Following the Enron/World com/ AOL etc disasters I have heard people (presumably employees of these benighted businesses) saying that their 401 accounts have been destroyed and that they have therefore lost their life savings, retirement fund, pension etc.
THis is usually contrasted with the execs who conveniently sold off their own stock while it still had value.
I am confused by this. I am assuming that this account contains stock in the company they work for? If so hasn’t it struck these people that they have a lot of financial eggs in one basket if they’re employer goes belly-up?
Is there no back up provision (eg comapny pension fund, money purchase scheme etc)?
We don’t have this account in the UK. We have accounts in which shares can be held tax free, but these would never be one’s sole holdings.
Please shed some light.
Is this a common situation?
AFAIK The 401(k) is, in effect, a pension plan. The closest equivalent in the UK would be a personal pension scheme or a money-purchase employer-sponsored pension plan. For many people a 401(k) plan may be the only pension plan they have.
For some reason this has been widely regarded as acceptable in the US up to recently. In the UK, so far as I know, regulation does not forbid a defined contribution pension plan from investing in employer stock but for reasons which in the present circumstances are obvious they rarely do so, at any rate in excess of the employer’s stock market weighting.
I believe most corporate pension schemes in the UK are outsourced to independent providers, who offer various products that have historically been popular. It would be impractical, I would have thought, to set up a pension scheme with single-employer investment unless there was a wider demand for it at the provider.
The 401(k) account my employer uses (incidentally, we’re owned by the British company GUS) is managed by Fidelity investments. I think that many 401(k) plans use outside managers such as Fidelity.
They’re only important if you plan on retiring some day. Look at the Pope. He can’t retire because he doesn’t have a 401k. Better plan ahead or you might end like him.
Yeah, but the Pope (a) lives in a country that doesn’t have an income tax and (b) he is the monarch of that country. As a result, he’d have access to any taxes that he paid anyway…
One of the specific criticisms leveled at Enron was that their plan required that the 401k monies include some horrendously large percentage of Enron stock. They (along with a large number of other U.S. companies) had rules that prohibited people from switching their investment to a different stock for many months after the initial purchase.
I agree that people should have diversified every penny they could, but when the stock price was riding the rocket up, it would have been difficult to say “Oh, let me put this money in some stock that is not doing nearly as well.”
No, it would be quite straightforward. While all pension scheme trustees in the UK appointe external investment managers, they also adopt a “statement of investment principles” which the investment managers have to take account of. Smaller schemes will tend to adopt investment principles which involve investing through already-available mutual funds – this tends to keep down investment expenses in a small fund – but larger schemes tell the investment managers to go out and make specific investment decisions in light of the investment principles. Investing all or a stated fraction of the assets in employer stock is no more difficult or expensive than investing in mutual funds, and probably rather less difficult and expensive than actually making stock selection decisions, so the investment managers would be quite happy to implement a policy of investing in employer stock.
No, the truth is that UK money purchase pension schemes do not invest in employer stock because it is quite obviously a bad idea. The surprising fact is that US schemes do regularly invest in employer stock, and I assume that this happens because the investment decision is distorted by some tax relief designed to promote employee stock ownership, or because it is distorted by an employer-imposed objective of promoting employee stock ownership (and/or mantaining the stock price by creating extra demand for stock).
Thanks for the correction, UDS. I was working off an assumption that it costs time and money (if only in terms of regulatory burden) to set up a new scheme, but obviously not! Ta.
It does cost time and money to set up a new scheme, but you don’t significantly reduce that by adopting an “off-the-shelf” investment strategy for your scheme. The regulatory burden doesn’t really revolve around investment issues.
I’ve participated in 3 corporate 401(k) plans. None of them encouraged investment in the company’s own stock, if they even allowed it as a choice. I already have options (submerged at present), and an ESOP - why should I tie 401(k) money to my employer, too? It may happen less in the computer industry, which tends to grant options to non-management employees more than others.[sup]1[/sup].
All of them, however, only gave a choice of a half-dozen or so fund options. It’s my contention that locked in choices in 401(k) plans is what keeps a lot of underperforming mutual funds afloat. No matter how BAD the available investment vehicles are, the tax write off tends to make maxing out your contribution attractive (even though you would do better in the long run if you found better investments. People love to be able to reduce their taxes). If your employer matches 401(k) contributions, it’s hard to argue against it, at least up to the point that the employer matches.
[sup]1[/sup] - that will come home to roost big time if companies are forced to expense stock options. If that happens, you will hear a howl out of the Silicon Valley companies comparable to the one you hear when any suggestion of meddling with H1B visas is brought up.
I have participated in two 401K plans. The first one limited the amount you could put into company stock to 20%. I recall people being angry that they could not put in more. There was some whining about the government not allowing them to invest as they chose. I am not sure if it was a government regulation or a company regulation however based on the complaints by Enron employees that all there retirement money was tied up in Enron stock.
My current plan does not allow for investment in company stock in the 401K. We can, however, buy company stock at favorable prices up to 15% of our salary. This has some complicated tax ramifications. There are no restrictions on selling this stock. As there supposedly were with enron stock.
According to this site http://www.nceo.org/columns/cr101.html 19% of 401(k) plan assets are held in the stock of the sponsoring employer. However this is not evenly distributed; according to this site http://was.hewitt.com/hewitt/resource/newsroom/pressrel/2002/07-08-02.htm 29% of participants have 75% or more of their plan assets in employer stock (and 15% have all of their plan assets in employer stock). The larger an employer is, the more likely it is to offer, encourage or require investment in employer stock.
Allowing pension plans to invest in employer stock seems to be pointless; the same result couild be achieved much more cheaply by not prefunding the pension plan at all, and simply having a pension promise, to be paid by the employer when it fell due, dependent on the value of the employer’s stock at that time.
In the 1980s many pension plans turned out to be woefully underfunded, causing retirees to lose most of their counted-upon benefits.
Remember, the OP asked about 401(K) plans. These do NOT have a return guaranteed by the employer as traditional pension plans do. The employer’s maximum responsbility is whatever matching funds it chooses to put into the plan and paying for administration of the plan.
Something no one has addressed is the employer’s matching contribution. This is what makes 401(k) plans different from other retirement plans. At my office the company matches 50% of my contribution, up to 6% of my total salary. So, if I choose to contribute $100 from my paycheck monthly, my company will add $50 to my 401k monthly. Pretty cool, right?
A problem arises when companies match contributions in stock, instead of in cash. People end up with a bunch of stock they might not have wanted to begin with, instead of cash they can invest in much safer securities like mutual funds. Or, in another case, the company might provide certain incentives that seem to draw emplyees away from other options, toward taking stock (like, we’ll match cash 30% or stock 50%, something like that where it seems like you are getting “more” if you take the stock).
Thus they end up with a high percentage of company stock in their 401(k) account, which tanks into nothingness when the stock bottoms out. Very sad. But it is a problem with the way the employer has structured their program, not the 401(k) itself. As others have said, most 401(k) programs offer a variety of investment options other than company stock and are managed by an outside company like Fidelity or Merril-Lynch.
401K plans are not pensions. They are retirement savings accounts. The employee puts in most of the money. Employers put in some amount of money usually tied in some piecewise linear fashion to how much the employee puts in. When you leave a company to got work in another company most people move the money in their 401K account to a new 401K account or into and IRA account that they manage themselves.
Also Companies like to have employees invest in the stock. More people buying and holding the stock will bring the price up. A large amount of stock will be in the hands of people that are generally friendly to the company.
Just for the further edification of the non-US people:
We’ve alluded to it a couple times, but one of the real attractions of the 401K is the tax advantage - an amount up to a certain limit ($11K for 2002) contributed to your 401K is deducted from your earnings BEFORE taxes - it doesn’t show up in the “gross earnings” box on your W2 at the end of the year.
For people who don’t have a 401K plan, a tax deduction for contributions to a (non-Roth) IRA is allowed, up to $2K.
As Gazpacho noted, the SOP for these things is that you transfer your 401K from one employer to another, or into a “rollover IRA”. IRAs are typically just brokerage accounts that let you invest in what you want to, rather than the fixed set of choices in a company 401K.
Investment income in either of these vehicles is tax sheltered, and subject to penalty if withdrawn before retirement age.
Pensions - since the inception of the 401K, most US corporations have done away with pension plans. It is much more attractive to them to offer the 401K, even sweetening the deal by matching it, than to have to look forward to administering a pension plan for some guy who retired 20 years ago. This way, they get to send him on his way with his accumulated retirement money, and that’s it.
This is more or less right. A couple of minor points
You can usually get money out of your 401(k) in advance of retiring, although you sacrifice tax efficiency by doing so.
You can usually use your 401(k) as security for borrowing, which is an indirect way of getting money out of your 401(k).
You don’t have to buy an annuity (in the UK sense of an insurance policy which provides an annual payment of a known amount for life) although you can do so if you wish. So far as I know there’s nothing to stop you taking all the money out and spending it on champagne and oysters in the first six months of retirement, but I’m open to correction here. Even if you can do this, presumably not too many people do. As the 401(k) is (relatively) new it may be that not too many people have retired with one yet, so there may not be much data on the spending choices which people actually make.
From the point of view of an employee who regards the 401(k) as savings to fund retirement income, investing in the employer company’s stock is plainly Not a Good Idea. He would actually be better off if the employer simply made an unsecured promise of a lump sum payment on termination of service, since on an insolvency he would then have priority over stockholders. And he would save on management and custody fees in his 401(k). Be that as it may, there is obviously some advantage for the employer, which is why investment in employer stock is relatively common.
Don’t know about the rules of the Enron 401(k), but many plans would give participants employer stock initially, but either immediately or after a period participants would be free to diversify – sell the employer stock and buy other assets, all within the tax shelter of the 401(k). The employees who are most likely to do this are those who are rational, risk averse financially educated and have no little or no retirement savings other than the 401(k). Conversely the irrational, adventurous, uneducated and wealthy employee is least likely to diversify.
There is now a debate in the US as to whether investment in employer stock in a 401(k) should be limited, discouraged or banned outright. From the point of view of a rational investment strategy to fund retirement income, it should be limited severely or banned outright, but this may be too simplistic. Employers are not obliged to establish 401(k) plans, or any kind of retirement plan, and if restricting investment in employer stock were to make these plans less attractive from the employer point of view, the end result could be the closure of plans, and an overall decline in retirement savings and therefore in retirement income.
