Managing ESOP Risk

by Jared Kaplan

Andrew Carnegie observed that the way to make money is to “put all your eggs in one basket, and watch that basket.” This strategy is embedded in the investment policy of all ESOPs: they are required by law to invest their assets primarily in the stock of the company sponsoring the plan.

The strategy often works. It is a good way to make money, especially if you have plenty of other assets, a bit of luck, or, preferably, both. But it’s only half the story. The strategy has a dark side—it’s also a good way to lose money.

That’s because there’s substantial risk involved in having an investment portfolio consisting of the stock of only one company. No matter how good the company, something bad can happen to any company at any time. One of America’s most successful businesses is Boeing Co., but its stock price dropped 5% in one day after the second fatal crash of its best-selling airplane resulted in a world-wide grounding of the aircraft. Investors call the risk involved in putting all your eggs in one basket “single-stock concentration risk.”

The antidote for single-stock concentration risk is diversification. Boeing’s stock appreciated by 9.36 % in 2018, the year before the crashes. If an investor had assembled a portfolio of equal proportions of ten stocks generating similar returns, including Boeing, her portfolio’s loss on Boeing’s bad day might have been only one-half of 1% instead of 5%, but her expected returns would have been unaffected. This is why diversification is widely recognized as a best practice for investors.

But diversification doesn’t work for ESOPs, because they’re required to keep their assets primarily invested in employer stock. So every ESOP has excessive risk, in the sense that a prudent investor would use diversification to manage single-stock concentration risk. The ESOP can’t use that mechanism and therefore is stuck with extra risk.

In 1974, when Congress enacted ERISA—the law embodying ESOPs and setting the rules for retirement plans generally—it had to deal with this issue. One of the provisions of ERISA requires retirement plans in general to be invested prudently, and to use diversification to avoid single-stock concentration risk. Since these requirements conflict with the rule that ESOPs have to invest primarily in employer stock, Congress included in the law a special exemption for ESOPs. In view of the importance of the exemption language, it’s worth quoting verbatim. It reads, in relevant part, as follows:

“ In the case of an [ESOP or similar plan], the diversification requirement …. and the prudence requirement (only to the extent that it requires diversification) ….is not violated by acquisition or holding of …. qualifying employer securities ….”

In other words, ESOPs are exempt from ERISA’s requirement of diversification. In addition, recognizing that prudence requires diversification, ESOP fiduciaries are exempt from that aspect of prudence but are still required to be prudent in all other respects. This wording is especially important because the standard of prudence for a fiduciary is very high. In ERISA, it requires the fiduciary to observe the same level of care that an expert investor would observe in dealing with his own investments.

As a practical matter, what is an ESOP fiduciary to do? He is really stuck with excessive risk, because the law requires investment primarily in employer stock. The law says he’s still supposed to act otherwise prudently, but how exactly is he expected to comply with that duty?

Although some fiduciaries and their advisers might conclude that the exemption from diversification permits them to simply hold employer stock and forget about it, that seems insufficient in light of the exemption’s language. Bear in mind that the exemption doesn’t make single-stock concentration risk go away; it just says that a fiduciary can’t be successfully sued for not using diversification to mitigate it. Prudence still requires that the fiduciary do what he can to protect and enhance the value of the ESOP’s assets. As an example, many ESOPs hold substantial assets other than employer stock, usually designated as an “other investments” account or the like. Is the fiduciary’s responsibility satisfied by investing the assets in that account prudently, without regard to the existence of the employer stock account? Or should the “other investments” account be invested more conservatively to offset the excessive risk unavoidably present in the employer stock account?

Looking beyond investment policy, shouldn’t fiduciaries seek other ways to deal with the excessive risk of their single-stock portfolios? Before the enactment of ERISA, Louis Kelso, widely considered to be the inventor of the ESOP concept, envisioned that ESOP accounts would be protected by a government-sponsored insurance arrangement similar to the Pension Benefit Guaranty Corporation. Ultimately, ESOPs found their way into ERISA, but PBGC insurance was limited to defined benefit plans.

In recent years, some proposals have been advanced for insuring ESOP benefits through public or private insurance arrangements, but no such insurance is currently available. There is an available mechanism using risk-pooling, which has been successfully employed by individual investors, but it has attracted only limited interest among ESOP fiduciaries and sponsors. An unresolved question is the extent to which the residual prudence duty of the exemption language requires fiduciaries to explore these and possibly other alternatives for mitigating risk. It can be hoped that this question will be resolved by fiduciaries, plan sponsors and their advisers. Otherwise, it may be resolved for them by regulation, litigation, or legislation.

Jared Kaplan is the CEO of Delaware Place Advisory Services, LLC, a consulting firm he founded after his retirement in 2017 from the law firm of McDermott Will & Emery, where he headed the ESOP Practice Group. He is the co-author of Bloomberg Bureau of National Affairs (BNA) Tax Management Portfolio 354-9th, ESOPs (2017) and BNA Corporate Practice Portfolio 62-4th, ESOPs in Corporate Transactions (2018).