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Reducing Liability for Company Stock in 401(k) Plans

Offering company stock in a workplace 401(k) or similar defined contribution plan opens the door to significant risk of audit by the U.S. Department of Labor (DOL), which, since the collapse of Enron, has increase​d its scrutiny of plans heavily invested in company stock. In addition, the post-Enron retirement world has seen hundreds of participant lawsuits related to company stock, most of which pertain to situations where the company:

  • Artificially inflated its stock price because of a failure to disclose adverse information.

  • Misled participants through deceptive company communications.

  • Failed to appoint an independent fiduciary despite the company’s conflicted interests as stock issuer and plan sponsor.

Despite these risks, under the right circumstances employers and employees can benefit from the addition of company stock to the 401(k)’s investment portfolio. Workers receive equity shares in their company using pretax dollars (or at no cost when shares are granted as a matching or other employer contribution), and businesses benefit from the capital generated and the deductibility of employer stock contributions.

However, the only benefit that matters when deciding to offer company stock is providing a secure retirement for participants. To that end, the decision to offer company stock is governed by the Employee Retirement Income Security Act (ERISA), which requires that plan sponsors:

  • Have undivided loyalty to participants.  Essentially, the employer, as plan sponsor, must act solely in the interests of the plan and its participants, for the exclusive purpose of serving plan-related goals, and cannot consider the goals of the employer in the decision to offer company stock.

  • Act in a prudent manner. Businesses must exercise the care, skill, prudence and diligence of a knowledgeable fiduciary, considering all issues that would be thought significant when making the decision to offer company stock.

  • Ensure the plan is diversifiedERISA expressly states the duty of asset diversification within the plan’s investment options and the duty of prudence to the extent it would otherwise require diversification from company stock.

  • Following the terms of the plan’s documents. Companies must hew to the plan’s founding document, summary plan description, investment policy statement, trust documents and related materials.

Five Steps

In deciding whether to offer or retain company stock as a 401(k) plan investment, take the following five steps:

Step 1: Design the Plan to Reduce Liability

If you have decided to offer company stock, designing the plan with specific provisions can greatly reduce your liability.

First, express clearly in the plan documents what the objectives are in offering company stock, and make sure provisions pertaining to the stock are consistent across plan documents and participant communications.

In addition, consider how the company stock investment will be funded, whether by employee or employer contributions or both.

Many plans contain a provision mandating that employer contributions be made or invested in company stock, which can prevent participants from being able to immediately diversify. This can be significant if participants are being forced to invest in poorly performing stock.

These restrictions have been a source of litigation when businesses have declined to the point of insolvency and the plan’s rules required continued investment in company stock. To address these cases, in 2006 the Pension Protection Act (PPA) gave participants the right to immediately diversify their own contributions out of employer stock at any time. Moreover, after completing three years of service, participants have the right to diversify out of company stock provided as the employer’s matching or other contributions, and beneficiaries have the right to diversify out of company stock after the participant dies.

At a minimum, plan sponsors must ensure their plan complies with the PPA, but they should consider more liberal plan provisions that shorten (or remove altogether) the timing of a participant’s ability to move out of employer-contributed company stock and into other investments.

Finally, one of the best design strategies is to discourage participants from overinvesting in company stock. By imposing restrictions on the amount of company stock that can be held in a plan (for instance, 30 percent of a participant’s account), plan sponsors can reduce the risk of significant loss if the organization’s stock declines.

Step 2: Establish a Good Decision-Making Process

The decision to offer company stock is a major fiduciary risk. A plan sponsor’s fiduciary obligations require it to follow the terms of its plan. However, if the plan mandates the inclusion of company stock as an investment option, simply saying you were required to offer the stock will not get you off the hook. If the company stock was inappropriate for the plan because the stock was known to be at risk for a precipitous decline, you cannot hide under the plan documents.

On the other hand, if the terms of the plan specify a sound process and you adhere to that process, the burden of showing you acted prudently is greatly reduced. The plan sponsor, fiduciaries and participants should be very clear on how the decision to offer company stock occurs. The process begins with determining who is best able to make the decision and then putting the decision in writing via a committee charter, fiduciary acknowledgment and investment policy statement.

By following the process strictly, plan sponsors can minimize the chance that someone without proper authority will make a fiduciary decision to offer company stock, and, thereby, reduce their liability risk.

Step 3: Separate the Decision from the Company

Now that you have a process, you need to appoint the individual decision-makers. One of the biggest risk-mitigation steps is to divide fiduciary roles among different people. Much company-stock litigation involves conflicted fiduciaries who made decisions while being heavily influenced by the business’s interests.

One effective strategy is to appoint a totally independent fiduciary who will evaluate the company stock, monitor its continued performance and make recommendations to the plan’s trustee. The most significant drawback to this option is the plan sponsor loses control and influence over the decision, but this is also the greatest benefit. Independent fiduciaries generally operate under a presumption that the company stock should continue to be offered, and will only change that presumption if there is clear evidence that the organization’s financial condition is in doubt. The plan sponsor always retains liability for the selection and monitoring of the independent fiduciary.

Many plans find the cost of an independent fiduciary to be prohibitive. If an independent fiduciary is not an option, at a minimum, the plan sponsor should consider forming a dedicated committee of qualified company officials whose only fiduciary role is to evaluate the stock and provide a recommendation to the trustee.

Whatever approach is selected, the need is clear: to mitigate the plan sponsor’s liability. The more involved senior company officials are who have nonpublic (insider) financial knowledge, the greater the risk of corporate liability after a steep decline in the stock’s value. Thus, you should consider eliminating these individuals’ participation in the plan’s fiduciary structure or limiting their involvement in the decision to offer company stock.

Step 4: Monitoring Company Stock

If a plan sponsor chooses not to appoint an independent fiduciary, the investment committee will retain the decision-making authority, as it does over other investments, and it should use the same evaluation criteria.

A company stock’s performance may be more volatile than a normal investment benchmark because employer stock is a single security. Therefore, the investment review must determine if there is evidence indicating that the business should stop offering company stock. The investment committee would need to clearly document its consideration of all public information available to it at the time of the investment review and should pay particular attention to the following:

  • Sudden drops in stock price.

  • Announcements of adverse events affecting the company.

  • Recommendations of investment analysts.

  • Decisions made by independent institutional managers regarding the company stock.

  • Evidence of whether corporate insiders are buying or selling the stock.

Step 5: Review Participant Communications

Communications to participants must be carefully scrutinized to prevent any misrepresentations about company stock or the company’s financial outlook. Businesses that overstate the benefits of their stock and fail to advise participants of the risk of not diversifying out of company stock can find themselves in trouble.

Clearly communicate in the summary plan description or in a stand-alone communication the risks of investing in company stock. The communication should encourage participants to consult professional advisors regarding their allocations and the importance of diversification. Simply relying on the plan’s ERISA section 404(c) language is not enough; there should be dedicated plan provisions devoted to the company stock.

Nothing will completely insulate a plan sponsor from the fiduciary risks that company stock presents, aside from not offering such stock. There are, however, relatively simple and effective strategies that plan sponsors can take to reduce the risk. At the end of the day, none of these steps is effective if you do not carefully document the fiduciary decision-making process surrounding company stock and make sure to follow the terms of your plan.

Samuel Henson, senior ERISA counsel at Lockton Retirement Services.

Related External Article:

401(k) Plans Make Aggressive Moves to Limit Access to Company Stock, Pensions & Investments, March 2013

Related SHRM Articles:

Court Clarifies Rules on ERISA Trustees' Duties to Investigate and Diversify Investments, SHRM Online Legal Issues, December 2012

Stock Drop Claim (Against Employer's Stock in Retirement Plan) Dismissed, SHRM Online Legal Issues, October 2012

Proactive Steps Can Reduce Fiduciary Risk When Stock Markets Swoon, SHRM Online Benefits, August 2011

How Much Is Too Much Employer Stock in a Qualified Plan?, SHRM Online Benefits, November 2010


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