By Pat Look, J.J. Keller & Associates Inc
Some publicly traded companies like to offer employees a chance to have a vested interest in the company they work for, and they may be able to provide that opportunity by offering employer stock as an investment option in their defined contribution (DC) plan. This gives employees the chance to own part of the company and feel like they have some say in it. However, history has shown that owning too much employer stock (or being matched entirely in company stock) can be devastating under certain circumstances.
Take Enron, for example. Before the company imploded at the end of 2001, participants were matched 100 percent in company stock but had to wait until age 50 before selling it. Another issue that affected the plan at a critical time was a “lockdown” or “blackout” period during which employees were prevented from selling their stock for a specified period. When the company stock price tumbled, employees had no choice but to watch their account values sink.
In an attempt to prevent such occurrences from happening again, the U.S. Internal Revenue Service (IRS) and Treasury Department issued final regulations regarding diversification requirements for certain DC plans. These regulations became effective May 19, 2010, and apply for plan years beginning after Dec. 31, 2010. They affect administrators, employers, participants and beneficiaries of certain DC plans that offer publicly traded employer stock as an investment option.
Under the final regulations, a qualified plan that offers employer stock as an investment option must allow employee and employer contributions invested in employer stock, as well as rollover contributions invested in employer stock, to be sold and the proceeds reinvested in other investment options at least quarterly. This affects individuals who have completed at least three years of service with the employer, alternate payees of participants that have completed at least three years of service with an account in the plan and beneficiaries of deceased participants.
At least three investment options other than the company stock fund must be available in the plan, and each of these three options must be diversified enough to offer different risk and return results.
A plan that imposes certain restrictions or conditions on the employer stock fund that it does not impose on other funds will be in violation of the requirements. Yet, there are several types of restrictions that still are permitted under the regulations. For example:
• A plan can limit participants who are subject to section 16(b) of the Securities Exchange Act (typically executives) from trading their employer stock to a reasonable period of time (e.g., three to 12 days) after the company’s quarterly earnings are released.
• Participant who sell employer stock with the intention of investing in other funds may be restricted from participating in the employer stock fund for a specified period of time.
• Participants may be restricted from investing additional money in the employer stock fund because their balance in the fund has reached the maximum allowed (e.g., 10 percent).
• Restrictions on the timing and number of investment elections can be imposed to prevent short-term trading. For example, a seven-day rule or a restriction based on multiple trades within a certain period is allowed if it meets the standards for being “reasonable.”
• Imposing fees on other investment options that are not imposed on the employer stock fund does not violate the rules and is not considered to be providing an indirect benefit.
• Imposing a reasonable fee on the sale of employer stock is not considered a restriction on the sale of employer stock.
• Plans that offer a stable value or similar fund as an option may allow transfers in or out of such a fund more often than what is allowed in an employer stock fund. A stable value fund is designed to preserve principal, provide a reasonable rate of return and still provide liquidity as needed. Such transfers are permissible under this rule.
• Plans are allowed to freeze the employer stock fund so that no investments can be added. Dividends reinvested in the employer stock fund after it has been frozen are not considered to be new investments in the fund.
The Employee Retirement Income Security Act (ERISA) doesn’t place limits as to how much employer stock can be allowed in a participant’s DC account. However, in recent years many employers have been placing caps or limits on the percentage of company stock that participants can invest in their accounts—or on the deferral percentage elected. There is no magic number; each company needs to be careful in deciding the maximum stock ownership limit it is comfortable with for its employees. It could be 10 or 15 percent—or even up to 50 percent. However, a lower cap is becoming much more common, and some employers are even eliminating this investment option.
Companies need to consider whether or not offering company stock in their plan still fits with the objectives of the company. Rather than eliminating the option, adding a managed account program to the plan might help to keep diversification in check.
Plan sponsors must take their fiduciary responsibilities seriously and consider the consequences if circumstances change and the economy turns the tide on their company. Employers want to avoid lawsuits and to protect the retirement savings of their employees.
Patricia Look has been the editor of the BottomLine Benefits & Compensation newsletter for J.J. Keller & Associates since its inception in 2007. She has worked in benefits and compensation management, with a focus on retirement plans and executive compensation, for over 25 years. In particular, her expertise includes 401(k) plans, qualified pension plans, deferred compensation and supplemental plans for executives.
New Rules Govern Employee Stock Purchase Plans and Incentive Stock Options, SHRM Online Compensation Discipline, February 2010
IRS Issues Final Employee Stock Purchase Plan Regulations, SHRM Online Compensation Discipline, December 2009
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