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Questions and Answers About Enron, 401(k)s, and ESOPs

By Corey Rosen, NCEO Executive Director (links to related articles are at the bottom)

January 2002

Just how common is employer stock in 401(k) plans?

The best data come from the Employee Benefit Research Institute/Investment Company Institute 2000 study. This comprehensive research study found the following:

Overall, about 19% of 401(k) assets are in company stock.
Smaller companies, almost all of which are closely held, rarely have company stock in their plans. Only 1 in 1,000 companies with under 100 employees does, 1 in 100 with 100-500 employees, and 4 in 100 in companies with 501 to 1,000 employees. But 8.7% of companies with 1,000 to 5,000 employees do and 25.6% of companies with over 5,000 employee do.
Where company stock is offered as either an employer match and/or an employee investment option, 32% of plan assets are in company stock.
Where employer stock is offered as a match, 33% of employee directed deferrals are in company stock. But where company stock is not the match (but is available as an investment), just 22% of employee deferrals are in company stock. This may suggest that employees see the match as a sign from the company that the stock is a good investment choice.

What effect would limiting employer matches in stock have on 401(k) plans?

Clearly, employees would be more diversified, and that would be desirable. On the other hand, if employers get a lower tax deduction for matching in the form of their stock, or are limited in how much they can put in through overall percentage caps, they might contribute a lower match. Not only would employees get a smaller match (or perhaps no match at all), but some employees would save less because there was less of a matching incentive. Unfortunately, there are no data one way or another on this issue. Company trade associations certainly argue that the Boxer-Corzine approach, or similar bills, would hurt employees, but at this point, we just don't know. It does, however, raise concern about investigating this issue carefully before acting, rather than just responding impulsively to the Enron case.

If employers had to offer employees the right to diversify 401(k) matches made in company stock earlier than they presently have to, would companies make smaller matches?

This is also a critical question because if the answer is yes, legislation that appears to protect employee interests could harm them. Again, however, at this point, we just don't know. Earlier diversification would certainly be much less of an issue, however, than overall percentage caps or reduced tax deductions for employer stock matches.

Do companies that have ESOPs or 401(k) plans heavily invested in company stock have other retirement plans?

According to testimony by Doug Kruse of Rutgers University before the House Subcommittee on Employer-Employee Relations of the Committee on Education and the Workforce (2/12/02), "about 70-75% of participants in plans that are heavily invested in employer stock [ESOPs, 401(k) plans, and profit sharing plans] are in companies that also maintain diversified pension [or other retirement] plans, indicating that such plans tend to supplement rather than substitute for diversified plans. Among participants in large ESOPs (over 100 employees), 66.2% are in companies also sponsoring defined benefit plans, 34.7% are in companies also sponsoring diversified defined contribution plans, and 75% are in companies that sponsor either of these diversified plans. The numbers are similar for non-ESOP plans that invest more than 10% of assets in employer stock, with 70% of participants in companies also sponsoring either type of diversified plan. While exactly comparable numbers for the full workforce are not comparable, employer survey data from the Bureau of Labor Statistics shows that 32% of all private-sector employees, and 50% of employees in medium and large establishments, participate in defined benefit pension plans. Therefore, it appears that participants in ESOPs and other plans heavily invested in employer stock are more likely than other employees to also be covered by defined benefit pension plans."

In private company ESOPs, how common are other retirement plans?

A comprehensive study of all private company ESOPs by Douglas Kruse and Joseph Blasi of Rutgers, completed in 2001, shows that ESOP companies are much more likely to gave other retirement plans than matched comparable non-ESOP companies. The table below shows the percentages of companies having different kids of plans.

Percentage of Companies Having Other Retirement Plans
	ESOP	Non-ESOP
Defined benefit	20.1%	4.9%
401(k)	33.3%	6.2%
Non-401(k) profit sharing	35.7%	8.0%
Other defined contribution	14.7%	2.3%

We do not have data on the 5% of ESOPs in public companies.

Looked at from the employee perspective, a major study by researchers affiliated with the state of Washington in 1998 found that the average value (per participant) of all retirement benefits in ESOP companies (in 1995) was approximately $32,000, whereas the average value in the comparison companies was about $12,500. The diversified portion of ESOP accounts was about the same as the total account value for the non-ESOP employees. Moreover, looked at dynamically to project future balances, the study shows ESOP participants will accumulate three times the total assets, on average.

Don't ESOPs usually require employees to give up wages to participate?

It's actually rare for employees to give up wages to be in an ESOP -- less than 1% of all plans. In fact, a major 1998 study by researchers affiliated with Washington State found that ESOP companies pay both higher average as well as higher median wages. The average ESOP company wage of $19.09 is 12% higher than the average control company wage of $17, and the median ESOP company wage of $14.72 is 8% higher than the median control company wage of $13.58. At the 10th percentile, wages in the ESOP companies are 4% higher than in the controls.

Would requiring earlier diversification in ESOPs cause companies not to set up plans?

This is another question that is very hard to answer. Existing ESOP law requires that an employee with 10 years in the plan, and who has reached age 55, can diversify up to 25% of the company stock in his or her account (most mature ESOPs are already somewhat diversified, so this would add to that). At age 60, the percentage goes to 50%. The Boxer-Corzine bill would reduce the start of this process to five years and age 35. The effect would be that closely held ESOPs companies would have to start buying back their shares sooner than they do now. Companies whose stock value is growing faster than their cost of funds actually would benefit from buying back shares sooner. In any event, many employees would not diversify. Companies whose financial situation is shakier -- the very ones where diversification is more needed -- would find this problematic, however.

The question is whether companies thinking about ESOPs would worry that this early repurchase obligation might impose a cash strain at just the time when they most needed cash in the future, such as when their business cycle turns down. Fearing that, they might not set up a plan at all. That would be unfortunate from a retirement plan standpoint, because if these companies do not set up an ESOP, they will probably sell to another company. The data show these other companies will be less likely to have any retirement plan at all, or, if they, do, it will provide lower levels of benefits.

Do existing laws provide protection for employees if their employer stock assets are lost?

Existing laws provide some protection, but it may be of limited value. Fiduciaries of all ERISA plans (such as ESOPs and 401(k) plans) must operate the plan for the "exclusive benefit of plan participants" (as the statute puts it). In ESOPs, the presumption is that assets will be invested in company stock unless the fiduciaries know or should know that it is a bad time to invest in company stock or the price is too high. In 401(k) plans, fiduciaries can allow the employer to match in company stock without limitation, subject to the same proviso. In both plans, if fiduciaries know or should know that the company stock value will face a long-term decline, they should sell the stock.

The difficulty is that suing under these circumstances is costly, time-consuming, and hard to prove if there is no "smoking gun." In the Enron case, there appears reason to believe there could be; in a case such as Lucent, it would be much more difficult. Fiduciaries may genuinely believe, along with analysts, that the stock will do well in the long term. If the case can be proven, but the company is in bankruptcy court, the court may decide to give preference to other creditors. It is not a hopeless case; lawsuits have succeeded, and the fear of lawsuits has doubtlessly kept other people's feet to the fire, but this protection is obviously of somewhat limited value.

How common are ESOP bankruptcies or other meltdowns?

1995 study for the Department of Labor indicated that over a 10-year period, only .8% of the ESOPs filed for bankruptcy. That does not mean that other companies did not lose most of their value before being sold. However, Blasi and Kruse at Rutgers found that private company ESOPs were much more likely to stay in business than comparable non-ESOP companies (meaning they did not go bankrupt or, much more likely, be sold). Over roughly a 10-year period (starting points vary by each company in the sample), ESOP companies were about 15% more likely to be in business as independent companies than comparable non-ESOP companies. Earlier data by Blasi and Kruse, along with Margaret Blair from the Brookings Institution, found a similar pattern in public companies.

Does the NCEO have a position on employer stock in retirement plans?

Since we were started in 1981, we have urged companies and employees to think of employee ownership plans as investments that can be part of retirement, but not as retirement plans in themselves. Employees need to have a base plan of safe investments that can provide them at least minimally acceptable security in case the employee ownership plan does not work out. Companies owe it to their employees to help make this possible. We are not, however, a lobbying organization and do not take positions on legislative issues.