National Review

February 11, 2002

SECTION: Article; Vol. LIV, No. 2

I'm Okay, Your 401(k): The battle over savings and investment

By RICHARD NADLER

In the wake of Enron's collapse, pundits who formerly defined retirement security as a single underfunded plan (Social Security) locked into a single major asset category (U.S. Treasuries) have suddenly discovered "sound investment principles."

Enron employees saw the value of their company stock depreciate from a high of $90 to a low of $0.26. Clearly, some financial counseling is in order -- and Democrats are lining up to give it. Among those singing the "Song of the Portfolio Diversified" is Sen. Barbara Boxer, Democrat of California. "I believe," she said, "that the only way we can protect working people from losing their life savings in the course of an individual company bankruptcy is to make sure that workers are not disproportionately invested in any one company."

Of course, to deduce that company-stock ownership caused these thousands of investor calamities is to overlook a few other problems at Enron: earnings overstated by $580 million, a palimpsest of shredded financial documents, and officers who misrepresented the troubled stock's value even as they unloaded it.

But never mind: Boxer and her New Jersey colleague Jon Corzine have proposed a bill limiting how much company stock several popular work-based investment plans can hold. But the decisions of companies to offer their stock in work-based plans, and of their employees to participate in these plans, are neither diabolical nor irrational. There are three major ways in which firms sell their securities to employees: defined-contribution plans, employee-stock-ownership plans, and broad-based stock options. Each strategy meets particular investment objectives of employers as well as savings objectives of employees.

Participants in none of these strategies will benefit from the changes contemplated in the Boxer bill; some, in fact, may suffer because of them.

Defined-contribution (DC) plans, such as 401(k)s, are the primary target of the Boxer reforms. Fifty-five million Americans own retirement accounts in these tax-sheltered vehicles. Enron's contributions to these employee accounts consisted of company stock, but the workers' own contributions were not so restricted: They could invest in diversified, professionally managed mutual funds. But many, blinded by the company's meteoric rise, chose the company-stock fund. And there was nothing generically foolish in their preference for the stock of a blue-chip employer. Company-stock funds are, however, a rapidly shrinking orb within the DC firmament. Most 401(k)s are marketed as offering choices; the typical DC plan now offers a worker ten investment options, covering both his own contribution and his employer's.

Democratic economist Paul Krugman claims that "workers across the country have been cajoled or coerced into holding a high proportion of their retirement assets in their employers' own stock," but the facts do not support this assertion. A 2001 survey by the Profit Sharing/401(k) Council of America found that 78 percent of DC companies offered no investment advice at all; the most common explanation, voiced by 72 percent of employers, was their "fiduciary concern about liability for advice that results in a loss, even if the advisor is competent and there is no conflict of interest."

The ostensible goal of the Boxer regulatory scheme is to ensure that employees hold diversified portfolios, but they already do: As firms compete for employees, they diversify their plans. They offer company-stock funds less frequently than actively managed equity and bond funds, money-market accounts, and stable-value funds. The share of company-stock funds within DC plans is also decreasing: Only 1 percent of 401(k) employers offer them at all.

But to the extent that some 401(k)s still have too much company stock, the Boxer bill isn't the cure. Newsweek's investment columnist, Jane Bryant Quinn, understands this: "It's not enough to reform only 401(k)s. Companies can readily switch the matching-stock portion of a 401(k) into something called an Employee Stock Ownership Plan (ESOP)."

As their name implies, ESOPs are not retirement accounts. Rather, they are designed to provide employees an ownership share in their workplace. Legislation supporting ESOPs was enacted by Congress in the 1970s, with bipartisan support. The ESOP backers had an ambitious agenda: They wanted to transform corporate culture by mediating the interests of capital and labor through shared equity and shared management. The employee-owner, they hypothesized, would be more productive, loyal, and innovative than the alienated proletarian.

Two decades of research on ESOPs by Douglas Kruse and Joseph Blasi of Rutgers have largely confirmed this sunny thesis. By measures as diverse as output per employee, annual sales growth, stock-price changes, and worker satisfaction, ESOPs have been a rousing success. Currently, 8.5 million workers are enrolled in ESOPs. Firms whose employees own over half their equity include such giants as United Airlines and Publix Supermarkets. More commonly, ESOP companies are small; 95 percent of them are privately held. They dot the entire business landscape, from engineering to construction, from fast foods to metal fabrication.

Employee accounts in ESOPs are regularly "locked out" (to use our post-Enron parlance): An ESOP worker typically cannot sell company stock -- his sole plan option -- until age 55, and after a ten-year vesting period. These rules are crucial to Congress's intent, namely worker ownership. Under federal law, owners of privately held businesses receive substantial tax incentives to sell their stock to their employees when they retire. In the meantime, the ESOP trust serves as collateral against which business capital can be raised for acquisitions and expansions.

The same undiversified pool of company stock that makes ESOPs a superb vehicle for employee ownership renders them poor retirement investments. Company owners recognize this deficiency. That's why ESOP firms regularly feature a menu of benefits: Thirty-three percent offer other forms of profit-sharing; 20 percent offer defined-benefit pensions; and 33 percent offer 401(k)s. ESOP employees consistently own more total retirement assets than their non-ESOP peers.

The proposed Boxer reforms treat ESOPs as though the companies and employees who opt for such plans were simply foolish and irrational. They would slash the age at which a worker may sell company stock by some 20 years, and cut employee vesting requirements by half. ESOPs modified in this way would still provide a retirement-planning framework inferior to DC plans -- but they would also become relatively ineffective tools for employees hoping to own their workplace, and employers hoping to retire on advantageous tax terms. "Congress has a clear policy of encouraging employees to hold an equity position in their employer," said David Wray, president of the Profit Sharing/401(k) Council of America. The Boxer reforms strike at the heart of this concept.

The Boxer bill also makes no attempt to regulate the third method by which employees acquire company stock -- although it is unquestionably the riskiest. Broad-based stock options allow more than half a firm's employees to buy company equities at a fixed price within a specified time window. According to the National Center for Employee Ownership (NCEO), between 8 and 10 million employees held unexercised stock options in 2001.

These options are a key to the dynamism of American capitalism. Though it is the role of stock options in venture-capital start-ups that fills our imaginations and the pages of our business journals, they are as common among firms old and large as among those young and small. Stock options enable cash-starved entrepreneurs with bright ideas to "borrow" against future capital to pay first-rate specialists in the hereand-now. Among technology start-ups, according to a recent study by Advanced-HR, Inc., software programmers regularly get four times the options allotted to administrators. "The practice of granting options broadly in venture-backed, closely held companies . . . is clearly now an institutionalized part of compensation," says an NCEO study. "These venture-backed companies have a much more dramatic impact on technological innovation and corporate culture than their numbers alone suggest. Among their ranks, after all, are the next Microsofts and Intels."

Failure is more common: the upstart manufacturer litigated into ruin; the medical innovator starved with patents pending; the dot-com sales scheme hurtling toward bankruptcy. Stock options cycle our best and brightest toward entrepreneurship. Our economy's success is built on their willingness to risk failure. And their numbers -- successes as well as failures -- dwarf Enron.

The Clinton administration made a brief attempt to restrain stock options through taxation. It was furiously resisted by a united technology sector. Sen. Boxer wisely declined to duplicate that effort, preferring to fight economic growth at its margins rather than its vital core. Her proposed reforms are, however, worthless: futile and unnecessary with regard to defined contribution plans, destructive toward ESOPs, and nonexistent (thankfully) in regulating stock options. At first blush, they appear to give greater rights to worker-investors; but in fact, they needlessly constrict the range of work-based savings options available to employers and employees alike. These "reforms" cannot cure a problem that doesn't exist. But they can erode capital efficiency in the attempt.