The Right to Choose
| "You have brains in your head and feet in your shoes, you can steer yourself in any direction you choose." |
| -- Dr. Seuss |
NRON'S COLLAPSE WAS A MAJOR BLOW TO many investors’ financial health. Urged on by Enron’s management and fawning analysts, Enron was one of the most widely held stocks in the U.S.
Hardest hit were employees of the company who saw their retirement nest eggs disappear along with Enron. Like many companies, Enron offered company stock as a 401(k) investment option. In addition, company-matching contributions were also made in stock. Following the bankruptcy filing, the stock lost its value and so did the 401(k).
If anything positive can come of this, it will be real reforms in retirement plan regulation. Unfortunately, for this to happen, it literally has to be an act of Congress -- always a frightening proposition. Congressmen often (usually, always?) do what’s most politically expedient rather than what makes the most economic sense.
While it’s clear changes are necessary to protect workers’ hard-earned retirement savings from the next Enron, it isn’t so obvious what those changes need to be.
The Issues
All tax-deferred retirement plans are covered by ERISA. Contrary to popular belief, this doesn’t stand for Every Ridiculous Idea Since Adam, but rather the Employee Retirement Income Security Act of 1974. It stipulates the rules and regulations employers and their plans must follow in order to qualify for favorable tax treatment.One of the major tenets of the act is the fact that employers and others who handle plan assets are fiduciaries and as such, must act solely for the benefit of the employee participants.
...when an employee’s retirement savings become concentrated in one stock -- any stock -- the risk level dramatically increases. |
One of the chief means of achieving this balance is to diversify the portfolio. Modern Portfolio Theory has demonstrated that combinations of risky assets can actually produce higher returns with lower risk than concentrated holdings.
To this end, most employers let their participating employees choose from a menu of mutual funds. Funds by their very nature are diversified and if the employee mixes different types of stock and bond funds, the benefits of diversification are increased.
On the other hand, when an employee’s retirement savings become concentrated in one stock -- any stock -- the risk level dramatically increases. Certain features in 401(k) plan design can lead to this result and it’s here that reform could help.
What’s Not a Problem
ERISA allows both pension and 401(k) plans to hold employer stock. Pension plans are limited to 20%, but there’s no limit for 401(k)s. On the face of it, it might appear similar limits would be appropriate for both types of plans.But that’s not the case. The employer has full responsibility for pensions. If plan assets fail to meet required levels, the employer has to kick in the difference. In essence, the employer is bearing the risk for any stock concentration
The only reason ERISA imposes a single stock limit on pensions because the Pension Benefit Guaranty Corporation (PBGC) insures this type of plan.
Given that 401(k)s put the investment responsibility on the employees, anything that limits their ability to choose their own investments isn’t a good thing.ecisions now can save you from taxes in the future. |
There’s no insurance for 401(k)s where employees are responsible for their investment selections. If an employee wants to invest solely in his or her company stock -- as many Enron employees did -- he or she bears all the risk. There’s nothing wrong with that.
Neither is there anything wrong with employers contributing their own stock on behalf of the employees. Many companies match a percentage of employee contributions. Some do this with company stock rather than cash. This benefits the employer since it doesn’t affect cash flow while fostering an ownership interest and loyalty in the employees.
Unfortunately, some of the proposals currently before Congress seek to impose similar limits on 401(k)s as apply to pensions. If enacted, many employers would cut back if not totally eliminate matching contributions. This is certainly not in the employees’ best interest.
In fact, given that 401(k)s put the investment responsibility on the employees, anything that limits their ability to choose their own investments isn’t a good thing. If the employer contributes company stock and the participant chooses to hold it, he or she should be able to do so, regardless of the concentration.
The Real Problem
Along these same lines, there is a provision that could stand to be modified. Many companies that match with stock require participants to hold the match at least until reaching age 50 or 55. Enron had such a restriction. This is contradictory to both ERISA and the 401(k)’s assignment of investment responsibility.As we’ve seen, ERISA promotes prudent investment and diversification. If an employee is barred for selling any asset, his or her ability to diversify is limited. If the employee
chooses to hold matching contributions in stock that’s one thing, but if he or she is forced to, that’s another.
And that’s the real problem: 401(k)s make the participant responsible for investment performance. Along with this, they should be free to make their own investment decisions. Restrictions on the ability to sell any holding fly in the face of this fundamental relation.
Plan sponsors and their lobbyists argue that allowing employees to sell matching stock would add volatility to the shares. That’s probably right, but not an insurmountable problem. For example, holding restrictions could be reduced to 3-6 months. Employees would still be able to sell, but this would stagger the timing, reducing volatility.
Alternately, participants could be given the choice of receiving their match in cash or stock. Higher values in stock could be offered to at least partially offset its higher risk and holding restriction.
Regardless of the ultimate solution, the restriction on holding employer stock is the only provision that needs work. The rest aren’t broken, so shouldn’t be fixed. It’s just that simple.
As investors, we really don’t care what politicians, regulators, and company executives knew. You can’t trade on that. What’s more intriguing is what Wall Street and analysts knew and when they knew it.
Looking back with 20-20 hindsight, the sad story is this: As Enron imploded, most sell-side analysts were still touting the stock as a buy if not a strong buy. What’s up with that?
Supposedly these are the folks that are out scrutinizing companies to ascertain their worth. Their recommendations are the culminations of extensive research and valuation. Brokerage firms pay them exorbitant salaries for this complex and detailed analysis. So what happened?
Not surprisingly, analysts would have a tight consensus of estimates. Equally unsurprising was the fact that actual earnings would usually fall quite close to the consensus. Unsuspecting
In late 2000, the SEC began enforcing a new regulation barring corporate management from issuing statements to select groups without making the same information available to the general public.
Regulation FD ("Fair Disclosure") went into effect over a firestorm of protests from sell-side analysts. According to them, any limitation on their access to corporate management would only increase volatility.
We never bought this argument. Back in November 2000 right before the introduction of Reg. FD, in Why Regulation FD is a BFD we wrote:
Sometimes it’s not good to be right. Unfortunately the Enron situation demonstrated our prescience.
You might have thought that after the introduction of Reg. FD, analysts would have been more
Right up until Enron’s final weeks, sell-side analysts continued to tout the stock. They were as oblivious to the impending collapse as the average Joe on the street.
We would submit that prior to the introduction of Reg. FD, sell-side analysts had grown so complacent with their inside relationship with corporate management that the fine art of company analysis was lost. Enron only brought this to a head.
If we were wrong about anything back in 2000 it was in regard to market volatility. We questioned Wall Street’s assertion that Reg. FD would make the markets more volatile. After all, without management’s specific guidance, we argued analysts would be less precise resulting in a wider range of expectations. It would be easier for actual earnings to fall within the expected range, thus reducing volatility.
This hasn’t come to pass, primarily because analysts haven’t widened their range of estimates. Rather than being the result of their remarkable consensus, we suspect it’s because they simply follow one another. When actual earnings fail to meet the consensus estimate, analysts fall all over one anther to downgrade the stock, increasing volatility.
Our mistake -- like that of those following the analysts covering Enron -- was believing analysts would or could actually do their job. If we take nothing else away from the Enron collapse, it should be that the introduction of Reg. FD has finally removed any semblance of relevance still associated with sell-side analysts. They aren’t worth the paper their reports are printed on.
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"Everyone rises to their level of incompetence." -- Laurence J. Peter
HE FINGER POINTING HAS STARTED IN earnest. What did politicians, regulators, and company executives know and when did they know it? The Enron debacle will be with us for quite some time.
The Emperor’s New Clothes
Up until the latter part of 2000, analysts were spoon-fed information from corporate management. Companies would schedule a meeting or conference call open only to analysts where they’d “guide” them to the current quarter or year’s expectations. The next day, participating analysts would issue reports parroting this information.
investors would mistakenly believe analysts were remarkably accurate when in reality they were no more than shills for management.
You might have thought that after the introduction of Reg. FD, analysts would have been more vigilant in reviewing company financials.
[I]t's our contention that if analysts were doing their jobs -- the jobs they're being so dearly paid to do -- preferential treatment wouldn't be necessary. Why? Because they'd already know the scoop before management gives it to them…If forced to do what they've been claiming to do all along, it won't take long for investors -- their customers -- to find the truth about the emperor's new clothes.
Nothing Like Competence
Enron’s management was never known for its openness. As more details of their deception filter out, it becomes more and more obvious why. Crack sell-side analysts never picked up on this, in fact they didn’t really know how to handle Enron given they were so used to having such an intimate relationship with management.
vigilant in reviewing company financials. In the case of Enron, you’d be wrong.
Our mistake was believing analysts would or could actually do their job.
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