401(k) Specialist Issue 1 - 2015 - 25

INVESTMENT INSIGHT by David Blanchett & Nathan Voris
Company Stock and 401(k)s:
Don't Double Down
PETER LYNCH, THE FAMED INVESTOR and former portfolio manager of the Fidelity Magellan
Fund, has often said that investors should " invest in what you know. " Retirement plan
participants can therefore be excused for thinking the stock of their company might be a
wise investment. But it's not.
Although on the decline, company stocks in 401(k) plans are significant, especially
among larger plans. Some plan sponsors cram company stock into 401(k) plans to align the
incentives of the employees and the firm. The problem with this alignment is that it mixes
the employee's financial capital, which is their 401(k) plan balance, with their human capital,
which can be thought of as the present value of one's anticipated future earnings.
It is important to consider human capital when building portfolios because it is relatively
illiquid. For more on this, see the recent Morningstar Investment Management group's
research in the Financial Analysts Journal
( " No Portfolio is an Island " ), which suggests
investors should diversify sources of risk
across both financial capital and human
capital. This means, for example, employees
of an energy company may need to
underweight energy securities in their
portfolios. If they don't, they're doubling
down their bet on the energy sector and
multiplying the idiosyncratic risk related
to their employer; both their income and
retirement investments would hang on the
company's fortunes.
The obvious illustration is Enron, which
David Blanchett
collapsed in 2001, taking employees' jobs
and 401(k) plan assets with it. Most of the
Enron 401(k) was invested in company
stock. We might be tempted to think that
our company won't suffer the same fate as Enron. But before its demise, Enron had been
heralded by Fortune magazine for six straight years as " America's Most Innovative Company. "
It was well regarded within the industry and had significant ownership by institutional investors.
Few employees were aware of the accounting fraud taking place at the company, yet all
the employees were affected when the company filed for bankruptcy.
So it's important to take off your company " blinders " when thinking about the risks of
company stock. For example, picking some companies at random, do you think Apple would
offer Google or Target stock as a core option in its 401(k) plan? No way. For some reason
adding another company's stock seems absurd, yet it seems to be reasonable when it's your
employer. Again, it's not.
If your plan or clients' plans still own company stock in the 401(k), don't just advise participants
to dump it. There are tax advantages associated with net unrealized appreciation
(NUA) that you might be able to take advantage of. With an NUA strategy, a plan participant
can move company stock from a qualified plan to a taxable account, at which time ordinary
income tax is due on the basis of the shares. The difference between the cost basis and the
market value of the securities is what's known as net unrealized appreciation and is taxed
David M. Blanchett, CFA, CFP®, is the head of
retirement research at Morningstar Investment
Management and Nathan Voris is the Large Plan
Practice Leader in the Retirement Solutions Group
for Morningstar Inc.
INAUGURAL 2015 | 401kSpecialistmag.com 25
''With an NUA
strategy, a plan
participant can
move company
stock from a
qualified plan
to a taxable
account, at which
time ordinary
income tax is due
on the basis of
the shares.
''
at long-term capital gains rates when the
stock is sold, regardless of the holding
period. Any appreciation above the NUA is
taxed based on the holding period of the
investment. NUA benefits can be substantial
for participants who have accumulated
large company stock balances over a number
of years. Plan participants should be
advised to consult a tax professional about
their individual circumstances.
Investing in your company might also be
an emotional decision-you believe in the
company, its management, its strategy, so
you want to show your support by holding
company stock. But remember-plan participants
already have a major investment
in human capital tied to the successes and
failures of the company, so they're already
invested. Don't double down.

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401(k) Specialist Issue 1 - 2015

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