Investing, Federal Law, and ESOPs
When you invest your retirement savings, you should diversify. Outside the hard sciences, you won’t find many ideas more solidly grounded in empirical data than that one. On average, over time, a properly diversified portfolio of investments will outperform a portfolio that’s concentrated in only one investment.
According to the data, savvy investors should diversify in at least a couple different ways. First, investors should choose different kinds of investments—different classes of stocks, along with bonds and other more conservative investments, and so on. The best mix of investment types depends on the investor’s age, tolerance for risk, and other factors. Second, investors should diversify their investments across companies, industries, regions, and economic sectors. By doing that, investors offset risks that are specific to a particular company, industry, region, or sector by also investing in others. If, instead, you invest in only one company, you fail to guard against all those specific risks, and, on average, your investment return will suffer for it.
To put it simply, diversified investments are just better, on average and over time. Given that uncontroversial fact, it might surprise you to hear that federal law encourages companies to set up retirement plans that, by definition, invest workers’ retirement savings in the stock of a single company. Those plans are called employee stock ownership plans, or ESOPs, and they are designed specifically to invest in the stock of the employer that sponsors the plan. Federal law gives ESOPs all the same tax advantages that other retirement plans, such as 401(k)’s, get—plus a couple more that are only for ESOPs. An estimated 10 million U.S. workers participate in ESOPs, and total ESOP assets are in the neighborhood of a trillion dollars.
ESOPs ignore both of the kinds of diversification I’ve described. They concentrate investments in only one kind of investment (common stock of the employing company), and they fail to guard against the risks specific to that company, its industry and sector, and its location.
But the diversification problem gets even worse. Not only do ESOPs invest almost exclusively in the stock of a single company, that company is the same one the plan participants work for. That means the workers’ ESOP accounts are invested in the same company the workers depend on for their paychecks and their non-retirement benefits, such as health care insurance. If the company runs into hard times, the workers stand to lose their retirement savings, their jobs, and their benefits in one horrific swoop. Talk about putting all your eggs in one basket!
It’s true, some companies with ESOPs also have 401(k) plans, so workers can achieve some investment diversification. But research shows that those workers still have way too much of their retirement savings invested in their employer’s stock.
So why does federal law encourage ESOPs? Promoters of ESOPs say they’re good for workers, because they provide a share in ownership of the company. They also say ESOPs are good for companies, because workers who are also owners will be more productive. Critics, including me, respond that giving workers a little ownership doesn’t justify saddling them with the risk of radical under-diversification; we also point out that the evidence suggesting ESOPs increase productivity is, to put it charitably, weak.
But promoters have been successful in maintaining ESOPs’ privileged status under federal law. Lawyers, trustees, valuation companies, and others have built a substantial industry around creating and maintaining ESOPs; naturally, they don’t want to see that business model go away. On the other side, there’s no effective lobby for protecting workers’ interest in well-diversified retirement savings. The path of least resistance for Congress and other policy makers is to let ESOPs ride, despite the risks they impose on workers.
This is Sean Anderson.