Brainstorms

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Enron and Extremes
by Stephen W. Philbrick

The Enron story has many threads, some of which may continue to unravel for years. Several of these threads are generally interesting to anyone involved in the financial world, but I'd like to concentrate on one issue of special interest to actuaries.

The issue is diversification of a personal financial portfolio. Some of the Enron stories have emphasized the high proportion of Enron stock held in employees' 401(k) plans. We've learned that employees at many other companies are making large allocations of their retirement funds in the stock of their own employer.

I need to defend why this is an issue of interest to actuaries, beyond their own personal planning. I anticipate more discussion of these issues throughout society, due to the continued growth of defined contribution benefit plans, and I believe actuaries can contribute meaningfully to the conversation. General actuarial training gives us a solid understanding of investment and financial issues that may not be second nature to many people.

Of all the stocks one might select in an investment portfolio, there is one that deserves special attention—the stock of one's own employer. Many employees are allocating a substantial portion of their 401(k) to employer stock. While it is understandable that the matching benefits provided by companies might be in the form of company stock, many employees are voluntarily selecting company stock for their own contributions. This result should be surprising to actuaries who have studied the mathematics of diversification. One of the rules of thumb in diversification of a portfolio is to limit the amount invested in any single stock to no more than 10 percent. More recent studies have suggested that this value may be too high, and a better rule of thumb may be as little as five percent.

I can think of several reasons why one might consider an allocation other than five percent. An employee may have feelings of loyalty or pride, or may feel that purchasing company stock is evidence of being a "team player." Pride and loyalty are good things (though probably deliver more value to the employer than to the employee). However, prudent financial planning for retirement should trump any financial decision based upon loyalty.

An employee might believe that working at the company provides more knowledge about the company than is available to the ordinary investor. While this is certainly true to a limited extent, it may well be illusory. If the employee truly has inside information, the law prohibits the employee from trading on it. In the more limited case, where the employee simply believes the stock is undervalued in the market, it is unlikely to justify increasing the allocation by more than a nominal amount.

Actuaries are well aware of the rationale underlying the diversification argument. A risk-averse investor is interested in avoiding the risk of a significant drop in wealth. Concentration of one's portfolio in a single stock increases that risk. The key point is that one should be concerned about one's total financial exposure, not simply the exposure of the investments in a particular 401(k). I suggest that the very act of working for an employer subjects one to financial risks that are likely to be highly correlated with the company's stock price. This is particularly true if one accepts that the overall correlation isn't the critical issue, but rather the correlation at the extremes. (If one is concerned about tail events, then one should be concerned more about correlation in the tail than in the center of the distribution.)

For example, a company struggling to meets its goals is likely to take actions that affect employees total financial exposure. These actions may include less generous raises for employees, smaller bonuses, fewer promotions, and could even include layoffs. Each of these actions has a financial impact on the employee. At the same time, the stock price may be under-performing. It might be an interesting exercise to model these results to solve for the implicit "allocation" that should be ascribed to one's employer. It seems likely that the financial exposure created by employment exceeds the rules of thumb for maximum exposure to a single company. At a minimum, this "thought experiment" suggests that the explicit exposure to the stock of one's employer should be evaluated in light of the implicit exposure created by employment.

Another reason for altering the allocation is created when company stock is available at a discount. Calculating the required discount to justify purchase of employee stock is not a trivial issue. I hope to address it in a future column.

Recent news stories on employee investment decisions have highlighted a need for better education of the public. I think actuaries can contribute.