Thousands of employees across the country have discovered that too much employer stock can give their 401(k) retirement plan a case of indigestion.
They are violating one of the fundamental rules of investing: diversification of assets.
A recent survey of 401(k) plan providers by benefit consultants Hewitt Associates identifies the potential problem.
In 401(k) plans where employer stock is an investment option, 41 percent of the average account is allocated to employer stock. The rest is mostly in equity mutual funds.
Forty-one percent is a large allocation to a single investment. But that's just the average, according to the study.
No doubt many employees have invested more than 41 percent. Senior managers sometimes hold most of their net worth in employer stock, usually for sound reasons.
However, I have seen examples of nonmanagement employees investing most of their 401(k) assets in employer stock.
This is the golden age of business profits, and many employees have benefited from overly concentrating in employer stock. But as many employees have found out since mid-1999, such concentration can work against you as well.
Because of rising interest rates, competition, mergers and other factors, the shares of most stocks are down over the past 12 months. Here are two examples:
An employee of a Fortune 500 industrial company invested 85 percent of his company retirement plan in employer stock. The stock peaked at $60 a share in January and declined to $33.
A savings bank holding company was acquired by a regional commercial bank, and employees received the new employer stock in their retirement plans. The stock peaked at $64, and they watched in frustration as it experienced a two-year decline to $28.
Who knows how long it will take for the stocks of these two companies to recover some of their former glory?
In both examples, employees experienced a frustrating decline in 401(k) value. For employees considering retirement, such a decline can necessitate a dramatic change in plans.
Clearly there are risks to concentrating, so why do employees frequently embrace a faulty investment strategy when it comes to employer stock in retirement plans? There could be several reasons:
Retirement seems far away. Younger employees may have such a longtime horizon that they don't get overly concerned about the bumpy ride that employer stock can experience.
Employees expect past performance to persist. Nothing seduces an investor like a sharply rising stock price. Employees may become unrealistic about the future after they have experienced a run-up in the price of employer stock.
Blind faith in the company. Because they work there, employees may feel they have a good understanding of the company's prospects by virtue of their contact with management. Employees may assume that they know the company better than other companies they might invest in.
The correct portion of employer stock to hold in a retirement plan can be different depending on your personal situation.
Many financial planners recommend 10 percent to 15 percent as the maximum range. The correct number for you depends on such things as how much of your total investments the retirement plan represents, at what level you are employed in the company, whether you have other investments in employer stock like stock options and your level of investing sophistication.
Consider employer stock for its long-term investment potential just as you would any other investment.
If your 401(k) plan is your largest investment outside equity in your home, 40 percent is probably too much concentration in employer stock. Ask yourself, "What allocation would let me sleep comfortably at night if I knew that my employer stock would soon experience a decline in value of 40 percent and stay there for two years?"
Take a close look at your last 401(k) statement and spend a few minutes to determine whether your current allocation is right for you. Only you can determine your correct allocation. Spending a little time considering your asset allocation now can save you a headache later.