1. Naïve Investing – Company Stock PADM 5111 – Microeconomics for Policy Analysis Presented by Amanda Wright & Glenn Horne Wednesday, October 07, 2015

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

3. 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. 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. 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. 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. 7 EmployerCompany Stock % Procter and Gamble Co.90 Abbott Laboratories78 Pfizer Inc.75 General Electric Co.68 Southern Co.65 Marsh & McLennan64 Target Corp.60 Chevron Texaco Corp.60 Meadwestvaco Corp.59 Textron Inc.55 Kimberly-Clark Corp.55 Bank of America54 Merrill Lynch & Co.52 Johnson & Johnson50 Merck & Co.50 Allocation of Retirement Plan Assets to Company Stock

8. 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. 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. 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. 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. 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. 13 Benefits to Employer  Increased motivation & productivity  Advantageous tax treatment  Advantageous treatment under fiduciary law  “Friendly Hands”  Cash flow

14. 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. 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. 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. 17 Conclusion  You have to get at the root of the nudge.  Eliminate the company stock exemption from the diversification requirement.