Naïve Investing – Company Stock

1. Naïve Investing – Company Stock PADM 5111 – Microeconomics for Policy Analysis Presented by Amanda Wright & Glenn Horne Thursday, September 18, 2014

2. Agenda Background Survey Employee Attitudes Employer Attitudes Double Nudge Conclusion

3. Background • Employee Retirement Income Security Act 1974 (ERISA) puts forth three fiduciary principles for retirement plan investments: • Exclusive benefit rule requires that plans be managed for the benefit of participants • Prudence rule requires that plan assets be invested according to a ‘prudent investor’ standard • Diversification rule requires that plans be diversified so to minimize the risk of large losses • Company stock is exempt from the diversification requirement

4. Post Enron U.S. Congress has considered a range of legal reforms that would protect employees against the risks associated with investments in their employer’s security (company stock) The most cautious proposal would require an annual disclosure about company stock risks to participants and would limit an employer’s ability to restrict a participants right to diversify company stock More ambitious initiatives would require mandatory diversification above some limit or disallow employee contributions in stock when employers already match Legislation has not been passed because of questions regarding its necessity

5. The Study: Reality and Perceptions Survey 501 employee respondents at 100 different companies Goal to obtain a better understanding of how employees think about the costs and benefits of owning company stock The employer survey was 150 firms that offer company stock in their retirement savings plans Goal was to obtain better understanding of employers perspectives on the costs and benefits of requiring employees to own company stock

6. Employees and Company Stock 11 million participants is U.S. define-contribution plans have more than 20% of their account balance invested in company stock. Within this group 5 million have more than 60% concentrated in their employer’s stock. According to estimates $1 in company stock is worth less than half the value of $1 in a mutual fund.

7. Allocation of Retirement Plan Assets to Company Stock

8. Benefits to Employee Advantageous Tax Treatment: Investment in company stock does have tax advantages that are not available for other investment funds in 401(k) plans Only 1/10 respondents aware of the preferential tax treatment 12% think that company stock is taxed at higher rates Most respondents either didn’t know (35%) or think that company stock has the same tax treatment as other investments (44%) Those who know company stock has preferential tax treatment allocate 20.9% of monthly contributions to company stock Those who thought has tax disadvantage allocate 28.3%

9. Private Information: Employees might more know about their employer than of outside investors Unconvincing because employees at a large company unlikely to know about all the different products and divisions Large extent of company stock allocation based on public information Nonmonetary Benefits: Feeling as part of the team? 32% confirm they feel better for owning company stock However 59% said does not affect them Overall no evidence that employees value the benefits of owning company stock

10. Costs to the Employee Idiosyncratic Risk: Investing in single stock very costly People can loose job and retirement funds all at once (Enron) People do not understand the risk-and-return profile of company stock Only 16% of employees understand their employer’s stock is riskier than the overall stock market Vanguard survey data indicates that average participant views company stock as safer than a diversified stock fund

11. Even after educating people about the Enron bankruptcy case, 25% of respondents said they believe their company stock is safer than diversified fund and another 39% said they believe it has the same level of risk Participants base their risk perceptions on past returns and not on the volatility of returns Nonmonetary Costs: Not owning company stock may provoke employees to feel they have betrayed their employer However no evidence that loyalty correlates with decisions to invest in company stock

12. Summary: The Employee Majority of employees do not place much weight on the alleged benefits of owning company stock Most employees do not appreciate the risk of investing in a single stock

13. Benefits to Employer Increased motivation & productivity Advantageous tax treatment Advantageous treatment under fiduciary law “Friendly Hands” Cash flow

14. Cost to Employers • Costs as managers of the retirement portfolio: • Lack of diversification • However, they also indicated if given the opportunity to change the makeup of the portfolio they would not.

15. Employers Summary Benefits are limited at best. Employers do not appear to have a good perception of the true costs and benefits of having high rates of employee investment in company stock.

16. Double Nudge Employers are given a nudge via Employee Retirement Income Security Act 1974 Employers nudge employees based on overestimation of true benefits.

17. Conclusion You have to get at the root of the nudge. Eliminate the company stock exemption from the diversification requirement.