Updated: September 1, 2015
The highly publicized collapses of Enron and WorldCom destroyed many 401(k) accounts, devastating the retirement hopes and plans of many thousands of people. Especially after the Enron experience, politicians and experts have proposed retirement plan reforms, including a wider range of choice for employee investment and fewer limits on trading. Both of these would undoubtedly be good for employees. Unfortunately, reform is slow – how can you protect yourself while you wait for new governmental protections?
Let’s look at what happened at Enron and WorldCom, then at some basic principles of retirement investing. Then we’ll draw some action implications.1
Following Henry Ford, who sold Model Ts in any color customers wanted, “as long as it was black,” Enron allowed its employees to choose any investment they wanted for their employer matching contribution, as long as it was Enron stock. In addition, many Enron employees invested large chunks of their own retirement contributions in Enron stock, even though they had a choice of investments for these assets. When Enron’s stock price was dropping rapidly before the bankruptcy announcement, employees holding the stock in their retirement accounts were unable to transfer their retirement assets to other investments. Many employees lost hundreds of thousands of dollars.
WorldCom employees were in a very different position. They were not required to hold any of their employer’s stock in their 401(k) accounts. Nevertheless, before WorldCom’s stock price collapsed, 30% or more of the total value of WorldCom 401(k) accounts was invested in WorldCom stock. When the stock went from $14 per share to 30¢ per share, that 30% went to 4%. Many employees had their 401(k) accounts virtually wiped out.
Retirement Investing Principles
Principle 1 – Diversify. Your very livelihood depends greatly on the success of your employer. If your employer does well, and you contribute to that success, you will stay employed, your earnings will go up, and you may be promoted as well. Your employer’s stock is also likely to go up in price. If your employer does poorly, even if your professional contributions make your employer’s results less poor, your earnings won’t go up, you are less likely to be promoted, and your salary is unlikely to rise. Your employer’s stock probably won’t be such a great investment either. In short, holding your employer’s stock, either as a retirement asset or as a general investment, amounts to holding two raffle tickets with the same number – if that number comes up, you win big, but if it doesn’t, well… you lose very big. In other words, if you want to diversify, hold as little of your employer’s stock as you possibly can. Zero is a really good number here.2
Principle 2 – Diversify. Some employers offer you a choice between a defined contribution retirement plan, such as a 401(k) plan, and a defined benefit plan. The defined contribution plan is usually held by a custodian other than the employer (such as Fidelity or Vanguard), while the defined benefit plan is managed by and is the fiduciary responsibility of the employer. Even though the defined benefit plan or pension plan is probably insured by the federally chartered Pension Benefit Guarantee Corporation (PBGC), the insurance is imperfect. If the employer goes bankrupt, and the PBGC takes responsibility for the pension plan, you may receive benefits lower than your employer had promised. Many retired employees of USAir, Polaroid, and other bankrupt employers can testify both that they are pleased that the PBGC exists (because otherwise they would have no pension at all), and that they wish that their former employer hadn’t had any control over the pension assets (because then they would have suffered no loss when their employer went bankrupt). If you have the choice, choose a defined contribution plan where you can see and control your own retirement account3, and, if you don’t, strongly consider taking a lump sum payment at your earliest opportunity.
Principle 3 – Diversify. Even employees who have many investment choices could diversify much more than they typically do. Both Enron and WorldCom employees could have done so. Many employees keep their entire 401(k) retirement savings in money market assets, or all in one aggressive growth fund, or in several aggressive growth funds. Those unfortunate enough to be in the latter group have come to regret the significant risk they accepted, and the significant losses they suffered.
For example, large cap growth declined more than 50% from its peak in the spring of 2000 to its trough in 2003. Your entire portfolio, including your retirement assets, should be diversified across several asset classes whose future returns are expected to have as little correlation with each other as possible. That way, if one declines, another is likely to go up, or decline less. Stocks and bonds, value and growth equities, large and small company equities, and US and foreign equities and bonds are asset classes that have historically had less correlation with each other. Your portfolio needn’t contain allocations to each member of all of these pairs, but it should be constructed to provide shelter if, say, aggressive growth equities suffer a prolonged decline or inflation suddenly accelerates. And, your retirement portfolio allocation should be diversified as a key component of your overall holdings.
The losses suffered by Enron’s (and WorldCom’s) unfortunate employees provide us with a living example of the dangers of putting our entire nest eggs in one basket. It is possible (and desirable) to learn from the experiences of others. It would be both unfortunate and extremely disappointing to look back on your own missed opportunity to diversify your holdings. You would be saying, “I should have known better,” and you would be right.
- Hold as little of your employer’s stock as you possibly can.
- Given a choice between defined contribution and defined benefit plans, choose a defined contribution plan where you can see and control your own retirement account.
- If you have a defined benefit pension, strongly consider taking a lump sum payment at your earliest opportunity.4 You must roll over such a payment into an IRA within 60 days to avoid stiff early withdrawal penalties. You’ll then be able to control the allocation and diversification of the assets yourself, and your exposure to any single company’s performance will be limited.
- Diversify your entire portfolio, and coordinate your retirement portfolio holdings with the rest of your portfolio.
- If you have doubts about your portfolio’s diversification, ask a professional financial advisor to help ensure that it is well balanced – built to weather fluctuations in the market. Your retirement is too important to leave to hopes and guesswork.