Retirement

GE and the Risk of Company Stock

Investing in your company’s stock is nothing out of the ordinary. Many people invest in their employer’s stock without much thought. Being heavily invested in a single stock is risky no matter if you work there or not. There are several reasons why we do this and some pitfalls we should avoid.

Percentage of Retirement Plan Assets Invested in Stock of Employer

Source: Fortune

Familiarity Bias

Familiarity bias is our tendency to choose the things that are familiar, or well-known to us. This bias can be harmless in some areas of life, such as choosing the same restaurant over and over again, taking the same way home from work every day, or dating an ex (okay, this may be dangerous).

This bias is not as innocuous when it comes to your investments. It is one of many behavioral flaws that can hinder your investment decisions. Prudence says that you should diversify your investments. Familiarity bias leads people to do the opposite. They find safety in holding companies that they know well. This familiarity and false sense of security blinds them to the benefits of diversification. They think, “why would I hold 400 companies I don’t know when I can hold onto a few that I do?”

Familiarity bias can be especially strong when you work at the company that you’re invested in. The temptation only compounds the longer you work there. From the inside, you may think the company will never fail. I don't care how well you resonate with the core values, how good the product is, or how competent the leadership is, no company is immune to failure.

A study conducted by the Kaufman Foundation and Inc. Magazine looked at the 5,000 fastest growing companies in the US over a 5 to 8 year period. What they found surprised them: About two-thirds of these companies had either gone out of business, diminished in size, or sold at a reduced value. This risk isn't limited to small companies. If history has taught us anything, it’s that no company is too big to fail. Did you know that the average life expectancy of a Fortune 500 company has fallen from 75 years to about 15?

Everyone Else Is Doing It

When investing, we don’t only fight internal pressures, like familiarity bias, we fight external pressures too. I have spoken with many of my clients that have stock options through their employers. Most have mentioned feeling pressure to be heavily invested in their company’s equity. They fear that if they don't, they will be overlooked for promotions and ostracized by leadership. While some of this is only perceived, a lot of it is very real. I have some clients that were flat out told that this was true.

This is peer pressure at its worst. Employees should not be punished for being more risk averse than others. An employer should have no bearing on what an employee's portfolio looks like.

I understand that employers want employees to have a vested interest, but is it worth staking their livelihoods on it?

Danger, Will Robinson

You don’t have to go straight to Enron comparisons to see the dangers of being heavily invested in a company’s stock. A company doesn't have to go belly up to ruin someone's retirement. Individual companies go through regular periods of significant volatility. Just ask Gary Zabroski. Gary worked for GE for over 40 years and is now looking for a new job when he thought he would be retiring. He, and others like him, have seen the GE stock price go from $29.80 on January 1, 2017 to $11.53 as of September 27, 2018 (that’s over a 60% drop).

Conclusion

A company stock plan can be a way to increase employee engagement and create a vested interest in the company’s success, but internal and external pressures can lead people to making very unwise investment choices. Most people should not have more than 5 or 10% of their portfolio invested in the stock of their employer. The company that made you could just as easily be the company that breaks you.

 

 

Further Reading

How About Now? - The Irrelevant Investor

What GE’s Board Could Have Done Differently - Harvard Business Review

Having Too Much Employer Stock in Your 401(k) Is Dangerous. Just Look at GE - Fortune

When Workers are Owners - The Economist

 

My Reaction to the Kentucky Pension Crisis

On Monday night, my wife and I watched Kentucky governor Matt Bevin conduct a Q&A on the state's pension crisis. I know what you're thinking, "what a perfect date night!" Before you judge, my wife is a Kentucky public school teacher and I'm a financial planner, so our interests were both piqued. 

Before I get into my thoughts, a quick background on the pension crisis:

Pension Crisis Background

Who does this impact?

There are eight different pension plans in question, covering about 500,000 people in total (Courier Journal):

  • Kentucky Employees Retirement Systems (KERS)- This consists of two plans:
    • Hazardous
    • Non Hazardous
  • County Employees Retirement Systems (CERS)- This also consists of:
    • Hazardous
    • Non-Hazardous
  • State Police Retirement System (SPRS)- This system and the two above are administered under Kentucky Retirement Systems (KRS).
  • Teachers Retirement System (TRS)
  • Kentucky Judicial Form Retirement System (KJFRS)- This system covers:
    • Judges
    • Legislators

How bad is it?

Standard & Poor's, the world's leading credit rating agency, ranked KY as the worst funded pension system in the United States.  The current pension debt is at $33 billion, but could be as high as $64 billion according to the Bevin administration. Kentucky's pension plans will run out of money if nothing is done to help fix the ailing system. Some are even projected to fail by 2022 (via PFM Consulting Group).

How did it get this bad?

There are three primary reasons for the current state of KY's pensions:

  1. The plans have not been adequately funded. This didn't happen overnight. Over the course of the past two decades, state legislators have failed to sufficiently fund the pension systems.
  2. Poor investment decisions and assumptions. The government actuaries overestimated the future return on their investments. As I look over the list of investments in the plan (you can see a list of them here), I see that many of them are very expensive. Some of the managers on the investments are charging 2 to 2.5% with added "performance" fees on top! With the emergence of low-cost mutual funds and ETFs, there is no reason to be in such expensive funds.
  3. An aging population base. KY retirees are living longer and there are less new hires to replace them than expected. This is leading to fewer people paying into the system to support older retirees. We're seeing a similar problem with Social Security.

Where Do We Go From Here?

The government has three main courses of action: (1) Cut spending, (2) Increase taxes, or (3) Adjust benefits. Most of the backlash has come from the last one.

The government contracted Public Financial Management (PFM) Consulting Group to recommend potential solutions for adjusting benefits. They came up with the following suggestions(see the full report here). I'll give the recommendation from PFM, followed by my thoughts on each- for what they're worth:

  1. Changes to Actuarial Assumptions
    • First, they recommend a more aggressive payment structure. Up till now, we have made payments that allow the debt balance to continue to grow. Think of it like paying only the minimum due on your credit card- you're good for this month, but your debt balance grows.
    • Second, they recommend adopting more realistic investment return assumptions going forward.
    • Both of these are no-brainers and should have been implemented a long time ago. PFM projected the 2019 impact of these two changes alone at over $1.8 billion.
  2. Benefit Changes
    • PFM recommends that all non-hazardous service (including teachers, judges, and legislators) pension systems use a 401(k) plan instead of a pension. Hazardous service plans (including State Police) would keep their pensions.
    • New non-hazardous service hires would go straight into a new 401(k) plan. This would also make teachers in the 401(k) plan eligible for Social Security benefits.
    • Current plan participants would have their current pension frozen and offered a buyout option. Teachers, however, would continue their pension plan if they are already enrolled.
    • They recommend increasing the retirement age for all pension participants not yet retired. This would be 60 for hazardous members and 65 for non-hazardous. They also recommend suspending Cost of Living Adjustments (COLAs) for retirees until the plan is 90% funded.
    • These benefit changes are the most controversial of their recommendations. The addition of the 401(k) is "on par" with the current times as pension plans have been on a steady decline over the past 25 years. The increase of the normal retirement age will be quite unpopular. No one likes to be told that they have to work longer, but the current ages are unsustainable. With people living longer and longer, some current early-retirees spend more time in retirement than they did working! No system would be able to sustain that indefinitely. These major overhauls should be a last resort, but some may be inevitable.
  3. Funding Changes
    • They recommend that the required plan contributions be based on a given formula. This amount should also be reflected in the state budget. This is to ensure that future contributions are not up to subjective changes.
    • They also mention shifting some costs to local school boards, such as Social Security.
    • I agree with the top two, but it's hard to know where I stand on the third one without knowing the true impact on local school boards.
  4. Investment Practices and Approach
    • PFM recommends consolidation of the KRS and the TRS plan assets (everyone except the legislators and judges). They used the Indiana Public Retirement System as an example. With this consolidation, PFM claims they could save up to $5 million per year. They could save on investment costs, staffing overhead, and have greater coordination among plans.
    • On paper, this makes sense. Not sure why they excluded the legislators and judges here though. This is a very general recommendation and would be a giant change with many minute details to account for. But, if they could make it happen without undue burden, it could be a good thing.

Conclusion

In summary, we have a big problem in Kentucky. The current path we are on is not sustainable and changes have to be made. Participants, legislators, and employers must communicate to come to a satisfactory resolution.

To participants- Educate yourselves! Pour over the reports (linked below). Come up with your own informed opinions and let your legislators know how you feel!

 

Resources

PFM Pension Crisis Recommendations

ALL PFM Consulting Reports

Latest News and Updates

What To Do With an Inherited IRA

What is it?

An Inherited IRA, also called a Beneficiary IRA, is simply a retirement account that has been passed along from a deceased individual to another person.

What can you do with it?

In regard to contributions, you cannot make any additional contributions to the account. In regard to withdrawals, you have several options. If you are the spouse of the decedent, you can just assume the IRA as your own, but if you are a non-spouse beneficiary, you have several options.

You Have 4 Options:

  1. Open an Inherited IRA: This is often called a Stretch IRA. With this option, you can keep it in a retirement account and continue to defer paying taxes on the account for your lifetime. You will, however, be subject to annual Required Minimum Distributions (RMDs). The required distribution amount will be a factor of your life expectancy. You can calculate this required distribution here.
  2. 5-Year Option: With this option, you can elect to receive the entirety of the account over a 5-year period. During this 5-year window, you can withdraw the funds however you like, without penalty, as long as the account is empty by the end of the period. Each distribution is considered taxable income.
  3. Lump-Sum Option: You can elect to receive the entirety of the account at once. The whole distribution will be counted as taxable income in the year you receive it. With this option you may end up with a sizable tax bill, plus you will be forgoing the benefit of tax-deferred investing.
  4. Disclaim It: You actually have the right to refuse to accept an inheritance. When you do this, your portion of the inheritance will be distributed among the other primary or contingent beneficiaries. You will have zero say over what happens to the funds with this route. You generally have 9 months from the original owner's date of death to make this decision. It is important to consult with your attorney if you decide to go this route to ensure that you are meeting all legal requirements.

Which Option is Best?

There are many factors to consider when making your decision and some options may make sense in some situations, but not in others. Generally speaking, for a young individual, keeping the money in an IRA can be a powerful benefit over the long-term. Keep in mind this hypothetical example from Charles Schwab:

When six-year-old Tara inherited a $30,000 IRA from her grandfather, her parents decided to open an Inherited IRA with the money. By doing so, and by limiting Tara’s annual withdrawals (RMDs) to the minimum amount required, they ensured that the majority of her legacy had the potential to grow tax-deferred for decades. If the account earns 8% annually and Tara withdraws the required minimum amount over her 82-year life expectancy for 76 years, her grandfather’s initial $30,000 legacy could turn into a cumulative inheritance of $2.1 million.

How Should You Invest It?

When making any investment, you always have to keep in mind your time horizon and your tolerance for risk. Your time horizon lets you know how much risk you can afford to take on (your risk capacity), and your risk tolerance is completely unique to you. 

There is a caveat with inherited accounts that change things a little bit: the RMDs. Depending on your age, the annual required distributions can start getting quite large. When you're young they're relatively small in relation to the value of the account, but as you approach your own retirement, they grow. The reason this is an important factor to consider is because with other tax-deferred retirement accounts, you don't have to worry about taking money out until you retire or age 70½, but with an inherited account, you don't have a choice. 

You should structure your investments in a way that allows you to account for you annual distributions.

Conclusion

Inherited retirement accounts can be a tricky mix of tax, estate and investment planning and your decision should not be taken lightly. Before you act, you should carefully consider your options and make an informed decision.

Resources

https://www.irs.gov/publications/p590b/ch01.html

http://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/inherited_ira