Employees at insurance company Aon (NYSE: AON) can no longer count on the company’s stock as a linchpin in their retirement planning.
In July, Aon said it will no longer offer employees the option of buying company stock in their 401(k) plans. Employees will have to find other investment options within the plan.
On the surface, the move may seem harsh — but it’s actually good news for Aon’s employees. Yes, it’s smart to accumulate assets in a 401(k) plan that grows tax-deferred. But plan sponsors that stifle diversification are not doing the best thing for workers.
Participants in Aon’s plan make their own purchase decisions, as do 401(k) participants at firms all over the country. Aon doesn’t have any control over what investment options its employees choose. Nevertheless, those employees are pretty bullish when it comes to their opinion of the company’s prospects: At the end of 2016 they squirreled away more than $238 million worth of Aon stock in the company’s plan. The Aon workers got lucky with their timing; the stock’s price rose more than 50 percent in the past two years.
[See: 9 Psychological Biases That Hurt Investors.]
Plenty of employees at publicly traded companies throughout America also load up on their own company’s stock. And they do it with the same bullish zeal. When an employer’s stock is offered as an option in a company retirement plan, workers flock to it like moths to a light bulb. Some do this out of a sense of loyalty, others out of a belief that they have the inside track that Wall Street is missing. Whatever the motivation, building a concentrated position in an employer’s stock is not the best idea.
The reason for this isn’t tied to the employer’s stock, which could be a market leader or laggard, depending on the time frame. It’s tied to the reality that owning an individual stock — any stock — is risky.
Consider this in the context of the stock market as a whole. Let’s look at the Standard & Poor’s 500 index of the biggest U.S. companies. There are 10 industrial sectors that make up the index. If you drill down further, you’ll see that each of those 10 sectors consists of sub-sectors, or various industry classifications.
If you drill down even further, you’ll see that those sub-sectors are all made up of dozens of individual companies. It’s like splitting an atom. Look deeply and the universe just keeps getting smaller and smaller.
For example, the Technology Select Sector SPDR exchange-traded fund ( XLK) tracks the S&P stocks categorized under technology. But the holdings, including Apple ( AAPL), AT&T ( T) and Visa ( V) comprise a broad spectrum of industries under the wider tech umbrella.
So, to pick any one of those stocks out of any one of those sub-sectors and then to load up on it is akin to building a concentrated position in your employer’s stock. In 401(k) plans, the only reason people salt away shares of their employer’s stock is because they work there.
If you asked employees of Procter & Gamble Co. ( PG) to load up on Exxon Mobil Corp. ( XOM) stock (and vise-versa) they’d say you were crazy. When viewed objectively, like this, the idea is obviously just too risky. As it happens, there’s an entire science built around the study of risk and investment returns. It’s called Modern Portfolio Theory, which goes by the spiffy acronym, MPT.
[See: 9 Ways to Avoid 401(k) Fees and Penalties.]
MPT tells us that on one end of the risk continuum is a portfolio made up of just stocks. Adding different asset classes to that portfolio of stocks ratchets down the volatility and moves the mix closer and closer to the less risky end of the continuum. At each specific point on the continuum there is a balance between risk and expected reward that will appeal to different investors based on their unique appetite for risk. But nowhere on this scale is there a spot for just one stock.
This is because it is nearly universally understood that owning just one stock is super-duper risky. Owning just one stock, or having a concentrated position in a single stock, is pretty much the definition of that old phrase about having all your eggs in one basket. This is not a great long-term investment strategy.
So, for employees who are currently dedicating a large portion of their 401(k) investments to their employer’s stock the following steps would be well considered:
— If the position is more than 5 percent of your portfolio, stop adding to it.
— Begin to sell off the portion more than 5 percent.
— Consider your risk tolerances before reinvesting those proceeds.
— Use those proceeds to further diversify your account.
— Consider a mix of stocks, bonds and a small amount of cash.
— Think about mixing up your stock portfolio.
— Look at adding big, medium, and small company stocks to that mix.
— Include a mix of “growth” and “value” to the pot.
— Look beyond your horizons.
— Don’t hold only domestic stocks. Include international and emerging market securities to the mix.
The notion that owning a large chunk of your employer’s stock puts too many eggs in one basket actually sidesteps the bigger risk to employees. True, a high allocation in a single security adds market risk. However, a heavy investment in your employer’s stock increases your dependence on the health and viability of the hand that feeds you.
Employees need to consider their concentrated risk in terms of the whole package. Your current livelihood is dependent upon your employer’s paycheck. Your access to health care is dependent upon your employer’s insurance benefits. Loading up on your employer’s stock only adds to this concentrated risk.
If you need a vivid reminder of that, just remember what happened to the employees of Enron, many of whom tied up their retirement accounts in the company’s stock. When the company went belly-up in late 2001, many workers and retirees were left with nothing.
[See: The Best ETFs Retirees Can Buy.]
Nobody is suggesting that your employer will be delisted from the major stock indexes and its top executives will be wearing orange prison jumpsuits. But even so-called “good” companies go through bad stretches. Anything can happen — lawsuits, a management scandal, health and safety issues, industry-wide problems, or any number of crises that aren’t currently looming. Sure, your company may appear to be the brightest Faberge egg in the basket, but it’s still just one egg.
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