401(k) Employer Stock in 401(k) Plans

EMPLOYER STOCK IN 401(K) PLANS – A GENERAL OVERVIEW

Many 401(k) plans allow participants to direct the investment of their own accounts.  These plans are known as “participant directed plans” or “404(c) plans” and are subject to special rules and enjoy special protection from ERISA fiduciary liability (see “ERISA Section 404(c) Relief” for a general discussion on participant directed plans).  In these plans, participants choose from a menu of investment options that have been pre-selected by the plan sponsor.  In many cases, one of the options in which participants may invest all or a portion of their accounts is stock of the employer (“employer stock”) that sponsors the 401(k) plan.  Sometimes the plan sponsor makes a matching contribution, also in employer stock, although it may also be in cash.

401(k) plans that offer employer stock as an investment option are subject to special rules, and lead to unique considerations and concerns.  Although there are distinct advantages, such as allowing employees to partake in the success of their employer – and thus incentivize them to work hard – there are also distinct disadvantages. Plan sponsors wishing to offer employer stock should become very familiar with the rules and concerns, and carefully weigh the pros and cons of such an arrangement in their 401(k) plans.

The following is a very general discussion, omitting much detail.  Because of the risk of liability, Pan sponsors having, or wishing to add, employer stock to their menu of investment funds are strongly encouraged to consult with a qualified ERISA attorney.

WHAT IS EMPLOYER STOCK?

Generally stated, “employer stock” means:

• Publicly traded securities offered on a public exchange by the employer; or
• Privately held securities of an employer;

that are, in either case, available to 401(k) plan participants as a regular investment within the plan’s menu of investment funds.

ADVANTAGES TO OFFERING EMPLOYER STOCK

As one might expect, there are a number of reasons why a plan sponsor might wish to incorporate employer stock as an investment option in a 401(k) plan.  Some advantages include:

• Investment returns might exceed those available in other investment vehicles;
• The arrangement can represent an efficient, low-cost means for employees to invest in employer stock;

• Employees who are invested in employer stock may be incentivized to remain with the company longer, and to become more productive, so as to increase the success of the enterprise;
• The arrangement may help align the interests of both the employer and its employees by allowing employees to become company owners;
• The arrangement may add to the ability to fund the plan, without incurring an out-of-pocket cash expense or an accounting debit;

• Employees potentially may receive favorable tax treatment upon distribution of the stock, based on “net unrealized appreciation” (“NUA”); and
• Having a number of employees invested in the company might help reduce the risk of a hostile takeover.

DISADVANTAGES TO OFFERING EMPLOYER STOCK

On the other hand, offering employer stock as an investment option may not always be a good idea.  Some of the disadvantages of offering employer stock as a plan investment include potential liability – and resulting litigation — stemming from the following potential pitfalls:

• Investment in the employer stock fund may not be prudent from a fiduciary perspective, and participants could suffer losses;
• An employer stock fund can be riskier than a diversified stock mutual fund, because its performance depends upon the price of a single stock, which can fluctuate dramatically up or down — sometimes overnight.
• The value of the stock might decline during a “black-out period,” which often occurs during a plan changeover (such as a change in third-party administrators), and participants may be unable to sell at a critical point, thus suffering losses;
• Participants suffering losses may have grounds to allege that the plan sponsor knew, or should have known, that the value of the employer stock was about to decline; and
• Participants suffering losses may have grounds to allege that inadequate employee education, improper encouragement, or outright coercion resulted in over-allocation of their accounts to the employer stock fund. The results of such over-allocation may include subjecting the account balance to increased volatility, potential underperformance, or similar consequences.

DIVERSIFICATION AND FIDUCIARY DUTY CONCERNS

ERISA requires that 401(k) plan fiduciaries diversify the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.

Offering an employer stock fund poses a unique problem, in that it often represents a single security offered among a menu of mutual funds and similar co-mingled investment vehicles that are automatically diversified by their nature.  Therefore, the higher the percentage of a participant’s account that is invested in the employer stock fund, the less diversified his or her account becomes.

Although ERISA Section 404(c) generally shields fiduciaries offering employer stock in their plans from losses attributable participants decisions to invest in an employer stock, increasing numbers of cases filed in Federal courts allege fiduciary duty breaches, along with prohibited transactions.   (These are sometimes referred to as “stock drop” cases.)  Plaintiffs in these cases may claim that:

• Plan fiduciaries were imprudent when making the initial decision to include employer stock as an investment option; or
• Plan fiduciaries failed to regularly monitor whether maintaining the employer stock fund remained a prudent investment, as compared to the other investments offered under the plan.

Accordingly, it is crucial that plan sponsors, as fiduciaries, treat employer stock funds just as they do all other investment funds, in terms of monitoring and control.  If the employer stock fund is consistently underperforming as compared with similar funds, it may no longer constitute a prudent investment.

SPECIAL DIVERSIFICATION RIGHTS AND NOTICE REQUIREMENTS FOR PLANS OFFERING EMPLOYER STOCK

Under ERISA, defined contribution plans (including 401(k) plans) having publicly traded employer securities as an investment must periodically notify plan participants and certain other individuals of their diversification rights. Plan sponsors must provide each plan participant with a notice explaining his or her right to diversify employer stock fund investments by no less than thirty (30) days before the first day that the participant is eligible for this diversification right.  The IRS has provided a model notice to help plan sponsors fulfill this requirement, available here.

Additionally, final U.S. Department of Treasury Regulations provide that:

• Plans may not impose restrictions or conditions on the employer stock investments that are not imposed on the investment of other plan assets;
  • Examples of these restrictions are:
    • a restriction on a participant’s right to divest employer securities that is not imposed on the plan’s other investment options; and

• a benefit that is conditioned on an investment in employer securities.

• Plans may allow transfers into and out of a stable value or similar fund more frequently than other investment funds; and
• Plans may allow for transfers out of a “qualified default investment arrangement” (“QDIA”) more frequently than the employer stock fund.

However, the following are not considered to be prohibited restrictions or conditions:

• Plan-imposed limits on the amount of employer stock that may be held in a participant’s account (for example, no more than 20 percent);
• Closing the employer stock fund to new participants; and
• Restrictions required by Federal or state securities laws.

PLAN PROVISIONS/AMENDMENTS

In addition to the notice requirement, 401(k) plans having employer stock investment funds must include (or be amended to include) provisions that detail these diversification and notice requirements.