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...unravel as its accounting improprieties came to light. Enron stock plummeted over the next several weeks, and on December 2, 2001, the company declared bankruptcy, rendering its shares worthless. Thousands of Enron employees lost their jobs and a large fraction of their retirement wealth simultaneously.
We thank Hewitt Associates for their help in providing the data. We are particularly grateful to Lori Lucas and Yah Xu, two of our many contacts at Hewitt, for their help with the data and their useful feedback on this project. We appreciate the research assistance of Ananya Chakravarti, Keith Ericson, Jean Lee, Hongyi Li, Shih En Lu, Dina Mishra, and Chris Nosko. We are also grateful for comments from Christopher Carroll, William Gale, Nellie Liang, and other participants on the Brookings Panel as well as at seminars at the American Economics Association, the National Bureau of Economic Research, the University of Chicago, the University of Michigan, and Harvard University. James Choi acknowledges financial support from the Mustard Seed Foundation. All three authors acknowledge individual and collective financial support from the National Institute on Aging (grants R01-AG-021650, P30-AG012810, and T32-AG00186). David Laibson also acknowledges financial support from the Sloan Foundation. The opinions and conclusions expressed are solely those of the authors and do not necessarily represent the opinions or policy of the National Institute on Aging, any other agency of the federal government, Hewitt Associates, or the National Bureau of Economic Research.
Although the Enron 401(k) debacle was highly publicized, Enron was neither the first nor the last company whose collapse decimated its workers' 401(k) accounts. Over the past few years a similar fate has befallen employees of WorldCom, Global Crossing, Polaroid, Kmart, Lucent, and Providian, among others. In response, many bills have been proposed in Congress that would regulate employer stock holdings within 401(k) plans. Compared with existing law on defined-benefit pension plans, which strictly prohibits plans from holding more than 10 percent of their assets in employer securities, most of the bills proposed for regulating defined-contribution plans appear mild. Common themes in these proposals are empowerment and education rather than prohibition: give employees the right to sell the employer stock in their 401(k), and inform them about the risks of not doing so.
For example, one of only two bills that have so far come up for a vote in either house of Congress, the Pension Security Act (see table A-1 in the appendix), has two key provisions relating to employer stock. First, it would prohibit employers from requiring employees to invest their own 401(k) contributions in employer stock. Second, it would require that employers allow plan participants to diversify any matching funds contributed by the employer three years after receiving that match. Other proposed legislation would require that plan participants be notified if the fraction of their assets invested in employer stock exceeds a certain threshold (such as 20 percent), that companies offer a certain number of alternatives to employer stock if it is made an investment option, or that companies educate plan participants about the risks of not diversifying their assets.
This paper assesses how effective the "empower and educate" regulatory approach might be at reducing 401(k) employer stock holdings. We begin by studying five natural experiments in which employees experienced a discrete change in the restrictions on employer stock holdings. In these examples the restrictions changed for one of two reasons: either employees crossed an age or tenure threshold above which they were allowed to diversify their holdings, or the company changed its rules to enable all employees to diversify their investments. We find only a modest employee response to either type of change. Merely allowing diversification does not cause it to happen.
We then consider whether educational efforts might motivate employees to diversify out of employer stock. Although many studies have concluded that financial education does affect employees' choices, the subset of studies that randomly assign education and measure subsequent actions have found small effects. (1) These studies still leave open the possibility that other kinds of education might yield larger behavioral changes.
Here we evaluate a different form of education: witnessing the real-life experience of others. Economists since Armen Alchian in the 1950s have argued that the imitation of successful strategies (and, conversely, the avoidance of unsuccessful strategies) is an important force pushing economic actors toward optimal behavior. (2) We test this hypothesis in the context of the media coverage surrounding the Enron, WorldCom, and Global Crossing bankruptcies. Specifically, we investigate how much workers at other companies reduced their employer stock holdings in response to the blizzard of media stories early in this decade illustrating the dangers of putting all of one' s retirement savings in employer stock.
We chose Enron, WorldCom, and Global Crossing because a large percentage of their employees' 401(k) assets was held in employer stock, and because their bankruptcies, the associated accounting scandals, and their decimated 401(k) plans received so much attention from so many media outlets. For example, the New York Times ran 1,364 stories mentioning Enron during the last quarter of 2001 and the first quarter of 2002, of which 112 ran on the front page.
We find that this media barrage had a surprisingly modest impact on employer stock holdings in other 401(k) plans, reducing the fraction of assets held in employer stock by no more than 2 percentage points from an initial 36 percent of balances. We present evidence that this small reaction is not due to restrictions on diversification. In addition, we show that workers in Texas, who were likely to have been disproportionately exposed to Enron-related news, did not reduce their investment in employer stock any more than did workers outside of Texas. Even in Houston--Enron's headquarters--where the Houston Chronicle ran 1,122 stories mentioning Enron in the six months surrounding the firm's collapse, employees did not show evidence of learning the lesson of Enron.
This paper raises broader questions about retirement savings policy. It adds to the convergent body of evidence that many employees do not make optimal financial decisions. Households typically behave passively, following the path of least resistance. Such inertia often translates into household acceptance of the investment choices made automatically by their company on their behalf, even when those default choices are suboptimal for them. (3) For example, many firms automatically allocate 401(k) matching funds to employer stock, where the money typically stays even if employees are permitted to subsequently rebalance their portfolio.
Two policy solutions present themselves. First, society could give firms incentives to adopt socially optimal default choices. (4) However, it is not always obvious what such optimal defaults would be. Moreover, one default is rarely right for every employee, since employees face different economic circumstances. Alternatively, society could adopt default-free systems, which do not confer an advantage on one choice over another, by forcing employees to explicitly state their preference. (5) However, default-free systems will work only if employees are likely to make good decisions when forced to do so.
We begin with a brief summary of the current regulation of employer stock in 401(k) plans. We then summarize previous research on employer stockholding in 401(k) plans and how 401(k) outcomes are affected by plan features. Next we describe the employee-level 401(k) data we have for the seven companies examined in our analysis. Our empirical analysis begins with the results from five natural experiments on relaxing diversification restrictions. We then turn to examining the impact of the Enron, WorldCom, and Global Crossing crises on employer stock holdings for a large sample of employees at other firms. We conclude by discussing alternative legislative approaches that are likely to decrease employer stock holdings substantially, and implications for savings policies more generally.
Regulation of Employer Stockholding in 401(k) Plans
Like defined-benefit pension plans, 401(k) plans are primarily regulated under the Employee Retirement Income Security Act of 1974 (ERISA). (6)
Under ERISA, plan fiduciaries have four responsibilities: to act for the exclusive benefit of plan participants and their beneficiaries (the "exclusive purpose rule"); to act with the care, skill, prudence, and diligence that a prudent person acting in a similar capacity would use (the "prudent man rule"); to diversify plan assets across different types of investments, geographic areas, industrial sectors, and dates of maturity so as to reduce the chance of large losses (the "diversification rule"); and to act in accordance with plan documents.
At the time ERISA was passed, defined-benefit pension plans were the primary employer-sponsored mechanism for providing income to persons in retirement. To help safeguard the assets of these plans, ERISA explicitly caps the holdings of employer stock at 10 percent of total assets. Defined-contribution plans, however, face no such limit. The most common type of defined-contribution plan today, the 401(k) plan, did not exist when ERISA was enacted. Those defined-contribution plans that did exist consisted mainly of profit-sharing plans, to which employers made variable contributions based on company earnings, and employee stock ownership plans (ESOPs), which were explicitly designed to encourage ownership of employer stock. ERISA exempts these plans from the diversification requirements for employer securities.
When 401(k) plans were first authorized, in 1978, it was not anticipated that they would supplant defined-benefit pension plans as the primary source of employee retirement income. Hence Congress did not extend the 10 percent limit on employer stock holdings to 401(k) plans. Employers thus have much latitude in determining how much employer stock employees may hold in their 401(k).
A common way of holding employer stock in a 401(k) is through an ESOP. This combination of a 401(k) and an ESOP is sometimes referred to as a KSOP. Many companies, however, offer employer stock in their 401(k) plan without an ESOP, and many companies also operate an ESOP that is separate from the 401(k) plan. A KSOP is a savings plan intended to benefit employees, but it is also a corporate finance mechanism that encourages employee ownership. The KSOP's dual purposes can create a conflict of interest between plan beneficiaries and the employer. As a result, employer stock regulations for 401(k) plans with an ESOP differ from those for plans without one.
A 401(k) plan without an ESOP may not require that more than 10 percent of the employee's own contributions be held in employer stock. This requirement does not hold for a KSOP. Neither plan, with or without an ESOP, is limited in the amount of matching contributions by the employer that may be directed into employer stock. All assets within an ESOP, however, are subject to a set of explicit diversification requirements. Employees with ten years of tenure must be allowed to diversify 25 percent of their employer stock holdings once they reach age fifty-five, and 50 percent once they reach age sixty. (These diversification requirements do not apply to employer stock holdings outside of an ESOP.) Companies can and do, however, adopt diversification policies that are more generous than those mandated by ERISA. Finally, should a lawsuit arise, the fiduciary standards of prudence and exclusive purpose against which the company's behavior is judged are lower for a KSOP than for a 401(k) plan without an ESOP, because of the dual purposes of the former. (7)
Previous Research on Employer Stock in 401(k) Plans
Olivia Mitchell and Stephen Utkus report that, averaging across all 401(k) plans--including those without employer stock as an investment option--19 percent of plan assets are held in employer stock. (8) This statistic understates the diversification problem, since most participants do not have employer stock as an investment option--their employers do not offer it or are not publicly held firms. Only about 10 percent of companies offer employer stock in their 401(k) investment menu. Because these companies tend to be larger firms, 35 percent of all 401(k) participants are in plans that do include employer stock as an option. (9) These employees often have 401(k) portfolios that are heavily concentrated in employer stock. William Even and David Macpherson calculate that 50 percent of assets in plans offering employer stock were held in employer stock in 1998. (10) Plans offering employer stock can be further divided into those in which the employee must choose an investment allocation for the employer match and those in which the employer match is directed into employer stock by default. In 2001 two-thirds of those plans directing the match...
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