Tuesday, February 08, 2005

Company Stock Anomaly

There a number of anomalies within the world of pension and retirement investing. One in particular flys in the face of the most fundamental standards of prudence and diversification.

Company Stock in Pension Plans
The congressional debates leading to ERISA were initiated after an Enron-like corporate collapse where hundreds of workers lost not only their jobs but also their pensions. The company was the Studebaker Corporation of South Bend, Indiana, a leading U.S. automaker. When the company went bankrupt the underfunded pension plan collapsed, leaving Studebaker retirees and employees without their jobs or their pensions. Congress crafted ERISA in 1974 to include funding and diversification principles that were designed to avoid future calamities like Studebaker. Congress put a mandatory cap on the level of company securities that would be allowed ( i.e. prudent) within a defined benefit pension plan. That limit was 10% of plan assets.
Anecdotally, we don't see many DB plans with sponsor's stock. The P&I annual survey indicated that only 1.5% of the top 1000 DB plans was allocated to company stock. While this minimal allocation may be because of fiduciary issue it is also very likely due to the fact that single stock exposures are naturally inefficient and expose plans or investors to uncompensated risk!

As Defined Contribution plans were rapidly growing, their Studebaker equivalent occurred, focusing attention again on participant protection. ColorTile, a large DC plan with 90% of it's assets in employer assets went bankrupt, leaving workers without jobs and devalued retirement accounts. The DOL assigned a Working Group on Employer Assets in Retirement Plans to study and make recommendations regarding this diversification issue within the DC realm. The group recommended limitations on certain employer assets though ERISA's duty to diversify does not to this day apply to all pension Plans. Congress allowed exceptions under ERISA for certain types of DC Pension Plans.

It is difficult to overstate the significance of diversification in investment theory. There have been a number of Nobel prizes related to the premise that there are large and virtually costless gains available by broad diversification... yet large single stock exposures continue to be allowed in certain retirement plans. Beyond incurring an estimated 70% additional risk for a non -diversified portfolio, participants also increase the large undiversifiable risk associated with their

The defenses for not limiting employer stock includes; the benefits of alignment of interests, "anything is better than nothing" and employees can act to diversify in their own self-interest. Despite these arguments, allowing undiversified portfolios under ERISA is bad policy and leads to bad investment practice.


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