by: Meulbroek, Lisa
Source: Harvard Business School
The high-profile collapse of Enron has focused attention on just how much employees stand to lose when they invest retirement savings in company stock. Despite the apparent risks, employee ownership of company stock in defined-contribution pension plans is widespread, and Benartzi and Thaler (2001) find that employees inadequately diversify their investments in such plans, even when free to do so. Viewed after the fact, Enron employees clearly incurred a substantial cost by failing to diversify. But their strategy was costly before the event as well. All employees who hold company stock incur a substantial cost simply by owning that stock, a cost that stems from the type or risk exposure generated by lack of diversification. Company stock holdings expose employees to firm-specific risk that might otherwise have been 'diversified away.' Despite their higher risk exposure, employee investors earn exactly the same return as do fully-diversified investors, an imbalance that makes holding company stock inefficient for all employees, irrespective of their risk tolerance. This paper investigates employees' investment allocations in their defined contribution pension plans, examining how much employees sacrifice by investing in company stock. The costs are large, averaging 42% of the company stock's market value under reasonable assumptions. Even employees who work for relatively safe 'blue chip' firms are significantly worse off by concentrating their wealth in company stock. Because the firm grants the stock to employees at the expense of issuing it to fully-diversified investors who place a higher value on it, the firm also shares in these costs. Theses findings call into question the wisdom of requiring or allowing company stock holding within retirement plans.
Link: Company Stock in Pension Plans: How Costly is it?
Publication Date: 2002-01-01