocate 28.3%

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Private Information: Employees might more know about their employer than of

outside investors Unconvincing because employees at a large company

unlikely to know about all the different products and divisions

Large extent of company stock allocation based on public information

Nonmonetary Benefits: Feeling as part of the team? 32% confirm they feel better for owning company stock However 59% said does not affect them Overall no evidence that employees value the benefits of

owning company stock

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Costs to the Employee

Idiosyncratic Risk: Investing in single stock very costly People can loose job and retirement funds all at once (Enron) People do not understand the risk-and-return profile of company

stock Only 16% of employees understand their employer’s stock is

riskier than the overall stock market Vanguard survey data indicates that average participant views

company stock as safer than a diversified stock fund

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Even after educating people about the Enron bankruptcy case, 25% of respondents said they believe their company stock is safer than diversified fund and another 39% said they believe it has the same level of risk

Participants base their risk perceptions on past returns and not on the volatility of returns

Nonmonetary Costs: Not owning company stock may provoke employees to

feel they have betrayed their employer However no evidence that loyalty correlates with

decisions to invest in company stock

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Summary: The Employee

Majority of employees do not place much weight on the alleged benefits of owning company stock

Most employees do not appreciate the risk of investing in a single stock

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Benefits to Employer

Increased motivation & productivityAdvantageous tax treatmentAdvantageous treatment under fiduciary law “Friendly Hands”Cash flow

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Cost to Employers

Costs as managers of the retirement portfolio:– Lack of diversification

However, they also indicated if given the opportunity to change the makeup of the portfolio they would not.

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Employers Summary

Benefits are limited at best.Employers do not appear to have a good

perception of the true costs and benefits of having high rates of employee investment in company stock.

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Double Nudge

Employers are given a nudge via Employee Retirement Income Security Act 1974

Employers nudge employees based on overestimation of true benefits.

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Conclusion

You have to get at the root of the nudge.Eliminate the company stock exemption

from the diversification requirement.