Employer Stock in Pension Plans: Economic and Tax Issues
Released: 2002-09-04T00:00:00

Summary:
The loss of retirement assets held in Enron stock by Enron employees has stimulated proposals to restrict the holding of employer stock in retirement plans, and other proposals to regulate theseplans. Stock in the Enron plan came from firm contributions in the form of stock that was notallowed to be sold and from voluntary investment by employees. This report focuses on rationalesfor providing employer retirement plans and for holding (or not holding) employer stock in theseplans, both from the perspective of the private sector and of government policy.
Retirement plans fall into two types: defined benefit plans, where a pension based on earningsand years of service is provided; and defined contribution plans, where individuals receive benefitsbased on accumulated principal and interest. Either plan can hold employer stock, but holdings arelimited to 10% of assets in the case of defined benefit plans. These plans receive tax subsidies, asdo employee stock purchase plans and certain types of stock options.
The analysis suggests that there are economic reasons that firms and employees may engage in pension and profit sharing (or stock ownership) plans even in the absence of tax subsidies. Pensionplans, primarily defined benefit plans, may be attractive for administrative and risk-reductionreasons, for dealing with inadequate investment in on-the-job training, and for smoothing theretirement of older workers. Stock options and stock ownership plans may be useful for addressinginconsistency in objectives between shareholders and managers and worker monitoring problems,although these benefits are not likely to accrue to stock ownership by the rank and file of largecompanies. These employee stock ownership plans may also deter hostile takeovers, which mayundermine economic efficiency and stockholder interests. Stock contributions are also popularbecause they do not reduce cash flow, which has both benefits and costs from an economic efficiencyperspective.
Government subsidies to plans may be justified to increase retirement incomes and access to annuities because of a shortfall in optimal savings and certain economic problems with self selectionin purchasing annuities. These objectives also underlie the justification of Social Security. Pursuingthese goals may actually conflict with another worthy objective, on-the-job training. However,objectives that are addressed via employee stock ownership do not appear important in shaping thenature of large, broadly-based, retirement plans. Diversification of plan assets and prudentinvestment portfolios do appear consistent with rationales for government intervention.
Attempts to address this issue might take several forms: restrictions on shares of employer stock in plans, prohibiting employer stock contributions or lifting restrictions on sale, denying a taxdeduction on employer contributions until they could be sold, and requiring independent investmentadvice. The last proposal is not costless and could undermine participation for small firms. Foradministrative and other reasons, it may be rational to impose share restrictions on allocations ofcontributions, rather than on assets. There are no plans to update this report.

subsections: section_title: Basic Types of Plans
paragraphs: A broad range of plans that involve benefits to workers not in the form of cash currently exist,including a wide variety of plans that are for retirement purposes (and that employees cannot receiveuntil they leave the firm). These plans receive tax benefits in that contributions and earnings are nottaxed to individuals until received as pensions (or payments on separation). These plans fall into twobasic types: defined benefit plans (where workers are guaranteed a certain benefit related to earningsand years of service) and defined contribution plans, where employees receive benefits based on thesize of assets and accumulated earnings. For most types of plans, contributions to these plans aretypically made by employers, and thus do not permit employees to choose between them and cashwages. 
For a variety of reasons, defined benefit plans, which once dominated the pension landscape, have been in a decline over the past quarter of a century and defined contribution plans are on theincrease. This rise in defined contribution plans particularly reflects a popular form of definedcontribution plan: a 401(k) plan, where individual accounts are maintained, both employers andemployees contribute, and employee contributions are voluntary. Employees have some choice inthe allocation of their own contributions. Employer stock may be one of the choices; employercontributions may also be made in the form of employer stock. 
While all pension plans are subject to regulations of some type, the restrictions are greatest for defined benefit plans. Defined benefit plans are also covered by pension insurance, which insuresagainst total loss of assets. Some of the restrictions on plans, particularly defined benefit plans, weredesigned to insure sound investments and to make sure that the plans were not simply a tax shelterfor high ranking employees and managers. Only defined benefit plans have restrictions on theamount of employer stock that can be held (10%). For defined contribution plans, employees bearthe risk of loss of investment or low returns. Some types of plans with retirement features(Employee Stock Ownership Plans, or ESOPs) must hold assets primarily in the form of employerstock. Plans may be combined.
Tax benefits are also provided for acquiring employer stock that is not restricted to retirement plans. These benefits include benefits for stock options and stock purchase plans: the former aregenerally directed to high ranking employees and managers, while the latter are generally availableto all employees. (1)
section_title: Private Rationales for Pension and Profit-Sharing Plans
paragraphs: Why should firms pay employee compensation in the form of pension or profit sharing plans(or other fringe benefits) rather than in cash? Does the existence of these plans hinge solely orlargely on tax benefits? In this section we briefly discuss several reasons that firms might desire topay compensation, or that individuals might like to receive it, in the form of pensions or stock. Thefirst three reasons are largely associated with defined benefit pension plans while the last two areassociated with profit-sharing or stock ownership plans. Defined contribution plans not in the formof stock may, indeed, have largely arisen from a desire to exploit tax benefits, as it is difficult todiscern another reason for using them. 
subsections: section_title: Administrative Savings, Insurance and Risk-Pooling
paragraphs: One reason for the popularity of these retirement plans might be that collective plans, such as pension plans, could be considered desirable because of administrative savings and risk reduction. Pension plans are also often constructed to provide insurance elements, such as disability andsurvivor payments and life annuities. Insurance of this nature is often not efficiently provided inprivate markets because of adverse selection. (Adverse selection occurs when individuals sortthemselves out due to private knowledge of risks. For example, a person with a terminal illnessmight desire to buy life insurance but would not purchase a life annuity.) 
While administrative savings could apply to any plan, risk-pooling and insurance elements would tend to apply most strongly to defined benefit pensions plans with diversified assets andwould not apply to stock ownership plans which tend to increase risk. Administrative and riskreduction benefits have probably declined over time with the current availability of large mutualfunds and the benefits are particularly less important for defined contribution plans that do not haveunique elements of insurance and risk reduction associated with defined-benefit plans. 
section_title: Human Capital Investment
paragraphs: Investment in human capital is generally under-provided in a market economy, because individuals cannot engage in involuntary servitude or commit to a certain form of employment toinsure that future earnings are used to repay human capital investments. These problems apply bothto general education and to certain types of on-the-job training. Returns to on-the-job training thatteaches skills specific to the firm can only be exploited by remaining with the firm. However,returns to on-the-job training that teaches skills transferable to other jobs can be realized by eitherstaying with the firm or moving to another firm. It is in the interest of the firm to retain employeeswhen the firm has invested in their training and whose net product is low or even negative in theearly period of the career. Defined benefit pension plans that are not quickly vested, and whosebenefits become greatest when spending a long career with a company, can be used to allow firmsand employees to mutually exploit gains from these types of human capital investment. (Government pension regulations which require early vesting and portability as ways to protectworker retirement security and guard against tax sheltering may, however, have eroded this benefit.) 
section_title: Facilitating Retirement
paragraphs: Pension plans may also be a way of encouraging employees to retire as their marginal product falls, without undermining morale by firing older workers who have become less productive (or,these days, placing the employer in the position of potentially violating the law). Defined benefitpension plans are particularly effective because workers who have reached full retirement and remainat work forgo their pensions, and their net wage is reduced, creating a powerful substitution effectthat encourages retirement while also offsetting lost income. Defined contribution plans permitretirement but do not create as powerful an incentive to retire and thus do not perform this functionas well.
section_title: The Principal-Agent and Worker-Monitoring Problems
paragraphs: Another problem that large firms with many stockholders and/or employees face is the problem of a misalignment of shareholder and worker interests. In the case of managers, this problem is oftenreferred to as the principal-agent or agency cost problem: managers who run the company as anagent for shareholders may make decisions that do not necessarily maximize stockholder profits. Moreover, large firms may find it difficult to monitor the performance of workers; in particular theycannot easily distinguish between the effects of work effort versus outside influences onproductivity. One way that firms may attempt to remedy this problem is through use of stock options(which provide employees an incentive to increase the firm's value) and stock ownership plans,which provide some alignment with the shareholders' objectives. Of course, in theory, this approachwould not be particularly beneficial for the rank and file employees of large firms, where additionalwork effort by any one employee would have a negligible effect on the value of that employee'sstock. Stock options and ownership could have an effect on top management, whose actions haveimportant consequences, and on closely held firms. Moreover, many managers believe that employerownership boosts employee loyalty and morale. (2)
Employee stock ownership can also work against shareholder interests and economic efficiency. Firms where employees hold a large fraction of stock are more impervious to hostile takeovers, asemployees and managers may otherwise fear loss of pay and jobs in such a circumstance. However,threats of takeovers are also a market mechanism that may keep the principal-agent problem undercontrol and both takeover threats and actual takeovers may lead to a more efficient company. Reducing takeovers may be advantageous for managers and workers but may not be desirablesocially. 
section_title: Minimizing Cash Flow Effects
paragraphs: Providing compensation in the form of stock is often considered cheaper because it does not reduce current cash-flow. Such an approach may be particularly attractive to new and fast growingfirms, where access to capital markets is difficult and initial profitability is low. This motive maylead to more economic efficiency if capital markets consistently overestimate expected risk. It maylead to less efficient markets if the dilution of stock makes information on the firm's profitabilitymore difficult to assess by investors. 
section_title: Rationales for Government Intervention
paragraphs: The previous section has suggested private motives even in the absence of tax benefits fordefined benefit pension plans and for stock ownership plans, but there does not appear to be a strongprivate rationale for defined contribution plans not held in the form of employer stock. Clearlyanother reason for pension and profit sharing plans that may play a crucial role in encouraging theseplans, particularly defined contribution plans not invested in employer stock, is the tax benefitsassociated with them. Amounts contributed to a pension plan and their earnings are not subject totax until received as pensions, usually many years into the future. The combination of deferral of taxon the initial contribution and deferral of tax on earnings is the equivalent of an exemption ofearnings from tax, and is thus a valuable tax benefit. 
Why should the government intervene with tax subsidies (and regulations) to shape the compensation package? And why should it intervene with mixed signals, including both benefitsfor and restrictions on ownership of employer stock in pension plans?
The first set of rationales for supporting pension plans are also are among the reasons for establishing Social Security: adverse selection in annuity markets and failure of individualoptimization (failure to save a desirable amount). (3) Adverse selection in annuity markets occursbecause individuals expecting to have a shorter life span will avoid the annuities market, therebymaking the annuities unattractive for the average individual. This rationale would justify taxsubsidies to pension plans that provide retirement annuities, early vesting, and mandates for broadcoverage of employees. (The latter rule is probably necessary in any case to prevent the tax benefitsfrom becoming a tax shelter for highly compensated employees.) Of course, it is not clear thatindividuals do not save enough, and it is not clear why using resources (in the form of reduced taxes)to encourage a private pension system that covers about half of workers should be preferred todevoting those resources to an expansion of Social Security.
The entire pension system has been shifting away from plans that address these goals: many defined contribution plans have a lump-sum payoff option, and defined benefit plans have beenincreasingly displaced by defined contribution plans. 401(k) plans, which have become verypopular, allow voluntary, not mandatory, contributions. Outside of certain defined benefit plans,the current systems have simply become primarily ways to obtain tax benefits.
Of course, arguments are made that these tax benefits have encouraged saving, but neither economic theory nor empirical evidence has confirmed that view. (4) In any case, this rationalesuggests that prudence in investment is important to encourage. In that case, many of the proposalsfor revision, including limits on employer stock holding in any type of pension plan, and reducingor eliminating any required holding period, might be justified. Of course, such an approach alsosuggests that employee stock ownership plan subsidies be discontinued or modified. 
Some of the rules made to insure safe and broadly available worker pensions have been in conflict with solutions to other economic problems. For example, as noted earlier, a marketeconomy tends to under-invest in human capital. There are obviously massive governmentinterventions through direct spending, low-interest loans, and tax benefits to provide for formaleducation and training. Pension rules may, however, have undermined the use of defined benefitpensions for encouraging spending on on-the-job training. For example, rules mandating earlyvesting are in conflict with objectives to increase on-the-job training (objectives that might be worthyof pursuit by the government as well), although they may be appropriate to increase pension coverageand employee security. Similarly, non-discrimination requirements have been used to prevent theuse of the tax subsidies as a tax shelter for highly compensated employees and increase coverage,even though on-the-job training benefits may not be uniform across employees. Diversification ofassets is consistent, however, with both government and private rationales for defined benefitpension plans.
Economic problems arising from principal-agent costs or worker monitoring costs may beargued to justify government subsidies to stock ownership plans to increase efficiency beyond whatprivate markets may do. However, they are unlikely to be addressed by ownership of employerstock among rank and file employees of large companies, where most tax subsidies for pensions aredirected. Moreover, encouraging practices that make companies resistant to takeover may reducerather than increase economic efficiency. Nor is it clear that stock ownership plans benefits inpreserving cash flow outweigh the possible negative effects of using stock as compensation onstockholder information. Thus, the justification for government subsidies to stock ownership is notreally established. 
section_title: Implications for Reform Proposals
paragraphs: As discussed above, the discussion of justifications for government intervention based oneconomic problems suggests rationales for traditional pension plans, particularly those with definedbenefits, but do not necessarily suggest a justification of tax subsidies for plans such as 401(k) plans,where participation by employees is voluntary. These subsidies may not even increase retirementsaving. However, given that subsidies do exist, there does appear to be a case for increasing thesafety of investments by limiting investment in employer stock, while the rationale for supportingemployer stock ownership plans appears weak. 
If limits on ownership are to be imposed, how should constraints work? It would appear better for administrative and other reasons to impose the limits on the share of contributions made ratherthan the share of assets. A reason for limiting the share of assets in employer stock in defined benefitplans is in part because of pension insurance and because of limits on excess contributions, issuesthat do not exist for 401(k) plans. In the case of a defined contribution plan, a successful employerstock may simply become a larger part of the asset base because it is appreciating rapidly and forcedsales may not be sensible. Other legislative changes might be requirements that employees be ableto sell employer contributed stock immediately or within a few years (which is proposed in somelegislation), disallowing deductions for stock contributions until employees are allowed to sell, oreven prohibiting these types of contributions altogether. It is not clear whether these restrictions willbe successful, however, if ESOPs remain as an option.
Another legislative proposal that has been made to increase the security of individual investment plans (which might be used instead of explicit restrictions) is to require firms to provideinvestment advice, since firm managers may have a conflict of interest. Of course, investmentadvice is not costless, and it could significantly discourage the use of these plans in the case of smallfirms. Moreover, virtually any independent investment advisor would counsel against holding alarge part of retirement assets in a single stock, but many advisors would suggest taking on generalstock market risk. If explicit restrictions are imposed on ownership of a single stock, suchindividual advice might not be necessary. Alternatively, a general public information campaign maybe considered. Moreover, the publicity associated with the Enron bankruptcy, along with other firmfailures and the decline in the stock market, may be adequate to alert individuals to the need forportfolio diversification.
One criticism that has been made of these proposals is that firms may respond by reducing their contributions. It is not clear that such a reduction would occur or should be a problem if it did (andmany contributions are currently made in cash rather than stock). If stock contributions have anyvalue, then they are likely to substitute for cash wages. It is not clear that policy should be concernedabout employer matches in a risky asset as a substitution for cash wages, particularly when theparticipation is voluntary, both on the part of individuals contributing to plans and firms setting upplans. The beneficiaries in both cases are only part of the population (and the more affluent part). An argument could be made that the revenue derived from increased taxes on cash wages might bebetter used for other purposes.